Thread by @tycoonmindset05

Warren buffet & Charlie Munger's wisdom on

- Estimation of Intrinsic value of a business
- Book value & Intrinsic value
- How to read the annual report
- Allocation of capital
- Diversification

A Long thread 🧵👇

How to estimate value of a business

Warren - Evaluate the stream of cash over all of the years in the future discounted back at an appropriate interest rate.

- There is a lot more to intrinsic value than book value or P/E ratio and if anybody gives you the simplified formula for figuring out, forget it. A person needs to understand the business well, the mgt., over the years.

- People have made mistakes in the past in valuing Berkshire by looking at it by simply a break up of their businesses. The business should not be looked at, what would happen if they sold each division today ; looking at a static basis.

- For eg. People who didn’t understand coca cola and used the mechanistic methods of valuation could take precedence and really misjudged the value of the coca cola.

- A great company is a company which remains great for 30 years. If it is going to be great for 3 years then it is not a great company

- We do not think that we have the great ability to predict where the change is going to be, we think we have some ability to find business where we don’t think the change is not going to be important

- We focus on general models not the specific models and plug them in, sometimes the ideas are generated and sometimes it doesn't.

- If you focus you do see repetition of certain business patterns and behavior and wall street tends to ignore those. we assume that we will be around forever. Other businesses don't have the same horizon on this thing.

Book value in comparison with intrinsic value

Warren - Book value is used as a proxy in tracking movement of intrinsic value but it doesn’t represent anything like intrinsic value per share. Intrinsic value is materially higher than the book value.

- Berkshire is a group of fine businesses. The intrinsic value will be affected by the job done in allocating capital, job done by the managers in running the businesses, some items which cant be foreseen now and perhaps have no control over.

- You cannot go from year to year and trace the intrinsic value precisely with the changes in book value. Book value changes can be used as a rough guide for the movement of intrinsic value.

- Book value and multiplying it with a multiple and coming up with a precise number is not right for calculating intrinsic value.

Discount rates used

Warren – We use long term government rate but we don’t put the risk factor in per se because the idea is that you’re discounting future cash flow and it doesn’t make any difference whether cash comes from a risky business or the so called safe business.

- The value of the cash delivered by the water company which is going to be around for a hundred years is not different than the value of the cash derived from some high-tech company that you might be looking.

- It may be higher for you to make the estimate and you may therefore want a bigger discount rate when you get all through with the calculation but up to the point which you are willing to pay you may decide you can't estimate it at all.

- We believe in trying to stick with businesses that where we think we can see the future reasonably well. I don’t think you can stick some numbers on a highly speculative business where the whole industry is going to change in 5 years.

- It won't mean anything when you stick extra six percent on the interest rate to allow the risk factor, I tend to think that’s kind of nonsense. It's mathematical gibberish.

- Stick with the businesses that you can understand and use the government bond rate and when you can buy them something which you can understand well with a significant discount then you should start getting excited.

On Ridiculous valuation

Warren - we don't pay much attention to that. throughout there have been thousands of cases where things are ridiculously priced. That will always go on. We are not predicting the market, we are trying to find wonderful businesses.

- We have tried shorting the obvious fraud and we have not made money over that. we don't look at the indices from stocks in general or from p/e or price sales ratio. We really just focus on businesses. we don't care if there is a stock market.

- We care about what the business does.
You just have to stay away from doing something foolish. it’s little like investing, you don't have to do anything smart, you just have to avoid doing things that are ungodly dumb when looked at about a year later

How Warren buffet reads the annual report

Warren – I like to know as much as I can about the person who is running it and how they think about the business and what’s really going on the business.

- I would like to have the report that would be identical to what if I owned half of a company but was away for a year and I had a partner who on the other hand & when I came back that he would tell me about what had taken place during the past year & what he foresaw coming up.

- I like to understand generally what’s going on in all kinds of businesses if we own stock in a company in an industry and if there are eight other companies that are in the same industry, I want to be on the mailing list for the reports for the other eight.

You just have to stay away from doing something foolish. it’s little like investing, you dont have to do anything smart, you just have to avoid doing things that are ungodly dumb when looked at about a year later

How Warren buffett reads the annual report

Warren – I like to know as much as I can about the person who is running it and how they think about the business and what’s really going on the business .

- I would like to have the report that would be identical to what if I owned half of a company but was away for a year and I had a partner who on the other hand and when I came back that he would tell me about what had taken place during the past year & what he foresaw coming up.

- I like to understand generally what’s going on in all kinds of businesses if we own stock in a company in an industry and there are eight other companies that are in the same industry, I want to be on the mailing list for the reports for the other eight.

- I want to have the perspective in terms of market share, what's going on in the business or their margins or their trend. I can’t be an intelligent owner of the business unless I know what other businesses are doing so I try to get information out of the report.

- If I am thinking in the specific company, I try to size up their business and the people that are running it.
You can't read brokerage reports and get anything out of it, you have to research it yourself and get your arms around it.

- The way you learn about business is by absorbing information about it, thinking it, deciding what counts and what doesn’t. relating one thing to another and you can't get that by looking at a bunch of little numbers on the chart.

On diversification

Warren - Diversification as practiced generally makes very little sense for anyone that knows what they are doing. Diversification is a protection against ignorance. There is nothing wrong with that.

- That is a perfectly sound approach for somebody who does not know how to analyze business. If you know how to analyze businesses and value businesses, it’s crazy to own 40 or 30 stocks.

- There simply aren’t that many wonderful businesses that are understandable to a single human being in all likelihood. It might protect your job but it’s a confession that you don’t understand the business that you own.

- In Berkshire I could pick out three of our businesses and I would be very happy if they were the only businesses we owned but I love that we find more great businesses and we keep adding to it but three wonderful businesses is more than you need in this life to do very well.

- Fortunes were not built out of the portfolio of 50 different companies, they were built by identified with a wonderful business. A very wonderful business is protected against the vicissitudes of the economy over time.

- There is less risk in owning 3 easy to identify businesses than owning 50 well known big businesses.

Repurchase of shares

Warren - Willingness to repurchase the share by the management. If mgt is repurchasing share above rationally calculated intrinsic value then you are harming the shareholders.

- The Berkshire favors, when business is wonderful, using funds to make the business even more wonderful & repurchasing shares if those shares are below intrinsic value.

- To decide the intrinsic value in case of repurchases, don’t think in terms of book value, in terms of specific p/e, or don’t think in terms of any little model. But think in terms of what would you really pay to be in those businesses & pick only those which you can understand

Allocation of capital

Warren - It's much tougher for Berkshire to manage 17 billions than 17 million. allocation of capital is a constant challenge.

- The inflow of money and the outflow of money shouldn’t be attempted to be matched because you get investment in business opportunity at times that differ from the times that funds come in.

- One of the most important disciplines in running a business or managing investments is that is to not try to coordinate your actions simply with the availability of cash.

- If you have got a lot of capital you will do something, you might like to do something smart but if need be you do something dumb, you will rationalize it but you will do it. People don’t like to sit around and do nothing all day.

- If you feel you have to invest everyday you are gonna make a lot of mistakes, you have to wait till you get the fat pitch.

On Banking industry

Warren - It is a little hard to have any secret formulas. In banking business, anything you do your competitors can copy. Nevertheless there is an advantage in being first and learning more about the distribution methods. But such advantages can be copied.

- When business decline due to shift in trends
Charlie – we don’t have any ways of avoiding declines in some of our businesses some of the time. Blue chip stamps once sold $120 millions a year now it's about $200k per year.

Warren - Through electronic means, you can deliver information at cost far far less. The world would be adjusting to that. It is very unlikely that Charlie and I are going to be smarter than the rest of the world in terms of the electronic world.

- We are looking at it as something which is obvious and something which in our capability of doing something about. We are not trying to beat people at their own game where we’re not good at.

On insurance float

Warren - Insurance business provides us with float. Float Is money we hold that doesn’t belong to us, it’s like a bank having deposits. A bank has a deposit that money doesn’t belong to, there is an explicit cost and an interest rate attached to it.

- In the insurance business, you don’t really know the cost of the float is until all your policies are settled so you are only making estimates of the cost of the float. Berkshire being 29 years in this business, it appears that our float has not cost us anything on average.

- This float has not been fully appreciated in connection with Berkshire. People have not paid attention to the liability side. Charlie and I have paid a lot of attention to the liability side.

- Float per se is not a blessing, the job is to get it and to get it in increasing quantities and above all to get it cheap. And you can do that in a business by having some kind of competitive advantages.

- We have 7 billion float. If I would trade 7 billion dollars for this float but I would have to stay out of the insurance business forever. I wouldn’t have accepted the trade coz I would rather have 7 billion float than 7 billion of free money because I expect the float to grow

On good management

Warren - The really good business is one that doesn’t require good management, I mean that’s a terrific business and the poor business is one that can only succeed or even survive with great management.

- We look for people that know their businesses, love their businesses, love their shareholders, want to treat them as partners and we still look to the underlying businesses.

- So if we have somebody that we think is extraordinary but they’re locked into one of those terrible businesses and the best thing you can do probably is get out of it. We try to figure out what their attitude is towards their shareholders and that it isn’t uniform.

On gillette’s moat
Warren – In the case of Gillette, it is going to expend many multiples of money in developing the better shaving system, they have got the distribution system, they have got the believability.

- If they bring out a product for men then men look at it and the same thing happens to women in the shaving field. Those are assets that can be built and are very hard to destroy. It helps to predict the next 10-20 years.

- I don’t want to bet on anyone else, in the end we want to understand ourselves where we think where the business is going.

On selling a good business

Warren - it's hard to find good business thus while selling any good business you gotta ask whether you are going to get a chance to buy back the same business at a lower price or am I going to buy something that is almost as good at a lower price.