INVEST IN PRODUCTS & SERVICES

Even our feeble-minded caveman ancestors were clever enough to limit their investments to well-understood tools... like a club or stone axe-- and seldom ventured very far beyond unfamiliar territory to avoid unfamiliar predators. You too should be wise to the advantages of investing only in companies whose products and services you understand and in markets you are intimately familiar with.

Quite often, we regionalize our investments. We think we know and understand the local industry and the company where we work. Investors from Arkansas invest in Wal-Mart. Californians buy Silicon Valley stocks. Seattle residents feel comfortable with Microsoft, Boeing or Starbucks; Texans invest in the oil industry. New Yorkers feel they know the media and advertising industry. What is amazing is the number of Asian investors who seek out all these USA stocks on the other side of the planet!

However, you don't want to invest in auto manufacturers just because you drive a car or because you live in Detroit (or Thailand and China where many auto parts are manufactured today). Nor should Floridians buy Disney or orange juice makers, or Singaporeans buy Singapore Airlines just because they fly to Hong Kong once a year. It's more than just knowing something about the company that you're investing in and the products those companies make or the services those companies provide. You also need to know that the stock you're buying is an excellent value and that the company is part of a growing industry.

A good test is to ask yourself if you could explain your investments to a ten-year-old. That may help you determine whether or not you really know what you own.

The wild swings in share prices are really your friend. Be careful of groupthink that is so prevalent in the stock market. Warren often quote his teacher Ben Graham as saying, 'You are neither right nor wrong because the crowd agrees or disagrees with you. You are right if your principles, research, date, future projections, and reasoning are right.'

The major university head librarian who said about Buffett, 'You know, Warren is a great future investor,' meant that he is able to predict the future stream of earnings of a business and industry and buy it at a discount to its real value for the long term.

All investors must look into the future. In 1979 in Forbes magazine, Warren said, 'The future is never clear. You pay a very high price in the stock market for a cheery concensus. Uncertainty is the friend of the buyer of long-term values.' Buying when everyone is selling and selling when everyone is buying is the old adage on how to make money in the stock market, but that's easier said than done. However, if you know what you own and understand why it is such an excellent value, then you position yourself to take natural advantage of the adage.

Learning to understand what you own is a matter of learning to ask the right questions of the right people. Remember the story of the fellow standing next to a dog and a stranger approached and asked, 'Does your dog bite?' The fellow said, 'No,' so the stranger reached down and petted the dog and the dog bit him! Alarmed, the stranger said, 'I thought you said your dog doesn't bite.' The man said, 'Well, that's not my dog.' The moral of the story is to know to ask the right questions to the right people in order to truly understand.

Berkshire's largest investment of a partly owned business or stock is Coca-Cola, and it provides an excellent example of knowing what you own. As a young lad Buffett sold bottles of Coke door to door in his neighborhood, and as a teenager he was in the vending machine business with his pinball machines, but he didn't rely entirely on these early experiences to understand his billion-dollar investment.

For all of his early years and most of his adult life, Warren drank Pepsi-Cola, some say even that at one time if you cut his vein, Pepsi would come out instead of blood. So he personally understood the competition.

Next he read everything he could about The Coca-Cola Company: how it was founded, grew, and expanded, and its market share, international expansion, and management. Like GEICO thirty-five years earlier, Buffett could have written an extensive stock analyst's report of the security he likes best: Coca-Cola. After careful and thorough reading and research, he noted that Coke's management was buying back its own shares. The last thing he wanted to do was tip his hat and let management know he was interested in buying. So he quitely purchased $1 billion of the stock.

Like the average investor, Warren had no exclusive or insider information. Unlike the average investor, he studied and understood what he was buying. The soft-drink beverage business is not a very difficult business to know. Figuring out when it is selling at an excellent value compared to its future earnings is the genius part.

Coca-Cola earned 42 cents per share in 1989, so Berkshire paid 15.5 times what it was then earning with an average price of $6.50. Book value was $1.18 per share, so it paid 5.5 times book. Buffett was paid back with actual net earnings in 9 years, nearly one half of the projected earnings payback time. Meanwhile, book value has quadrupled, the stock price has climbed 7-times, Coke earns 3-times more than when it was first purchased, and management continues to buy back its shares (10% since Buffett's purchase), which gives the shareholders in essence a nontax dividend making the remaining 90% of shares more valuable.

Today Coke sells over 1 billion servings (out of a total of 50 billion) a day and continues to enjoy worldwide leadership of the soft-drink beverage industry. So with just 2% of the world market, Coke has enormous growth opportunities ahead.

This type of analysis is all very easy to do in hindsight and over a decade later. The difficulty is being able to see the wonderful investment opportunity in advance, which is what makes Warren Buffett's talent so profound.

Notice how patient Buffett is and hos thoroughly he understands what he is doing. A half-century after he was selling Coke door to door and more than a century after it was first formulated, he made a substantial purchase.

The husband of famed author and mystery writer Agatha Cristie was an archaeologist. 'That was the best occupation for a husband,' said Agatha, 'because the older things get, the more interested he becomes.' Warren invests like an archaeologist-- the older things become, the more interested he is.

Sage@wallstraits.com


Credits: Much of this article (with modifications) is extracted from Ch. 5 of Warren Buffett Wealth by Robert Miles, 2004.

Article excerpted from http://articles.wallstraits.net/articles/1358