Warren Buffett part 7 Risk

 Many academics and market participants measure the risk of investments by volatility, which indicates the strength of the price fluctuation of a financial instrument over a certain period of time and measures the uncertainty of the price fluctuation of the instrument, i.e. risk. Relative fluctuations indicate the risk of a stock. The more the value of an investment fluctuates, the riskier it is, according to theorists. Buffett and Munger define risk differently. For them, risk means the reasonable probability that an investment will produce a decrease in purchasing power.

Buffett has often quoted Benjamin Graham, saying that “in the short run, the market is a voting machine and in the long run, a measuring machine.” Price fluctuations describe the voting machine, but in the long run, the market follows the measuring machine, i.e. the success of the business. When an investor focuses on investing for the long term, he can forget about volatility and focus on making sure that he pays less for his investments than the present value of their future cash flows. Taking advantage of short-term price fluctuations by buying stocks at a lower price when prices are fluctuating downwards reduces long-term risks, as long as the investor does their homework and does not invest money they cannot afford to lose.

It is foolish to claim that buying a stock for a long-term investment today for 30 euros is less risky than buying it for 20 tomorrow if nothing has happened to the company's business or new information has emerged. In individual cases, anything can go wrong. The law of large numbers states that the relative accuracy of a hit should be the same as the probability of an event when samples are taken infinitely. Many investment decisions when the probabilities are on the investor's side will eventually show up as increasing returns for the investor.

An investor must evaluate probabilities through many possible outcomes, even if only one of them comes true. Estimates must be made based on the information at the time. When investing, probabilities are always relative estimates of the person making the investment. Probabilities change as investors gain new information. Every investment decision you make is based on estimates of probabilities, whether you calculate them or not. Using them, you can calculate the mathematical expected value of your investment's return. The simplest mathematical formula for expected value is as follows:

Expected value = probability of profit * its magnitude - probability of loss * its magnitude

Calculating probabilities is a more complicated process for investors, because in reality the magnitudes and probabilities of losses and profits vary more. According to Buffett, the most important factors when calculating probabilities are:

1. The probability with which the investor can assess the long-term financial development of the business.

2. The probability with which the investor can assess the ability of the management to exploit the opportunities offered by the business and to use the money circulating in it wisely.

3. The probability with which the management will distribute the rewards generated by the business to the owners instead of to itself.

4. The price paid for the business.

5. Much of the change in the investor's purchasing power from gross proceeds is reduced by taxation and inflation.

In the stock market, investors make a large number of decisions, all of which involve risk. Everyone must accept the risks and act accordingly. The best way to prepare for risk is to only invest money that you can afford to lose. In addition, focusing on long-term results reduces risk, because volatility reduces the probability of returns in the short term, but buying at a lower price increases the probability of returns in the long term with volatility. You can use the following chain of thought to reduce risk:

1. First calculate the probabilities

2. Wait for the best probabilities

3. Adapt to new information

4. Decide on the amount of money to invest

When calculating probabilities, the primary consideration is how likely this investment is to yield you more than alternative “risk-free” investments, such as long-term US government bonds or continuous savings in low-cost index funds. The less you can pay for a share compared to the present value of the probable future cash flows you have calculated, the more likely you are to succeed in your investment. In other words, the larger the safety margin, the better the opportunities and the lower the risks. The more uncertain your situation is, the larger the safety margin you need.

You will have to wait most of the time for the best opportunities, so you will get new information before making any potential investments. You will have to make new calculations about probabilities. You will have to answer the following questions, among others: Has something new happened to the company's competitiveness or its industry? Has the company's management started to behave differently towards the owners or has the management changed? Has its financial situation changed, etc. Probabilities change with the changes and you need to react to the changes.

Deciding on the amount of money to invest is an important part of the investment decision. The more the probabilities are on your side, the larger the amount of money you should invest. You will have to determine how much of your investable capital you will put into the investment. Your biggest risk is investing too much in a single target. This is a result of incorrectly assessed probabilities. You also have to deal with whether and how much leverage you should use. It can destroy your returns in the long run if you have to sell your investments too early because of your creditors. Leverage should always be used in a way that doesn’t destroy long-term investment opportunities. Good opportunities don’t come along often, so smart investors bet big when the odds are in their favor and wait it out otherwise.

Warren Buffett part 6 Managers

Buffett has often said, “When a good manager and a bad business meet, the reputation of the bad business remains, but the reputation of the good manager goes.” Finding a sustainable competitive advantage for the business is always more important to Buffett than that of good managers. The latter come in handy for him. The most important individual in a company is the CEO. He must always prioritize the interests of the company. His ego must not demand much higher rewards even when his earnings are sufficient. The CEO must constantly fight against arrogance, bureaucracy and complacency, because they are the worst enemies of business.

A good manager has three special characteristics:

1. Reasonableness

2. Owner-friendliness

3. The ability to resist conformity, i.e. following others

The most important task of a manager is to allocate capital. Many CEOs fail Buffett in this task because they do not have enough experience in it before being elected as CEOs. This lack makes many fail even when the quality of the business is high. Capital allocation can be done in the following ways:

1. Investing in current operations

2. Repurchasing own shares

3. Paying dividends

4. Acquisitions

5. Paying off debts

The above allocation methods are not mutually exclusive. Many companies allocate their capital in all ways. The differences in their emphasis depend partly on where in the company's life cycle they are. In the development phase, the company loses money, so all the money goes to improving current operations. The company will probably also need to borrow money. In the rapid growth phase, most or all of the money goes to growth, i.e., current operations. A company that has reached the mature phase generates positive cash flow, which can also be used for alternatives other than investing in current operations. In the final, fourth phase, the company's turnover and profit begin to decrease as the company increases its capital, until the capital also starts to be lost and the company has to cease operations. In the last two phases, capital allocation has many options.

Berkshire invests mainly in companies at a mature stage. Let's start with investing in current operations. According to Buffett, a company should allocate its capital primarily to its current operations, i.e., efficiency, expansion of its scope of operations, expansion or improvement of current operations, and other measures aimed at increasing the moat. In reality, the situation is rarely such that a company should allocate all of its distributable assets to its own business. Investing in current operations only makes sense when the cost of capital acquisition is lower than the returns.

Buffett is considered to favor the purchase of its own shares as the best way for companies to distribute their excess capital to their owners. The most important criterion for Buffett is price. An owner or investor should favor this allocation method only if the company's shares are highly likely to be undervalued. Another reason for management to buy its own shares is that it signals that it has the best interests of its owners in mind. Buffett has two reasons for the wisdom of buying its own shares below their true value alternative. The first is when investments in the company's own business make more sense and debt growth does not make sense. The second, but less common, option is when the acquisition offers clearly more value to the owner than buying undervalued own shares.

The most important aspect of dividend distribution from Berkshire's perspective is whether the management of the acquired company can make more money for Berkshire by investing in its own business than Berkshire's ability to reinvest the same money elsewhere after taxes. There is no clear answer to this question, because company management has different abilities to allocate capital. In addition, the level of taxation affects the interest rate. Buffett favors buying sufficiently large shares of companies, because Berkshire's taxes are then lower. In that case, reinvesting the profits is more profitable from a tax perspective.

Buffett is skeptical about buying growth through takeovers or mergers. In his opinion, these take place on average at the expense of the current owners. The seller knows the value of his business better than the buyer on average. Sometimes, the seller may be in such a difficult situation that that the acquisition makes sense. For a company, managing a new business and merging it with its own business increases the likelihood of mistakes by management. It is better for it to distribute profits to owners, either as dividends or by buying back its own shares. The most important question a CEO can ask is “will the acquisition or merger make our current owners wealthier on a per-share basis than before?”

Berkshire focuses on investing mainly in companies with no net debt, so paying down debt as an alternative to allocating capital is rare for it. Paying down debt can be worthwhile when investing the company's capital cannot generate returns that are greater than the interest paid on the debt. In theory, the opportunity costs of paying down debt can be determined, but in reality they are difficult to calculate, at least if you believe Charlie Munger, who has said that no one at Berkshire knows how to calculate them.

Owner-friendliness is an important characteristic for managers. Corporate management is most likely to be owner-friendly when it has a large portion of its assets tied up in the company's shares. An even better situation is when management has purchased the shares with its own money and has not acquired them at the expense of other owners, such as through stock options. Corporate management must be absolutely honest and always tell the owners the truth. This also applies to its own mistakes. The most important things to tell financially literate owners help answer three questions:

1. What is the value of the company's business?

2. What is the probability that it will meet its future commitments?

3. How well has the management done compared to the opportunities given to it.

Business leaders must have the courage to openly talk about their mistakes, because they will make them sooner or later. Overly optimistic managers pursue their interests in the short term, but everyone suffers from exaggeration in the long term. An investor can examine the admission of mistakes and the extent of optimism by looking at what management has said about the future prospects in its previous reporting. The words can then be compared to the company's success after the reporting.

Capital allocation should be logical and simple. Why do so many business leaders still fail? According to Buffett, the main reason is the tendency of business leaders to conform, i.e. to follow and repeat what others do. For some reason, management rationality disappears as soon as herd mentality strikes. This has several consequences. The first consequence is the company's resistance to change. The second is the waste of funds generated by the company's projects or takeovers. The third is the need of the company's manager for acquisitions. He is supported by producing useless and detailed reports that confirm the damage caused by his stupidity. The fourth consequence is following other companies in the industry by expanding the business unnecessarily, by having similar option programs or by any other stupidity that has been imitated by others.

Unfortunately, few business managers dare to look stupid at a time when other companies are jumping off a cliff to their deaths. Changing direction or making decisions that seem different is not easy. It is easier for business owners to accept the inevitable short-term losses than to make the necessary changes in the management of the company. Instead of making changes, many managers do stupid things, believing that acquisitions will help them achieve better results. Three factors best explain Buffett's follies: First, most CEOs can't control their urges to do something that leads to acquisitions. Second, most CEOs compare their companies to others, whether they're in the same industry or something else. Third, most CEOs have too much confidence in their own abilities.

This is all a result of following other CEOs unreasonably. Part of the reason may also be the operating environment, where CEOs have to be able to justify their compensation while owners pursue short-term interests. Berkshire's unique corporate culture does not encourage this kind of behavior, so it has helped the company succeed. Buffett has never had to fear being fired, so he has been able to facilitate similar activities.

Warren Buffett part 5, Selling

 Selling

Buffett believes in long-term investing in companies that enjoy enduring competitiveness. His ideal holding period is eternity. Buffett has said that he is not prepared to sell any of the companies that Berkshire owns outright. This does not mean that he is not prepared to sell his minority stakes in publicly traded companies or other investments, such as bonds. Selling is a rarer event for Buffett. His motivation to sell is primarily due to the following events:

1. The market bubble has grown too big

2. A better opportunity arises

3. A change in the business or its operating environment

4. The target price is met

Market bubbles are rare. They do not come many times in a century. A bubble takes a long time to form. It can be characterized by a period when companies with P/E ratios normally below twenty rise to forty or fifty. Corporate valuations have risen to levels that are untenable. During a bubble, bonds are likely to yield more than stocks, so it’s a good time to sell. As I write this in March 2017, bonds are in an even bigger bubble, so buying them is not recommended. Stocks are not suffering from bubble prices as I write, even though they are high.

Sometimes you may find yourself in a situation where you don’t have enough cash when you find a buying opportunity in an investment other than your holdings. In this case, you may have to sell your holdings if you can’t leverage them. Buffett sees this as a valid reason to sell so that you can invest your money in a better-performing asset. The expected return must be significantly higher for a switch to be justified. As I write this, Berkshire has so much cash on hand that it has no need to sell its holdings to buy better assets.

A market economy is a constantly changing system, which means that change is a natural part of it. Companies' business operations change, but they must not go in a direction where a permanent competitive advantage is lost or an entire industry melts away. Buffett's Berkshire Hathaway was a good example of the latter when its textile business moved to cheaper countries in the 1950s and 1960s. Banks and other financial institutions are the most dangerous investment targets because they are able to hide changes that threaten them on their balance sheets. This applies to companies in the industry whose profits and return on equity are disproportionately high. Berkshire sold Freddie Mac shares for this reason.

Meeting the target price is perhaps the rarest reason to sell, and this mainly applies to Berkshire's arbitrage trading, which is almost non-existent today. When the target price is met, it is good to sell because there is not much to gain, but even more to lose. Buffett engaged in this type of trading more when he had a private investment firm. Today, Berkshire's capital is so large that the benefits of such activity are not sufficient.