[Summary] Creating a Portfolio like Warren Buffett

On my daily bus ride to work, I would spend the precious time to read books. “Creating a Portfolio like Warren Buffett” is one of the latest book which I’ve completed reviewing.

As an investor for roughly 4.5 years, I like to read books to pick on the author’s perspective of the financial ratios. Most importantly, the stories and the philosophy of author could be worthwhile learning lessons to strengthen my existing investing framework.

In the following paragraphs below, I aim to detail down what I thought to be vital characteristics of a successful investor. While simple in concept, it is hard to execute and follow. Here we go!

“Whenever businesses try to institute new initiatives to improve, those changes take multiple quarters or years to reflect the bottom line. Those initiatives might be reducing costs, introducing new products or services, penetrating a new market, spinning off divisions, or acquiring other businesses to grow revenue. Therefore, upon getting word of such initiatives, you cannot buy the stock today and expect those changes to happen quickly and increase stock price. Instead, you need to be patient until those initiatives deliver the expected results.

If one of your existing holdings get into trouble or a temporary downturn, you should not sell that position.

Perhaps, as an investor, it should be a great opportunity to load up more of its shares or initiate a new position since markets are impatient. Start to think like an owner instead of a trader.

Riding out the gains: “If you are a business owner and your business doubles, you do not immediately sell the business. You know the true worth of the company and you ride it out as much as possible. Traders sell their positions as soon as they double their money.

“When you buy in, you should allow sufficient time to judge whether your investment is successful. During the short term, the price variation of the stock is irrelevant to the underlying company’s fundamentals. But, during the long term, a company’s fundamental changes should reflect the stock price.’

On losing the upside for AAPL: So, why did the other 99 percent of the investors not get that kind of return? The answer is because of their short-term focus. As soon as they doubled or tripled their money, they likely sold their shares and left the huge upside on the table.

Buffett’s view: Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever.

On permanent loss of capital: “This is what happens for normal investors. As soon as they see red in their portfolio, they feel that they made a mistake. That feeling gives them a pain. To avoid the pain, they sell the position at the low price and take a permanent capital loss. To recoup that lost money, they try to look for quick gain opportunities like other hot stocks or options.

On selecting stocks to analyse: “When a company operates in a boring business, it does not attract many new competitors. This lack-of-competitor advantage allows for an increase of market share and in turn an increase in revenue and earnings over time. Investors should shy away from hot stocks in hot industries.”

For a quick calculation on retained earnings translating to market cap growth: Find out what is the retained EPS earnings of a company for the last 10 years. Find out the change in market price of the stock in the last ten years. Divide the change in market price over total accumulated retained EPS. This gives you a feel about each dollar retained would have generated how much dollars in market cap.

On any one-time event to increase earnings: one-time events could be a sale of assets, a big order from a particular customer, a big tax refund, insurance, or a legal settlement. To add on to the author, my personal experience was looking into Triumph Group (NYSE:TGI). You can never assume that its margins are going to stay the same. I was stunned when the margins dropped, presumably because some of the older contracts (which were secured at good margins) ended.

Few things to take note:

1. Whenever a company releases a new product, ask yourself, what percentage of that company’s sales come from that product?
2. Does the company have client concentration? In Michael Porter’s 5 forces, client concentration is bad, it reduces a company’s bargaining power. Your clients knows you need them, more than they need you. They will demand price reductions or longer payable days. Also, if clients don’t do well, you’d get badly hit!

On the importance of debt and a case study of turnaround: For Las Vegas Sands, during crisis, their sales were badly affected. To make things worse, they have many development projects so debt load was high. It crashed from $133 to $1.38 in March 2009. The author stalked the company for a long time. Eventually, he went in and made 400% return in 13 months. Why? He saw the company wasn’t going to collapse after founder Gary Adelson injected personal money of $475m dollars into the company. Talk about massive skin in the game!

On the required capital expenditure to stay competitive: If a company is spending large amounts of revenue as a capital expenditure, then it is not a great business. This is so so important. The surplus money that a company earned gets redeployed into the business. The more is left over, the more that is available to get redeployed for value-creation activities. Just think of why Warren Buffett closed down the textile business of Berkshire Hathaway.

Personally, this paragraph reminds me of a term called “reinvestment opportunities”. Why are dividends stock, dividends? This is because they lack of growth opportunities and chose to return money to shareholders. However, a growing business will always choose to redeploy into the business. A dollar redeployed generated excess of a dollar in returns. Plus, the money that is redeployed has to be good. Trace the ROE figures over a long period, has it dropped at all? On this note, check out whether it is investing in a unrelated business or focusing on its area of expertise.

On management: choose management with energy, integrity and success-oriented. Think about Sam Walton of Wal-mart, Steve Jobs of Apple, Bill Gates of Microsoft. Find out whether a management is consistent in keeping their words, earning guidance, and their future plans. Do they own a significant amount of their wealth inside the stock? Did they buy shares?

There are some red flags to be cautioned on: related party transactions, complex footnotes or financial statements, a management trumpeting successes and tries to hide poor results.

On hidden assets: does the business has any hidden assets? I recalled that Mandarin Oriental’s market cap was somewhere around US$3b and it was exploring a sale of their The Excelsior property, According to news site, it was able to fetch HKD $30b. After currency conversion, it means the property itself already covered the entire market cap of the company!

On deteriorating debtors / trade receivables: Do a ratio called net receivables / revenue trend. Check out whether it is rising or decling. A rising trend might not be good as this means the company is having troubles collecting payment or their suppliers are exerting their bargaining power over the company. I recalled Swiber’s net receivables were past due but not impaired. It represented a financial risk to me.

On deteriorating inventory turnover days or growing inventories: Do a ratio called “change in inventories / change in sales” year on year changes. If the ratio is rising very quickly, this means the company is having troubles selling off their inventories. To sell off, it might even have to resort to discounts which affects the profitability margins.

On pricing power: can the company raise prices according to inflation? This can be monitored using gross profit margins. If this margin drops siginficantly, it is either competition coming in to attack the firm at the pricing level or the cost of goods risen above the firm’s ability to increase its prices.

On catalysts: it is better to buy a company with catalysts so that markets are able to realise the stock faster. For example, new product introduction, acqusition or sale of a particular division, entering into a new market, big contract, corporate raider, analysts coverage.

On margin of safety: Insist in a 25% margin of safety. Be disciplined around it. However, for well-established companies, waiting to buy it at 25% margin of safety, it will be extremely difficult. If the company that you want does not fall into your preferred buying price, put it on a monitor list and try to find another under-valued stocks; this way, you can avoid permanent capital loss.

Turnaround Checklist!

• Is the management cutting costs according to the reduced revenue?
• Is management puting the company into cash-conservation mode?
• Is the company able to service existing debt?
• What is the management doing to increase sales in the curent environment?
• If the company has debt with a high interest rate, is the management trying to refinance existing debt to a lower interest rate?
• Is the company selling or spinning off any non-profitable divisions to raise cash to pay down its debt so it can spend less in interest costs?

(For Auric Pacific, it simply closed down its Delifrance and Food Junction businesses which were loss-making. Then, it refocused back on its SCS Butter and Sunshine Bread businesses which is fantastic)

In closing, you need to be a deicison-maker. Do not let market price influence you to act. The simple rule is to follow is to buy the stocks that are trading at or below your buy price. You should not violate this rule at any time. Just wait for the perfect pitch and when it comes, swing big.

Enjoyed this book thoroughly!