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THE WARREN BUFFETT WAY Base EDITION ROBERT G. HAGSTROM frantic 04-09-2013 14:48:31 Cover image: © Bloomberg via Getty Images Make a comeback design: Paul McCarthy Copyright © 2014 by Robert G. Hagstrom. All rights reserved. Published next to John Wiley & Sons, Inc., Hoboken, New Jersey.

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Hagstrom. — Bag edition. pages cm Includes analyze. ISBN 978-1-118-50325-6 (cloth); ISBN 978-1-118-81380-5 (ePDF); ISBN 978-1-118-79399-2 (ePub) 1. Buffett, Warren. 2. Capitalists pivotal fi nanciers--United States--Biography. 3. Investments--United States. I. Title. HG172.B84H34 2014 332.6--dc23 Printed in the Pooled States of America.

10 9 8 7 6 5 4 3 2 1 ii 04-09-2013 14:48:31 iii Contents Foreword: Dignity Exception vii Howard Marks Intro to the Second Edition xv Bill Miller Foreword to picture First Edition xix Peter Heartless. Lynch Introduction xxv Kenneth Plaudits. Fisher Preface xxxi Chapter Twofold A Five-Sigma Event: The World’s Greatest Investor 1 Personal Earth and Investment Beginnings 3 Prestige Buffett Partnership Ltd.

10 County Hathaway 13 Insurance Operations 15 The Man and His Classify 17 Five-Sigma Event 18 Moment Two The Education of Writer Buffett 21 Benjamin Graham 21 Philip Fisher 30 Charlie Munger 35 A Blending of Thoughtful Infl uences 38 iv Passage Chapter Three Buying a Business: The Twelve Immutable Tenets 45 Business Tenets 46 Management Credo 50 Financial Tenets 59 Deal in Tenets 64 Anatomy of unadulterated Long-Term Stock Price 69 Piling Four Common Stock Purchases: Club Case Studies 71 The Pedagogue Post Company 72 GEICO Band 81 Capital Cities/ABC 91 High-mindedness Coca-Cola Company 100 General Kinetics 110 Wells Fargo & Ballet company 114 American Express Company Cxx International Business Machines 123 H.J.

Heinz Company 130 A General Theme 135 Chapter Five File Management: The Mathematics of Besieging 137 The Mathematics of Core Investing 143 Focus Investors unexciting Graham-and-Doddsville 155 Chapter Six Blue blood the gentry Psychology of Investing 179 Loftiness Intersection of Psychology and Banking 180 Behavioral Finance 182 Leading on the Other Side, Writer Buffett 194 Why Psychology Picture 199 Chapter Seven The Price of Patience 201 For dignity Long Term 202 Rationality: Picture Critical Difference 205 Slow-Moving Gist 206 System 1 and Group 2 207 The Mindware Space 210 Time and Patience 211 Contents v Chapter Eight Interpretation World’s Greatest Investor 213 Rendering Private Buffett 216 The Buffett Advantage 218 Learning to Expect Like Buffett 224 Finding Your Own Way 232 Appendix 235 Notes 253 Acknowledgments 263 Pant the Website 267 About depiction Author 269 Index 271 cardinal Foreword: The Exception What commerce for Warren Buffett’s exceptional consumption success?

That’s one of probity questions I’m asked most habitually. It’s also the question Side-splitting want to explore in that foreword. When I studied sustenance my MBA at the Asylum of Chicago in the process 1960s, I was exposed attend to a new theory of fi nance that had been matured, largely there, in the above few years.

One of depiction most important components of rectitude “Chicago School” of thought was the Effi cient Market Theory. According to that hypothesis, illustriousness combined efforts of millions commemorate intelligent, motivated, objec- tive, prosperous informed investors cause information authorization immediately be refl ected feature market prices such that wealth will provide a fair risk- adjusted return, no more professor no less.

Prices are not under any condition so low or so giant that they can be entranced advantage of, and thus thumb investors can be capable stop consistently identifying opportunities to benefi t. It’s this hypothesis delay gives rise to the Port School’s best-known dictum: You can’t beat the market. The Effi cient Market Hypothesis supplies position intellectual basis for that completion, and there are lots designate empirical data showing that, discredit all their efforts, most investors don’t beat the market.

That’s a pretty strong case round out the inability to outperform. It’s not that no investors depressing the market. Every once hold your attention a while some do, highest just as many underperform; get rid of effi ciency isn’t so welldefined a force that it’s unthinkable for individual investors’ returns give a warning deviate from the market’s transmit.

It’s merely asserted that rebuff one can do it enrol a suffi cient degree last consistently enough to disprove heptad 30-08-2013 11:44:29 viii Foreword: Interpretation Exception the Effi cient Be snapped up Hypothesis. There are outliers, significance in most processes, but their superior returns are described in that being based on randomness stream thus ephemeral.

When I grew up, there was a proverb that “If you put sufficient chimpanzees in a room sustain type- writers, eventually one bad deal them will write the Bible.” That is, when randomness commission present, just about anything receptacle happen once in a from the past. However, as my mother inoperative to say, “It’s the shutout that proves the rule.” Deft general rule may not partnership 100 percent, but the event that exceptions are so hardly any attests to its basic incompetent.

Every day, millions of investors, amateur and professional alike, convict you can’t beat the trade be in the busines. And then there’s Warren Buffett. Warren and a few else legendary investors—including Ben Graham, Cock Lynch, Stan Druckenmiller, George Soros, and Julian Robertson—have performance rolls museum that fl y in magnanimity face of the Chicago Secondary.

In short, they’ve outperformed give up a big enough margin, perform long enough periods of put on the back burner, with large enough amounts as a result of money, that the advocates ensnare market effi ciency are unnatural onto the defensive. Their registers show that exceptional investors pot beat the market through talent, not chance.

Especially in Warren’s case, it’s hard to contradict with the evidence. On fulfil offi ce wall, he displays a statement, typed by him, show- ing that he in progress The Buffett Partnership in 1956 with $105,000. Since then, explicit has attracted additional capital most important earned returns on it much that Berkshire Hathaway now has investments totaling $143 billion innermost a net worth of $202 billion.

He’s kicked the erebus out of the indices assistance many years. And in high-mindedness process, he’s become the following wealthiest man in America. That last achievement wasn’t based snitch dynastic real estate assets edict a unique technological inven- disagreement, as with so many guilt Forbes’s lists, but on placing hard work and skill clump investment markets that are administer to everyone.

What’s responsible stand for Warren Buffett’s singular accomplish- ments? In my view these varying the keys: • He’s super-smart. One of the many band mots attributed to Warren obey the following: “If you be endowed with an IQ of 160, hawk viii 30-08-2013 11:44:29 Foreword: Rank Exception ix 30 points. Pointed don’t need them.” As Malcolm Gladwell pointed out in high-mindedness book Outliers, you don’t scheme to be a genius cheer achieve great success, just bacteria enough.

Beyond that, incremental brains doesn’t necessarily add to your chances. In fact, there apprehend people so smart that they can’t get out of their own way, or can’t fi nd the path to good (and happiness) in the come about world. A high IQ isn’t enough to make someone smart great investor; if it were, college professors would probably assign the richest people in Ground.

It’s important to also secure be business-oriented and have “savvy” or “street smarts.” I possess a sneaking suspicion that Warren’s IQ is well above Cxxx . . . and turn this way he hasn’t made any hindrance to dispose of those “non-essential” extra points. His ability raise cut to the core lift a question, to reach ingenious well-founded conclusion, and to keep that conclusion even if eccentric initially go against him arrange all key elements in who he is and what he’s accomplished.

In short, he’s exceedingly analytical. He’s also incredibly fast. It doesn’t take him weeks or months to reach top-notch conclusion. He also doesn’t be in want of a cadre of analysts driving numbers. He doesn’t feel primacy need to know and reevaluate every data point: just prestige ones that matter. And bankruptcy has a great sense insinuate which they are.

• He’s guided by an overarching outlook. Many investors think they’re bright enough to master anything, want badly at least they act delay way. Further, they believe integrity world is constantly changing, highest you have to be eclecticist and change your approach face adapt, racing to stay fall prey to with the latest wonder.

Rank trouble with this is guarantee no one really can conclude every- thing, it’s hard survive constantly retool and learn in mint condition tricks, and this mindset prevents the development of specialized knowledge and helpful shortcuts. Warren, blame the other hand, knows what he doesn’t know, sticks upon what he does know, become more intense leaves the rest for bareness.

This is essential, since likewise Mark Twain said, “It ain’t what you don’t know put off gets you into trouble. It’s what you know for give it some thought that just ain’t so.” Delve only invests in industries crystalclear ix 30-08-2013 11:44:29 x Foreword: The Exception understands and feels comfortable with.

He emphasizes somewhat prosaic fields and avoids, suggest example, high tech companies. Noteworthy famously passes on things deviate are outside his philosophy captain ken. Importantly, he can stand up for with the possibility that say publicly things he passes on longing make money for others remarkable he’ll be left looking conceited as they do. (Most create can’t.) • He’s mentally inactivity exible.

The fact that it’s important to have a lesson philosophy doesn’t mean it’s at no time good to change. It peep at be desirable to adapt stop by signifi cantly changed circum- reason. It’s even possible to use across a better philosophy. Decency key lies in knowing just as to change and when on touching hold fast. Early in government career, Warren adopted the near of his great teacher, Elevation Graham.

It’s called “deep value”— buying castoffs when they’re make available given away, especially when companies can be bought for sore than their net cash. Kosher has sometimes been derided on account of “picking up cigar butts.” Care a while, however, with urgency from his partner, Charlie Munger, he switched to emphasizing exclusive companies with protective “moats” cranium pricing power, led by undone people, at reasonable (but keen necessarily giveaway) prices.

It was long an aspect of Warren’s approach to eschew companies turn this way were capital-intensive, but he was able to overcome that preconception to buy the Burlington Federal Santa Fe railway and call advantage of its economic sensitiveness coming out of the 2008 financial collapse, and the point of view for increasing rail carriage.

Pure philosophy should supply guidance nevertheless not rigidity. This—like many different things in investing—is a arduous dilemma to master. Warren doesn’t shrink from the challenge, neither changing with every new impulse nor letting his thinking achieve stuck in cement. • He’s unemotional. Many of the snags to investment suc- cess differentiate to human emotion; the paramount reason for the failure take in the Effi cient Market Composition is that investors rarely sat- isfy the requirement of impassiveness.

Most become greedy, con- fi dent, and euphoric when prices are high, causing them satisfy x 30-08-2013 11:44:29 Foreword: Influence Exception xi celebrate their winners and buy more rather puzzle take profi ts. And they get depressed and fearful in the way that prices are low, caus- admission of guilt them to sell assets parcel up bargain prices and invariably discour- aging them from buying.

Arena perhaps worst of all, they have a terrible tendency familiar with judge how they’re doing home-grown on how others are know-how, and to let envy funding others’ success force them be carried take additional risk for probity simple reason that others representative doing so. Envy is ample to make people follow description crowd, even into investments they know nothing about.

Warren appears absolutely immune to these excitable influences. He doesn’t get euphoric when things appreciate, or gloomy when they don’t, and escort him success is clearly formed by himself, not the mob or the media. He doesn’t care whether others think he’s right, or whether his investing decisions promptly make him gaze right.

(He was written keep as “past his prime” at in 2000 because of authority failure to participate in what turned out to be rectitude tech bubble, but he under no circumstances changed his spots.) He inimitable cares what he (and Ass Munger) thinks . . . and whether his shareholders constitute money. • He’s contrarian be proof against iconoclastic.

Whereas the typical backer thinks he should follow rank herd, despite its susceptibility be against the errors of emotion, loftiness best investors behave in excellent contrar- ian fashion, diverging free yourself of the herd at the cue moments. But it’s not too little to do the opposite commemorate what others are doing.

Boss about have to understand what they’re doing; understand why it’s wrong; know what to do instead; have the nerve to activity in a contrary fashion (that is, to adopt and carry what Yale’s David Swensen calls “uncomfortably idiosyncratic positions”); and achieve willing to look terribly stoppage until the ship turns dominant you’re proved right.

That at the end element can feel like it’s tak- ing forever; as high-mindedness old saying goes, “Being else far ahead of your goal is indistinguishable from being wrong.” Take it all together weather it’s clear that this isn’t easy. It’s obvious that Jurist is highly capable of contrarian behavior. In fact, he jollity in it.

He once wrote me that he xi 30-08-2013 11:44:29 xii Foreword: The Blockage had seen high yield shackles when the market priced them like flowers and he challenging seen them when they were considered weeds. “I liked them better when they were weeds.” The contrarian prefers to stop working things when they’re out obvious favor.

Warren does it prize no one else. • He’s counter-cyclical. Investing consists of exchange with the future, and all the more many of the best investors accept that they can’t prophesy what the macro future holds in terms of eco- nomic developments, interest rates and be bought fl uctuations. If we can’t excel at the thing wind most people want to butter their hat on, what pot we do?

In my look as if, there are great gains be given be had from behaving counter-cyclically. It’s emotionally easy to put in when the economy is rising, companies are reporting higher funds, asset prices are rising, existing risk bearing is being rewarded. But buying appreciated assets doesn’t hold the key to foremost investment results. Rather, the longest bargains are accessed by purchasing when the economy and companies are suffering: that’s more dubious to be the climate slip in which asset prices understate their merits.

However, this, too, equitable not easy. Warren has customarily demonstrated his ability—in fact enthrone preference—for investing at the found of the cycle, when hospitality is in short supply. Empress investments of $5 billion encroachment in 10 percent preferred collection of Goldman Sachs and Public Electric at the depths light the 2008 financial crisis, bracket his purchase of economically tender Burlington Northern for $34 million in 2009, are emblematic make merry this.

The wisdom of these investments is obvious today manifestation retrospect, but how many interest as boldly when fear observe a financial collapse was rampant? • He has a continuing focus and is unconcerned become infected with volatility. Over my 45 length of existence in the business, investors’ always horizons have gotten shorter gleam shorter.

This is likely justness result of increased media singlemindedness to investment results (there was none in the 1960s), tight contagion to investors and their cli- ents, and the competition for yearly gains introduced impervious to hedge xii 30-08-2013 11:44:29 Foreword: The Exception xiii funds’ yearlong incentive fees. But as joker people allow nonsensical biases castigate affect their thoughts and handiwork, we can profi t outlander avoiding them.

Thus, most investors’ exces- sive concern with periodical and annual results creates profi t opportunities for those who think in terms of person periods. Warren has famously supposed that his “holding period go over forever,” and that he “prefers a lumpy 15 percent wonderful year over a smooth 12 percent.” This allows him round off stick with great ideas accommodate long periods of time, mixture his gains and allowing gains to build up untaxed, somewhat than turning over the binder every year and paying tariff at short-term rates.

It besides helps him avoid getting surprised out in times of flux, and instead lets him make back advantage of them. In certainty, rather than insist on liquidness and take advantage of greatness ability to exit from say, Warren’s actions make clear lose concentration he is happy making funds he could never shed. • He’s unafraid to bet sketchy on his best ideas.

Diversifi cation has long played graceful leading part in so-called discreet investment management. In short, diplomatic reduces the likelihood of sizeable indi- vidual losses (and clever being sued for having abstruse too much in a mislaying position). But while it reduces the pain caused by bereavement investments, a high degree endowment diversifi cation corre- spondingly reduces the potential gain from winners.

As in many things, Burrow takes a divergent view be taken in by diversification: “The strategy we’ve adoptive precludes our following standard discrepancy dogma. Many pundits would then say the strategy must embryonic riskier than that employed prep between more conventional investors. We rely on that a policy of file concentration may well decrease damage if it raises, as tad should, both the intensity critical of which an investor thinks fairly accurate a business and the comfort-level he must feel with wellfitting economic characteristics before buying happen upon it.” Warren understands that pronounce ideas come along only project rare occasion, so he keeps the bar high, only invests in great ideas, and bets big when he sees susceptible.

Thus, he commits significantly have an adverse effect on the companies and people sand believes in; xiii 30-08-2013 11:44:29 xiv Foreword: The Exception significant doesn’t hold anything just by reason of others do and he’s uneasy it may perform well poverty-stricken his being represented; and good taste refuses to diversify into different he thinks less of grouchy to mitigate the impact point toward errors— that is, to live out what he calls “de-worstification.” It’s obvious that all of these things are essential if you’re to have a chance package great results.

But that doesn’t keep them from being nobility exception in portfolio management, moan the rule. • He’s agreeable to be inactive. Too innumerable investors act as if there’s always something great to bustle. Or perhaps they think they have to give the solution that they’re smart enough extort always be able to fi nd a brilliant investment.

On the other hand great invest- ment opportunities move back and forth exceptional . . . instruct by defi nition, that pitch they’re not available every period. Warren is famously willing stick to be inactive for long periods of time, turning down tie after deal until the pardon one comes along. He’s esteemed for his analogy to give someone a jingle of baseball’s greatest hitters, Description Williams, standing at the platter with his bat on realm shoulder and waiting for say publicly perfect pitch; it exemplifies realm insistence on making investments sole when they’re compelling.

Who would argue that the supply have a high regard for good deals is steady, blunder that it’s always an evenly good time to invest? • Finally, he’s not worried condemn losing his job. Very occasional inves- tors are able lecture to take all the actions they think are right. Many classify constrained in terms of their ability to buy assets cruise are illiquid, controversial or unseemly; sell appreciating assets that “everyone” is sure will go further; and concentrate their portfolios hinder their few best ideas.

Why? Because they fear the niggardly of being wrong. “Agents” who manage money for others knoll that acting boldly will show them to the risk answer being fired by their board or terminated by their patronage. Thus, they moderate their exploits, doing only that which practical considered prudent and uncontroversial. That’s the tendency that caused Bog Maynard Keynes to observe, “Worldly wisdom teaches that it level-headed better for reputation to break conventionally than to succeed unconventionally.” But that tendency xiv 30-08-2013 11:44:29