Interesting Articles June 8, '07

Insights

Investment Advice From Buffett & Munger Whitney Tilson, Value Investor Insight 06.07.07, 6:00 PM ET http://www.forbes.com/finance/2007/06/07/buffett-berkshire-munger-pf-iiin_wt_0607insights_inl.html?partner=rss The following is an excerpt of notes taken by Whitney Tilson, co-editor of Value Investor Insight at Berkshire Hathaway's annual meeting in May 2007. Warren Buffett: We favor businesses where we really think we know the answer. If we think the business’ competitive position is shaky, we won’t try to compensate with price. We want to buy a great business, defined as having a high return on capital for a long period of time, where we think management will treat us right. We like to buy at 40 cents on the dollar, but will pay a lot closer to $1 on the dollar for a great business. If we see someone who weighs 300 pounds or 320 pounds, it doesn’t matter-we know they’re fat. We look for fat businesses. We don’t get paid for the past, only the future [profitability of a business]. The past is only useful to give you insights into the future, but sometimes there’s no insight. At times, we’ve been able to buy businesses at onequarter of what they’re worth, but we haven’t seen that recently [pause] except South Korea. Charles Munger: Margin of safety means getting more value than you’re paying. There are many ways to get value. It’s high school algebra; if you can’t do this, then don’t invest.

Circle of Competence and Margin of Safety When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly. Buffett: Let’s say you decide you want to buy a farm, and you make calculations that you can make $70 an acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7% return, so you’d pay $1,000 a acre. If it’s for sale at $800, you buy, but if it’s at $1,200, you don’t. Special Offer: Tech stocks make some of the best value stocks. John Buckingham recommended Apple (AAPL) at less than $8 per share in 2002. Click here for a handful of tech stocks with decent dividends and low valuations this month in Prudent Speculator TechValue Report.

If you’re going to buy a farm, you’d say, "“I bought it to earn $X growing soybeans." It wouldn’t be based on what you saw on TV or what a friend said. It’s the same with stocks. Take out a yellow pad and say, "If I’m going to buy GM at $30, it has 600 million shares, so I’m paying $18 billion," and answer the question, why? If you can’t answer that, you’re not subjecting it to business tests. We have to understand the competitive position and dynamics of the business and look out into the future. With some businesses, you can’t. The math of investing was set out by Aesop in 600 B.C.: A bird in the hand is worth two in the bush. We ask ourselves how certain we are about birds in the bush. Are there really two? Might there be more? We simply choose which bushes we want to buy from in the future. The ability to generate cash and reinvest it is critical. It’s the ability to generate cash that gives Berkshire value. We choose to retain it because [we think we can reinvest each dollar to generate more than $1 of value]. If you were thinking about paying $900,000 or $1.3 million for a McDonald’s stand, you’d think about things like whether people will keep eating hamburgers and whether McDonald’s could change the franchise agreement. You have to know what you’re doing and whether you’re within your circle of competence. Munger: We have no system for estimating the correct value of all businesses. We put almost all in the "too hard" pile and sift through a few easy ones. Buffett: We know how to recognize and step over one-foot bars and recognize and avoid seven-foot bars.

Advice on Becoming a Successful Investor I think you should read everything you can. In my case, by the age of 10, I’d read every book in the Omaha public library about investing, some twice. You need to fill your mind with various competing thoughts and decide which make sense. Then you have to jump in the water--take a small amount of money and do it yourself. Investing on paper is like reading a romance novel versus doing something else. [Laughter] You’ll soon find out whether you like it. The earlier you start, the better. At age 19, I read a book [ The Intelligent Investor by Benjamin Graham], and what I’m doing today, at age 76, is running things through the same thought process I learned from the book I read at 19. I remain big on reading everything in sight. And when you get the opportunity to meet someone like Lorimer Davidson (former CEO of GEICO), as I did, jump at it. I probably learned more in those four hours than in almost any course in college or business school.

Munger: Sandy Gottesman, a Berkshire director, runs a large, successful investment firm. Notice his employment practices. When he interviews someone, he asks, "What do you own and why do you own it?" If you’re not interested enough to own something, then he’d tell you to find something else to do. Buffett: Charlie and I have made money in a lot of different ways, some of which we didn't anticipate 30 to 40 years ago. You can’t have a defined road map, but you can have a reservoir of thinking, looking at markets in different places, different securities, etc. The key is that we knew what we didn’t know. We just kept looking. We knew during the Long Term Capital Management crisis that there would be a lot of opportunities, so we just had to read and think eight to 10 hours a day. We needed a reservoir of experience. We won’t spot every one, though--we’ve missed all kinds of things. But you need something in the way you’re programmed so you don’t lose a lot of money. Our best ideas haven’t done better than others’ best ideas, but we’ve lost less. We’ve never gone two steps forward and then one step back-maybe just a fraction of a step back. Munger: And of course the place to look when you’re young is the inefficient markets. You shouldn’t be trying to guess if one drug company is going to have a better pipeline than another. Buffett: You should do well in games with few other players. The RTC [Resolution Trust Corporation; click here for more on this] was a great example of a chance to make a lot of money. Here was a seller [government bureaucrats] with hundreds of billions of dollars of real estate and no money in the game, who wanted to wrap up quickly, while many buyers had no money and had been burned. There won’t be any scarcity of opportunity in your life, although there will be times when you feel that way.

Ben Graham Still Beats The Market John Reese, Validea Hot List 04.20.07, 12:00 PM ET http://www.forbes.com/personalfinance/2007/04/20/posco-jakks-buffett-pfguru-in_jr_0420guruscreen_inl.html?boxes=relstories Among the cognoscenti of value investing, Benjamin Graham is a revered figure. The first superstar strategist on Wall Street, he is actually the father of modern securities analysis and was Warren Buffett's teacher at Columbia University. As regular readers of this column know, I believe you can be successful by consistently following the strategies of Wall Street's best investors, and Graham is the granddaddy of them all.

From steel to finance, several stocks appeal strongly to the strategies of Buffett, Lynch, Graham and other superstar gurus. Though he died in 1976, his books are still in print, and his investment philosophy is still widely studied. Among those who follow my guru strategy approach to investing, he is also held in high regard. Currently, out of the dozen or so strategies I follow, the one that I base on Graham's writings comes in No. 2 in terms of total return. Since I've been tracking the guru strategies starting in July 2003, the Graham strategy has provided a 177.2% return. That compares with a 46.8% return from the S&P 500 during the same time period. Keep in mind that this is not backdating or theorizing. This impressive return is based on nearly four years of applying the Graham strategy's discipline to the market. Graham is the classic value investor. He sought out companies that were performing well and operated in basic businesses--nothing too esoteric (hence his disciple Buffett's tendency to steer clear of technology and other types of businesses that he says he doesn't understand). In addition, to improve his chances of making money, Graham would buy stocks from such companies only if they were trading at a discount to what he thought they should be. Make no mistake, the Graham strategy is a highly selective one, and some investors and analysts argue that because The Intelligent Investor, Graham's book on which I base the methodology, was published in 1949, the exact approach is too rigorous and outdated. With a return that's nearly triple that of the market over the last four years, I beg to differ. The Graham strategy wants to see earnings per share grow at least 30% over 10 years. But it doesn't just look at the first and last year's EPS. It averages the earnings of the first three years of the 10-year period and then averages the last three years of that same 10-year period. Likewise, when looking at the price-to-earnings ratio, Graham uses the average EPS of the last three years, not just the most recent year. By using the average EPS over three years and not just the common one year, Graham cleverly overcomes the distortion when the EPS is unusually high, low or even negative in one of the comparison years. This is particularly helpful with cyclical companies. Because of its superb record, and the strategy's ability to find deep value stocks, I want to present a few ideas that the Graham screen recently uncovered. Jakks Pacific (nasdaq: JAKK - news - people ): This toy manufacturer has a strong current ratio of 2.64 (meaning that it has a lot of liquid assets relative to the size of its debt), has had consistent and hefty (404%) EPS growth over the past 10 years, has a modest (13.10) price-to-earnings ratio

and a reasonable price-to-book ratio of 1.17. When multiplying the P/E by price-to-book ratios, the number cannot exceed 22; in Jakks' case, it comes to 15.33. Very nice. Encore Wire (nasdaq: WIRE - news - people ): A manufacturer of copper electrical building wire and cable, Encore has an impressive current ratio of 9.98. The company's long-term debt is $99 million, less than a third of its net current assets of $333.9 million. Over the past five years, EPS has consistently been positive, and over the past 10 years, it has grown an impressive 342.6%. The stock has a P/E of only 9.0 (using the three-year average), while the P/B ratio is 1.78. Multiplying the P/E and P/B ratios comes to 16, well below the 22 maximum allowed. Posco (nyse: PKX - news - people ): According to Morningstar, South Korea-based Posco is the third-largest steel maker in the world. It is a favorite of the Graham strategy because its current ratio is 2.41, long-term debt is but 35% of net current assets, the P/E ratio is 2.4, the P/B is 1.69 and multiplying the P/E with the P/B produces the remarkably low figure of 4.06. Muellar Industries (nyse: MLI - news - people ): Muellar manufactures metal and plastic products used in air conditioning, plumbing, heating, machinery and automobiles. Its current ratio is an impressive 3.04, its 10year EPS growth has been 69.3%, EPS has been positive in each of the past five years and its P/E ratio is 10.7, while its P/B ratio is 1.92. Multiplying the P/E and P/B comes to 20.54, just below the 22 maximum allowed by the strategy. Novamerican Steel (nasdaq: TONS - news - people ): Canadian-based Novamerican manufactures steel and aluminum. Its current ratio is a high and impressive 3.36. Its long-term debt is only $2.5 million, while its net current assets are $227.5 million--net current assets are a whopping 91 times long-term debt. In addition, EPS has grown 363.9% during the past 10 years. The P/E ratio is 12.83, while the P/B is 1.58. When combined, they come to 20.27. These are five companies that are performing well financially, while having stock prices that are modest, given the companies' performance. The Graham strategy is itself performing well. I would say the prospects for all of these companies' stocks appear quite good. John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best . Click here for more of Reese's insights and analysis, and to learn about subscribing to the Validea Hot List. At the time of publication, John Reese and his clients were long on Jakks Pacific, Encore Wire, Posco and Muellar Industries.

Tech Stocks For Buffett And Zweig John Reese, Validea Hot List 04.24.07, 4:25 PM ET While both have amassed huge fortunes because of their incredibly successful investing strategies, a trip to the homes of Warren Buffett and Martin Zweig might lead you to believe that the two Wall Street greats have little in common. Buffett, whose net worth of $52 billion makes him the world's third-richest man, still lives in the gray stucco house he bought nearly 50 years ago for $31,500, according to Forbes, which says that the Omaha, Neb., home was assessed at $700,000 in 2003. Zweig, meanwhile, reportedly lives in Manhattan's most expensive apartment, a $70 million penthouse atop the tony Pierre Hotel. The apartment includes the Pierre's original ballroom, which is now a "grand salon" with 20-foot-high French doors overlooking the Big Apple. Forbes ranks the home as the eighth-most expensive in the world. While they have made quite different uses of their money, the principles that helped Buffett and Zweig amass their respective fortunes are in many ways quite similar. Buffett, perhaps the most famous investor in the world, has built a reputation for a conservative, long-term approach to stock purchasing. He targets companies that have long histories of growth and hangs onto his holdings for years, or even decades. Zweig, whose Zweig Forecast newsletter was considered one of the best, if not the best, investment manual during its 27-year run, is a growth investor but has a serious conservative streak. He also has strict historical earnings criteria and often holds onto stocks for years. Because of their conservative, stringent approaches, Buffett and Zweig don't often target the hot technology stocks, many of which gain attention because of recent price jumps that are due to promising future prospects, not strong long-term performance. So when I find tech stocks that score well using the "guru strategies" that I base on the philosophies of Buffett and Zweig, I sit up and take notice. Currently, there are three tech stocks that have exhibited the type of longterm earnings success that gets them approval from either my Buffett- or Zweig-based strategies. Total System Services (nyse: TSS - news - people ) is a Columbus, Ga.based company that provides electronic payment processing technology and services to merchants, allowing customers to use credit, debit and other types of cards. Total System, which has a market cap of $6.5 billion, gets strong interest from my Buffett-based model, in part because of its history of predictable, steadily increasing earnings. Its earnings per share have increased in every year for the past decade, rising from 24 cents 10 years ago to $1.26 last year.

As another part of his conservative approach, Buffett looks for companies that have little debt, and my Buffett-based strategy targets companies whose earnings would allow them to pay off their debt within two years if need be. With debt of just $10 million and annual earnings of $256.1 million, Total System is in a position where it could easily pay off its debt within two years, which my Buffett-based model considers exceptional. Buffett also likes companies that use retained earnings in a way that benefits shareholders. The strategy that I base on his philosophy thus looks at how a company's retained earnings over the past 10 years compare with its gain in earnings per share over the same period. In the past decade, TSS has experienced a $1.02 gain in EPS and a $5.22 gain in retained earnings, meaning that management has proved it can earn shareholders a 19.5% return on those retained earnings. My Buffett method considers that more than acceptable. Two Zweig-Type Choices The strategy that I base on Zweig's writings currently has strong interest in two tech stocks. The first I'll examine is FactSet Research Systems (nyse: FDS - news - people ), which provides financial information on thousands of companies around the world, allowing users to analyze company fundamentals and compare stocks. The Norwalk, Conn.-based FDS, which has a market cap of $3 billion, passes several of my Zweig-based earnings tests. With long-term EPS growth of 19.88% per year, based on the average of the three-, four- and five-year EPS growth rates, FactSet comes in above my Zweig method's 15% minimum. Its EPS figures have increased from 78 cents to 98 cents to $1.15 to $1.43 to $1.64 over the past five years, passing another of this method's earnings tests. Zweig doesn't just like earnings to be growing, however; he also likes the rate of that growth to be increasing. FactSet's EPS growth rate for the current quarter (compared with the same quarter last year) of 36.84% easily exceeds its long-term EPS growth rate of 19.88% (based on the average of the three-, four- and five-year figures), showing that earnings growth is accelerating. In addition, this quarter's EPS growth rate exceeds FactSet's average growth rate for the past three quarters (17.54%, when compared with the same three quarters last year), meeting another of my Zweig-based model's earnings acceleration criteria. Moreover, while companies in the computer services industry have average debt/equity ratios of almost 136%, FactSet has no debt, garnering high marks from my Zweig-based strategy. Another tech stock that gets high marks from my Zweig model is Quality Systems (nasdaq: QSII - news - people ), an Irvine, Calif.-based company that develops and provides information technology systems for medical and

dental offices. Like FactSet, Quality Systems has generated consistent historical earnings growth and posted successive EPS figures over the last five years (21 cents, 28 cents, 40 cents, 61 cents and 85 cents) that pass my Zweig model's earnings persistence test. In addition, Quality Systems' earnings growth in the current quarter--77.78%, compared with the same quarter last year--easily surpasses its historical earnings growth rate (43.18%, based on the average of the three-, four- and five-year EPS figures) and its EPS growth rate for the previous three quarters (46.55%, compared with the same three quarters last year), passing two of my Zweig method's earnings acceleration tests. My Zweig-based strategy also likes that Quality Systems, like FactSet, has no debt. The only blemish on Quality Systems' fundamentals, according to my Zweig method, is that the company's revenue growth (27.25%) has not increased as quickly as its historical earnings growth (43.18%). Zweig says that costcutting measures can go only so far, and that continued earnings growth must be driven by sales growth, so my model looks for stocks that have a sales growth rate that is comparable to earnings growth. But this sales growth rate shortcoming may be due more to Quality Systems' extremely high earnings growth rate than to a sales problem. Its sales increased 43.9% this quarter and 26.8% last quarter (compared with the same respective quarters last year). Zweig likes stocks to have a greater sales increase in the current quarter than the previous quarter, showing sales acceleration. So while it failed the first Zweig sales-related test, Quality Systems passes this one. Jumping into the technology sector can be a risky proposition. Because of the rapidly evolving nature of technology, many tech companies are relatively new and don't have a lot of history to go on. And, as many investors found out all too painfully a few years ago, speculation about new technologies or products can wildly drive prices of stocks within the sector, skewing the perception of how valuable some companies are. Each of the three companies I've mentioned has a strong history of growth and little or no debt, making them the kind of tech stocks that I think even conservative-minded investors like Buffett or Zweig might appreciate. If you're looking to add a few lower-risk tech stocks to your portfolio, you'd be wise to give them a closer look. John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best.

Buffett Strategy Big On Retail John Reese, Validea Hot List 05.17.07, 1:50 PM ET A report from the National Federation of Retailers' Shop.org showed this week that the online retail sales market is booming, forecasting an 18% jump this year. For the first time, computer-related products were not No. 1 on the list of top online sales items. Instead, apparel took the top spot, a sign that online buying has gone mainstream. On the whole, however, the retail industry is far from booming. Last month's retail sales were the lowest on record for April, according to The Associated Press, which led, if only briefly, to the market's biggest dip in two months May 10. I thought that this weakness might create some buying opportunities in the industry, so to find some good buys I ran a bunch of retailers through my "Guru Strategy" computer models on Validea.com. Each quantitative gurubased strategy is based on the philosophy of a different Wall Street great. One of the interesting things I found was that, despite being one of my more stringent models, the strategy that I base on the philosophy of the legendary Warren Buffett spots more bullish opportunities in retail. Buffett, of course, has been doing some major shopping of his own recently. On Tuesday, he revealed Berkshire Hathaway's (nyse: BRKA - news - people )major stakes in two railroads--Norfolk Southern (nyse: NSC - news - people ) and Union Pacific (nyse: UNP - news - people )--as well as its $79.5 million stake in the nation's largest health insurer, WellPoint (nyse: WLP - news - people ). And Buffett's not done buying--he has said that Berkshire is now looking to make an acquisition in the $40 billion to $60 billion neighborhood if he could find the right company at the right price. I'm not going to suggest that any of the retailers approved by my Buffett-based model will become that big buy. (Most, in fact, are too small for the type of investment Buffett has suggested.) Here are several strong retailers that I would consider "Buffett-type" investments: Walgreen (nyse: WAG - news - people ): This drugstore giant has been around for more than 100 years, but its growth has increased exponentially over the past two decades. It has opened more than 4,700 stores since the mid-1980s, and it plans to reach the 7,000-store mark by 2010. But Walgreen, which now has a market cap of $44.4 billion, hasn't just grown physically; it's also had steady growth in earnings in the past decade, one of the reasons it scores so well using my Buffett-based method. Buffett likes companies that have a long history of strong, stable earnings, so my strategy requires that a stock's earnings per share have increased in at least nine of the past 10 years. Walgreen's EPS have increased every year for the past decade, passing the test.

When I talk about "Buffett-type" stocks, I'm also talking about companies that are conservatively financed, so my Buffett-based strategy requires that a company could, based on its earnings, pay off its long-term debt within two years. Walgreen doesn't need two years; in fact, it doesn't even need two hours. The drugstore chain has no long-term debt, easily passing this test. Another "Buffett" criterion is strong management. One way to measure this is by checking out how management has used a company's retained earnings. Walgreen's EPS have increased by $1.28 in the past 10 years, while its retained earnings over that period total $8.25, showing that the company can earn shareholders 15.5% annually on earnings it has kept. That falls into my Buffett method's best-case range. Sysco (nyse: SYY - news - people ): Sysco, which has a market cap of $20.6 billion, supplies food service providers with an array of products, ranging from fryers to freezers to food itself. Though its EPS dropped from $1.47 to $1.34 last year, this is the only time its earnings have dipped in the past decade, which is good enough to pass my Buffett-based earnings predictability test. Sysco does have debt--$1.63 billion worth of it, to be exact--but its earnings of $951.5 million are high enough that the company could pay off that debt in two years, showing conservative financing. One area in which Sysco has really excelled is in its return on equity. Buffett sees ROE as a measure of whether a company has a "durable competitive advantage" over its counterparts. He likes companies with ROEs greater than 15%, so my Buffett-based method sets that as a target both for average ROE over the past 10 years and the past three years. Sysco's ROEs over the past decade is 28.3%, while its average ROE over the past three years is 31.6%. The Houston-based company is taking what it has and making it grow significantly every year, a great sign. TJX Cos. (nyse: TJX - news - people ): If you're looking to get some nice clothes at good prices, you should check out discount retailers like T.J. Maxx, Marshalls or Bob's Stores. If you're looking for a nice stock at a good price, you should check out TJX, the parent company of all three of those discount retailers. The Massachusetts-based firm, which has a market cap of $12.9 billion, has posted EPS gains every year for the past decade. It has $808 million in debt, but it could almost pay that off in a year based on its $792.2 earnings, showing good, conservative financing. So far, all of the Buffett-based criteria we've looked at have been quantitative; that is, they deal with the strength of a company's fundamentals. But Buffett doesn't just buy companies that fit a certain profile; he also makes sure that he's buying them at good prices. One way he does this is by comparing a company's initial expected yield to the long-term Treasury yield. (If it's not going to earn you more than a nice, safe T-bill, why take the risk involved in a stock?)

When we take TJX's trailing 12-month EPS of $1.62 and its current price of $28.37, we get an initial expected rate of return of 5.71%, exceeding the current long-term Treasury yield (4.75%). Combined with TJX's historical EPS growth (11.6%, based on the average of the three-, four- and five-year figures), we see that the stock is a better choice than Treasury bills, which Buffett sees as a good sign. CDW (nasdaq: CDWC - news - people ): This Illinois-based tech firm sells items made by such big brands as Apple (nasdaq: AAPL - news - people ), IBM (nyse: IBM - news - people ), Sony (nyse: SNE - news - people ), Panasonic and Adobe Systems (nasdaq: ADBE - news - people ), and provides support services to its clients. It has a market cap of $6.2 billion and, like the other stocks I've mentioned, has a stellar earnings history. Its EPS has dipped just once in the past 10 years, rising from $0.59 to $3.30 during that time. What's more, CDW has no debt. CDW also gets high marks for management, as its EPS gain in the past decade ($2.71) and total retained earnings over that period ($18.06) show that management has earned shareholders a sterling 15% per year on retained earnings. Its return on equity has also consistently exceeded this model's 15% minimum, with a 10-year average ROE of 21.2% and a threeyear average ROE of 19.3%, indicating that the company has a durable advantage over its competition. Hibbett Sports (nasdaq: HIBB - news - people ): Buffett generally buys big companies, both because they tend to have the kind of consistent earnings he likes and because Berkshire Hathaway has got so big that it needs to make large purchases to have any kind of impact. But that's not to say that there aren't small-caps that meet my Buffett-based strategy, and Alabamabased Hibbett, with a cap of $854 million, is one such company. Despite its small size, Hibbett, which sells sports equipment and apparel, has demonstrated remarkable earnings persistence over the past decade. Its EPS have grown in each of the past 10 years, averaging a 25.6% gain over that span. What's more, the company has no debt. That shows that, like the other stocks I've mentioned, Hibbett is conservatively financed, part of the reason my Buffett-based strategy likes it so much. As I said earlier, I'm not saying that Buffett's impending "big buy" will come out of this bunch. Nonetheless, all of these companies have strong positions in their industries, consistent earnings streams and manageable debt, and have shown they can get shareholders good returns, making them the type of investments that Buffett has gravitated toward. They may not get added to Buffett's holdings, but they are all stocks you should consider adding to your own portfolio. John P. Reese is founder and CEO of Validea.com and Validea Capital Management. He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best . Click here for more of

Reese's insights and analysis and to learn about subscribing to the Validea Hot List.