Chapter 11

Ten Great Investors and Their Strategies

IN THIS CHAPTER

Bullet Trading tips from the masters

Bullet Investing for value

Bullet Looking for prospects of growth

Bullet Doing it with ratios

Bullet Becoming an expert in your field

Investors come in all shapes and sizes. Here I select nine of the best-known and most successful investors of the past 85 years — and one (Charles Viertel) perhaps not so well known, but no less effective. Each has followed a fairly stringent set of principles to achieve their success — Benjamin Graham was the ‘father’ of value investing, while Philip Fisher took a different point of view with his strategies for growth investing. These investors had these features in common — each took his task seriously and each has added to our understanding of the investment process.

Warren Buffett and Charles Munger

Much has been written about the investment philosophies of Warren Buffett, who’s known as the ‘Oracle of Omaha’. He built a US$70 billion fortune from a $50 start in 1956. Warren Buffett is part of a two-man team that manages the legendary investment firm Berkshire Hathaway, and is certainly more famous than his partner, Charlie Munger, vice president of Berkshire Hathaway, who acts as Dr Watson to Buffett’s Sherlock Holmes.

The stated aim of the company is to

… increase Berkshire’s per-share value at a rate that, over time, will modestly exceed the gain from owning the S&P 500. A small annual advantage in our favour can, if sustained, produce an anything-but-small long-term advantage. To reach our goal we will need to add a few good businesses to Berkshire’s stable each year, have the businesses we own generally gain in value, and avoid any material increase in our outstanding shares.

Warren Buffett doesn’t dwell on Berkshire Hathaway’s share price or its earnings; instead, he examines the company’s net tangible asset (NTA) value, or what Americans call ‘book value’. Since 1965, Berkshire Hathaway’s annual percentage change in book value has beaten the S&P 500 (with dividends reinvested) in 37 of 55 completed years. Over that time Berkshire Hathaway’s value has grown at a compound annual growth rate of 20.3 per cent, versus 10.0 per cent a year for the S&P 500 index. In only 18 years has the index beaten Berkshire Hathaway, with the most recent occasion being in 2019, when Berkshire’s book value grew by 11.0 per cent, while the S&P 500 gained 31.5 per cent in total return. Berkshire Hathaway’s success means that an investor who put US$1,000 into the company in 1964 now has a stake in the company worth US$27.4 million. Another investor who put US$1,000 in the S&P 500 index in 1964 has earned US$197,840. That is the power of compounding — which Buffett describes as a ‘simple concept capable of doing extraordinary things’. He describes Berkshire Hathaway as simply a ‘compounding machine’. A 55-year record of a compound annual growth rate of more than twice that of the market index is successful investing in anyone’s language.

How do Buffett and Munger do it? They look for companies with a track record of financial success. This means the companies have a competitive advantage, excellent management and superior products or services with a respected brand name. Buffett and Munger also try to buy these companies at a reasonable price. That’s the simple secret of buying a stream of earnings reliable enough to fuel Berkshire Hathaway’s growth. The key statistics these fund managers look for in companies are

  • Growth in sales and earnings
  • High return on equity
  • Low gearing (33 per cent or less)
  • Rising book value
  • Strong and growing profit margins

Buffett and Munger also look for growth in owner earnings, which is earnings (per share) minus depreciation (per share) plus capital expenditure (per share). Owner earnings represent the cash that the business has left after its required maintenance spending — cash that it can spend however it wants. This pair also prefers a company with a relatively high price/earnings (P/E) ratio — they’re long-term investors and figure that a stock trades on a high P/E ratio because the market is prepared to pay a premium for it.

Buffett and Munger are known for having ‘permanent’ stock holdings: Buffett says his ideal investment horizon is ‘forever’. Berkshire Hathaway is the biggest shareholder of Coca-Cola Co. and American Express Co. and Buffett has held those stocks for 32 years (Coca-Cola) and 56 years (AmEx); indeed, Berkshire has never sold a Coke or AmEx share. Banking group Wells Fargo and business and financial services heavyweight Moody’s are other holdings considered to be ‘permanent’. However, this status is not set in stone — retailer Walmart was thought to be a permanent holding, but Berkshire sold out in 2016. In April 2020 the group sold its airline holdings (American Airlines, Delta Air Lines, Southwest Airlines and United Continental Holdings) in the wake of the COVID-19 pandemic, with Buffett saying that that ‘the world has changed for airlines’. Before the sell-off, Berkshire held 8 per cent to 11 per cent stake in these airlines.

At the time of writing, Berkshire Hathaway’s top ten holdings were

  • Apple (35.5 per cent of the portfolio)
  • Bank of America (11.2 per cent)
  • Coca-Cola Co. (10.1 per cent)
  • American Express (7.4 per cent)
  • Wells Fargo & Co. (5.3 per cent)
  • Kraft Heinz (4.6 per cent)
  • Moody’s (3.0 per cent)
  • US Bancorp (2.6 per cent)
  • Bank of New York Mellon (1.5 per cent)
  • Charter Communications (1.4 per cent)

A rare dud for Berkshire Hathaway is Kraft Heinz. Since the merger of the venerable Kraft and Heinz brands in July 2015, the shares of the combined company have lost 59 per cent in value. Berkshire Hathaway owns 27 per cent of the company, and is estimated to have lost US$5 billion on its investment so far.

Many Australian fund managers say that they follow similar principles to those of Berkshire in terms of valuation precepts. But even managers considered to be Buffett-oriented, such as Magellan, Clime and Caledonia will tell you that using the basic premises that Buffett and Munger espouse is one thing, but putting it into practice on a Berkshire scale is difficult in the Australian market. Our market is both much more limited in terms of high-quality businesses than the US market, and with a higher component of resources investment, where many of those principles do not work.

Remember Buffett and Munger have been able to pick the fundamental eyes out of an industrial-based economy like the US through ‘information arbitrage’ — learning more about a company than anyone else. Not only is this harder to do these days in the US, but it’s also very difficult to do in Australia, where the market’s resources orientation means many of the major Australian companies experience tremendous swings in earnings.

Moreover, no Australian manager can invest in exactly the way that Berkshire does, because Australian fund managers have to service their investors’ capital. Since its inception, Berkshire has paid only one dividend.

The compounding effect of retaining earnings and retaining dividend flows gives the company its dramatic earnings power. Buffett also has the ability, as he did at the height of the global financial crisis (GFC), to invest in companies through instruments other than shares. In fact, this was Buffett’s preferred method of investing after the GFC hit in 2007.

For example, at the height of the GFC in 2008, Berkshire Hathaway stumped up $US8 billion (A$12.9 billion) in emergency funding for Goldman Sachs and General Electric. Buffett’s US$5 billion (A$8 billion) investment in Goldman Sachs in 2008 — hailed as a dramatic and confidence-boosting announcement at a time when the global financial system looked to be in danger of collapse — was actually a purchase of perpetual preferred Goldman shares that paid an interest rate of 10 per cent. In addition, Berkshire received warrants giving it the right to buy US$5 billion worth of Goldman’s common shares at any time up to September 2013, at a price of $115 a share. By the time Goldman Sachs redeemed the perpetual preferred stock, in 2011, Berkshire Hathaway had earned a return of $US3.7 billion, including $US1.3 billion in dividends. The warrants were exercised in 2013, delivering Berkshire Hathaway $US2 billion in cash and 13 million Goldman shares, but Berkshire has since sold most of that holding.

Quotable Buffettisms abound, such as: ‘When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact’; ‘When you combine ignorance and leverage, you get some pretty interesting results’; and ‘I don’t care if the stock exchange closes down for five years. I’ve got my stocks, and I like them.’

Buffett’s annual letter to Berkshire Hathaway shareholders has become over the years a compendium of investment insight. For example, in the 2019 letter, he told shareholders that he and Munger did not view the constituents of their US$248 billion (A$353 billion) share portfolio as:

[A] collection of stock market wagers — dalliances to be terminated because of downgrades by ‘the Street,’ an earnings ‘miss,’ expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour. What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning more than 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt.

John Neff

John Neff managed Vanguard’s Windsor fund for 31 years, from 1964 to his retirement in 1995. The Windsor fund was closed to new investment in 1985 and was, at that time, the largest mutual fund in the USA. Neff beat the market 22 out of 31 years, turning each dollar invested in Windsor in the first year to $56 by 1985. The Windsor fund’s total return was 5,546 per cent, more than twice as good as that of the S&P 500 index over the same period. The Windsor fund’s average return was 13.7 per cent a year, versus 10.6 per cent for the S&P 500.

Remember Neff’s strategy was to look for stocks trading at a low P/E ratio. Often described as a value investor, the label that Neff thought best described his style was low P/E investor. He bought companies that were in line for a re-rating in the medium term, reasoning that a re-rating was more likely to happen to a company with a P/E about half the market average than to a high P/E growth stock.

He looked for companies with an earnings growth of 7 per cent or better. Above 20 per cent, Neff thought the stock too risky. Neff considered yield a return that investors could pocket. He said that share prices ‘nearly always sell on the basis of expected earnings growth rates and shareholders collect the dividend income for free’.

The total return that Windsor was looking for was annual earnings growth plus dividend yield. Because the P/E ratio showed what it paid to achieve that annual return, Windsor divided total return by P/E ratio to give a total return ratio. Neff bought stocks with a total return ratio at 2 or above. He was happy to buy cyclical stocks, but at low P/E ratios based on the earnings that he thought were achievable at better points in the cycle. He looked for solid companies in growing fields.

He also looked for companies with what he called a strong fundamental case, which meant that the trends in cash flow, sales and margins combined to drive earnings growth. Neff would sell when he felt that the fundamental case was deteriorating, or if the price approached his expectations. Typically he held stocks for about three years.

My favourite Neffism is: ‘Falling in love with stocks in a portfolio is very easy to do and, I might add, very perilous. Every stock Windsor owned was for sale. When you feel like bragging about a stock, it’s probably time to sell.’

Benjamin Graham

Benjamin Graham, who died in 1976, was one of the most influential investors the stock markets have known. He developed his ideas about value investing during the Great Depression, and co-wrote the 1931 classic text Security Analysis with David Dodd. He followed this up 18 years later with The Intelligent Investor. These two books set out the concept of value investing, which is based on the fact that a company’s share price is different from its intrinsic value.

Remember Value investing involves buying stocks that are trading at a low price relative to the company’s net worth per share, which is its value as though it were to be sold off tomorrow, or its NTA backing. According to Graham, this is a stock’s intrinsic value. He compared this intrinsic value to the current market price to determine a share’s true value. The further the share’s market price was below what Graham had worked out as its intrinsic value, the bigger he considered his margin of safety.

Benjamin Graham’s ten rules for choosing stocks were

  • Current ratio greater than two.
  • Dividend yield of at least two-thirds that of the AAA bond.
  • Earnings growth of at least 7 per cent a year, over the preceding ten years.
  • Earnings-to-price yield of at least twice the yield offered by the best AAA bond. (The earnings-to-price yield is the reciprocal of the P/E ratio. For Australian investors, this yield would be twice the yield of ten-year bonds.)
  • P/E ratio less than 40 per cent of the highest P/E ratio the stock had traded at over the past five years.
  • Share price of less than two-thirds of book value (NTA) per share.
  • Share price of less than two-thirds of net current asset value, which Graham defined as the current assets of a company minus all of its liabilities.
  • Stability of growth of earnings. (No more than two annual falls of 5 per cent or more in profit in the preceding ten years.)
  • Total debt less than book value (NTA).
  • Total debt less than twice net current asset value.

Over four decades, Benjamin Graham honed this set of ten criteria to what he described as a ‘practically foolproof way of getting good results out of common stock investments with a minimum of work’.

Philip Fisher

What Benjamin Graham is to value investors, Philip Fisher is to growth investors. His strategy was to identify growth companies early, buy them and hold them for a long time. Fisher was averse to bargain hunting. He wanted to identify the business characteristics of superbly managed growth companies. He felt that great growth stocks show gains in the hundreds of per cent each decade, while a value-oriented investor rarely finds a stock that is more than 50 per cent below its real value.

Fisher did not use economic data to help him decide when to buy stocks because he thought economists were not accountable. He preferred to use what he called ‘scuttlebutt’, which involved talking to suppliers, customers, company employees, and people knowledgeable in the industry and, eventually, company management. Not all investors can do this, although the internet era makes it a bit easier.

Fisher developed a series of questions you can ask before buying a stock:

  • Are there aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
  • Does the company have a management of unquestionable integrity?
  • Does the company have an above-average sales organisation?
  • Does the company have depth to its management?
  • Does the company have a short-range or a long-range outlook in regard to profits?
  • Does the company have a worthwhile profit margin?
  • Does the company have outstanding executive relations?
  • Does the company have outstanding labour and personnel relations?
  • Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
  • Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
  • Does the management talk freely to investors about its affairs when things are going well, but ‘clam up’ when troubles and disappointments occur?
  • How good are the company’s cost analysis and accounting controls?
  • How effective are the company’s research and development efforts in relation to its size?
  • What is the company doing to maintain or improve profit margins?
  • Will, in the foreseeable future, the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?

Fisher is famous for the comment that ‘if the job has been correctly done when a common stock is purchased, the time to sell it is — almost never’. However, he would sell in three situations — when he decided he’d made a serious mistake in assessing the company; if the company no longer passed his tests as clearly as it did before; and if he simply decided to take a profit and reinvest the money in another, far more attractive company.

Jim Slater

British investor Jim Slater’s share investment theories centred on the price-earnings earnings growth factor, or PEG. The PEG is a measure of the relationship between a P/E ratio and the expected earnings per share growth rate. To calculate the PEG, you divide the P/E ratio by the forecast growth in earnings per share (EPS).

Any company trading on a PEG of 1 or less is generally considered appealing, while those on PEGs of 0.6 are cheap as chips. To qualify for a positive calculation, a company must have displayed solid normalised EPS growth going back at least three years, with no setbacks.

Slater found that PEGs tend to work best for what he called small, dynamic companies. He formulated ten critical points against which a candidate for investment must be assessed:

  • Competitive advantage linked to reliability of earnings growth based on well-known brand names, patents, copyrights, market dominance or a strong position in a niche business.
  • Dividend yield — it doesn’t matter how low, as long as dividends paid are growing in line with earnings.
  • High relative strength of the shares compared to the market — when the market’s strong, the shares are strong; if it’s not, you’re on red alert.
  • Low P/E ratio relative to the growth rate (in other words, the PEG).
  • Optimistic chairman’s statement (in the annual report).
  • Positive rate of growth in earnings per share in at least four of the past five years. Cyclical stocks not allowed!
  • Reasonable asset position. Very few growth shares in a dynamic phase, said Slater, were priced near to or below asset value. A share price as low as 33 per cent of asset value is ‘passable for a growth share’.
  • Shares must have a ‘story’, that offers potential reasons for growth in earnings.
  • Small market capitalisation — elephants don’t gallop! Slater preferred companies valued at £10–50 million, and would not invest above £100 million. (Bear in mind, though, that the UK is a larger and deeper sharemarket than Australia.)
  • Strong liquidity, low borrowings and high cash flow. Liquidity here means ability to convert assets to cash. Avoid capital-intensive companies; look instead for those generating cash.

Slater also looked for management with significant shareholding in the company because investors wanted to see shareholder-oriented management that would look after their interests with an owner’s eye. Slater believed these criteria allow investors to identify smaller growth stocks, which give investors substantial capital and earnings growth.

Slater’s investments in private companies — as distinct from listed companies — were occasionally controversial, given that his strategy, once he had gained control, often involved selling off parts of the business that he considered disposable, whether it was property, plant or workforce. This approach was often described as ‘asset stripping’, which is a particularly hard-nosed form of capitalism, and is not to everyone’s taste. Indeed, under today’s emphasis on the ‘social licence to operate’, it would not tick all the boxes.

Charles Viertel

Charles Viertel was one of the great unsung heroes of the Australian Securities Exchange. From a fairly humble start in life, Viertel left a $60 million charitable foundation when he died in 1992, which has since appreciated to about $183 million — from which about $8.2 million a year flows to charities. He advocated the principle of buying and holding quality shares and picking up more of them after a correction. Viertel was one of the great exponents of the buy-and-hold investment strategy.

Viertel started buying shares and property during the Great Depression, but later sold all his property to concentrate on the sharemarket. Reportedly, he was so shamed by the notice written on the blackboard at primary school, ‘Viertel owes threepence’ (for schoolbooks), that he never again borrowed a cent. Nor did he smoke, drink or own a car. Until he died, he lived in the same modest home in Brisbane that he bought in the mid-1950s.

Trained as a cost accountant, Viertel based his sharemarket investment strategy on the forensic study of financial statements. He looked for value, whether it was a company that showed potential to grow its business or be taken over. He liked to buy Queensland companies. Once he decided to concentrate on shares as his investment vehicle, Viertel looked for companies with strong dividend yields that gave him the cash flow to expand his portfolio.

According to an interview that long-time friend George Curphy gave to Personal Investor magazine in 2001, the three fundamentals on which Viertel placed most emphasis were:

  • NTA backing
  • P/E ratio
  • Track history

Viertel was a voracious and methodical reader of company financial statements. He was always alert for takeover appeal and was reportedly a large buyer of shares when the market crashed in October 1987. He stuck to his principle of solid long-term investing.

Remember Any person living today has an almost unbelievable advantage over Viertel in terms of accessibility, and ease of accessibility, to information. That makes his success — and the gift, which keeps on giving, that he and his wife left the nation — even more admirable.

Peter Lynch

Peter Lynch became a household name in investment through his work at the Boston-based international fund Fidelity Magellan. Lynch retired in 1990, handing over to his successor a fund worth $14 billion. In his 13 years at the helm, Lynch managed the fund to an average compound return of 29 per cent a year, a record for funds of that size. This translates to a total return of 2,510 per cent, more than five times the appreciation in the S&P 500 over the same period. Lynch believes that individual investors who know what they’re looking for can spot good stocks before professional investors. He says that products or services you deal with in your workplace, buy in the shops, or use in your spare time and on holidays are a great source of investment ideas in the companies that make or offer them.

He divides companies into these main types:

  • Asset plays: Companies trading at a discount to their NTA backing.
  • Cyclicals: Those companies with earnings that closely follow the economic cycle.
  • Fast growers: Small, aggressive companies growing at more than 20 per cent.
  • Slow growers: Companies with earnings growth that match the growth rate in gross domestic product (GDP).
  • Stalwarts: Companies with solid growth in earnings of about 10–12 per cent a year.
  • Turnarounds: Poor performers that have cleaned up their act and are poised for recovery.

Of these types of companies, Lynch is interested only in fast growers, turnarounds and asset plays. Lynch likes companies that have a low PEG ratio (their P/E ratio is below their forecast rate of growth in EPS), a strong cash position, low gearing and a high profit margin.

John Bogle

John Bogle, who died in 2019, deserves to be considered one of the great investors — for inventing the index fund. An index fund owns a portfolio of stocks that is constructed to match the investment returns of a specified market index. The manager of the fund buys and holds that index, and doesn’t try to actively manage the portfolio.

Bogle was an economics student at Princeton University in 1949, researching his thesis on mutual funds managers, when he first hit on the idea. He founded the Vanguard Group in 1974 to practise his theories. His approach was that funds managers couldn’t consistently beat the market. A bond fund manager can’t outguess interest rates; nor can a share fund manager outperform the market, on a cost-adjusted basis. As Bogle put it: ‘What’s the point of looking for the needle in the haystack? Why not own the haystack?’

This philosophy flowed on to the exchange-traded fund (ETF), although Bogle (who did not invent the ETF) was not a fan of all ETFs, worrying that some were being manipulated by speculators. In his final book, he urged investors only to use ETFs as long-term investments. But broad-based index ETFs do allow any investor to ‘own the haystack’.

John Templeton

John Templeton rose from poor beginnings in Tennessee to found the huge Templeton Mutual Fund group, and was one of the first US fund managers to invest in foreign shares. The Templeton group paved the way for US investment in the Japanese stock market in the 1960s but, by the 1980s, the company felt that the Japanese market was overpriced and sold its holdings. The company looked silly for a few years, but with the Nikkei losing 80 per cent of its value over the period 1989 to 2003, you’d have to say that Templeton was right.

Templeton’s investment credo has been set out in ten points:

  • Avoid the popular: Too many investors can spoil any share selection method or any market-timing formula.
  • Buy when the market is most pessimistic: Conversely, sell when the market is most optimistic.
  • Hunt for value and bargains: In the sharemarket, the only way to get a bargain is to buy what most investors are selling.
  • Invest for real returns: The true objective for any long-term investor is to get maximum total real return after taxes and inflation.
  • Learn from your mistakes: ‘This time is different’ are among the four most costly words in investing history.
  • Never adopt any type of asset or selection method permanently: Stay open-minded, and sceptical.
  • Never follow the crowd: If you buy the same shares as everybody else, you’ll get the same results as everybody else. To be a true contrarian, buying when others are selling and vice versa requires the greatest courage, but pays the greatest reward.
  • Recognise no-one knows everything: An investor who has all the answers doesn’t even understand the questions.
  • Search worldwide: If you do, you’ll find more and better bargains than if you confine your investing to only one country.
  • Understand everything changes: Bull or bear markets, they’ve always been temporary.

Because he was a pioneer in overseas investing, Templeton also had a set of rules to cover his decisions. He avoided countries plagued by socialist policies and/or inflation and favoured those with high long-term growth rates. Templeton especially favoured countries that showed a trend towards economic liberalisation or privatisation, anti-union legislation, and greater openness and transparency in sharemarket dealings.