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The Master of Value Investing: Warren Buffett and Berkshire Hathaway

Warren Buffett has turned his steady devotion to value investing principles into some $53.5 billion in net worth. One of the wealthiest people in the world, Buffett is clearly the king of value investing.

Buffett displayed business acumen from an early age but dropped out of college before getting a degree. When Intelligent Investor, by Benjamin Graham, the father of value investing principles, hit the shelves, Buffett applied to Columbia Business School and became one of Graham’s students. Buffett later worked for Graham at the brokerage firm Graham-Newman, where he learned to manage investment portfolios and, eventually, to use insurance company assets as an effective investing vehicle.

From these beginnings Buffett started his own investment fund (with contributed capital from neighbors, relatives, coworkers, and the like) and later built the Taj Mahal of investment companies, Berkshire Hathaway.

Taking over Berkshire Hathaway

When Buffett first spied Berkshire in 1962, it was a faltering Massachusetts textile company. Buffet saw potential value in a very depressed stock and began buying shares cheap for his partnership. He continued to accumulate shares until, in 1962, the partnership owned 49 percent of the company, effectively giving him control.

Originally, Buffett’s plan for Berkshire was to right some of the wrongs and capture quick gains by selling or merging the company. Instead, he saw an opportunity to use Berkshire as an investment conduit to build worth by buying other businesses.

Buffett distributed the partnership in 1969, offering a choice of cash ($8,400) or 200 Berkshire shares (worth $42 each at the time) as part of the distribution. For his portion, Buffett (and a few others) took shares, and Buffett offered to buy the shares of other partners for himself. Under Buffett’s control, Berkshire grew to become the world’s largest investing pool, and those original shares, which were worth $42 apiece then? They’re now worth about $170,000 apiece in mid 2013. A 200-share investment would be worth $34 million today!

Breaking down Berkshire’s formula for success

The Berkshire formula is this:

  • Employ cash flows from businesses owned within the holding company.

  • Buy stocks and bonds in the open market.

  • Use the cash flow to buy businesses outright — preferably cash-rich and cash-generating businesses— to build the investment pool and increase book value.

  • Acquire solid insurance companies to provide cash flow and further build investing float and to insulate from downturns.

Gradually, Buffett shifted his emphasis from small, opportunistic, turnaround situations to longer-term large-cap investments and even acquired whole companies when the numbers were right. He did this with a clear eye on tapping the growth potential of major companies and major brands. Berkshire put together a world-class portfolio of high-visibility, blue-chip growth stocks, including such household names as Coca-Cola, Gillette, American Express, and Wells Fargo, and more recently, the Burlington Northern Santa Fe Railroad.

Intrinsic value on the balance sheet, solid earnings with at least some growth and growth potential, and solid value in the franchise are what Buffett looked for in all his investments. And always — repeat, always — at a good price.

Going beyond shares to buying whole companies

Acquiring shares certainly works over time and is what ordinary value investors should focus on. But Berkshire went beyond this strategy to buy whole companies for its portfolio. Why? Two reasons, mainly. One, if you own the whole company, you’re entitled to its cash and cash flow and can reinvest it as you like. Two, you don’t have to compete with other shareholders, and management and reporting relationships are simpler.

So Berkshire Hathaway has made many “whole enchilada” investments. The insurance group has grown substantially and is anchored by consumer favorite GEICO and by General Re in the lucrative reinsurance (wholesale insurance) market. Altogether, these companies produced almost $158 billion in revenue in 2012, with $15 billion in net profits and $73 billion in float to invest — cash taken in but not paid out on claims and used for investments. The insurance group Berkshire Hathaway now includes some 12 companies, and the manufacturing, retail, and service group now consists of some 69 companies, large and small, all successful in their own arena.

What do all Berkshire Hathaway companies have in common?

  • They are profitable, safe, and solid.

  • They are easy to understand with simple business models.

  • They produce plenty of cash flow to reinvest.

  • They are unique businesses with strong market positions and franchises.

  • They have solid, trustworthy management.

  • They were bought at reasonable prices.

Ordinary value investors can’t assemble this kind of portfolio, but you can learn from what makes Berkshire Hathaway and its master tick.

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