Warren Buffetts Probability Analysis Is His Key To Success Warren Buffetts Probability Analysis Is His Key To Success Warren Buffett is synonymous with wealth. Some misinformed souls may think he was merely lucky. If you ask people who have studied his process over the years, however, they will tell you Buffetts success is wholly earned and the product of several factors, from his native intelligence to his single-minded pursuit of value. At the core of his investing philosophy one basic principle – elementary probability – has been the north star of his strategy. Stable-boy Selection Warren Buffett began applying probability to analysis as a boy. He devised a tip sheet called “stable-boy selections” that he sold for 25 cents a sheet. The sheet contained historical information about horses, racetracks, weather on race day, and instructions on how to analyze the data. For example, if a horse had won four out of five races on a certain racetrack on sunny days, and if a race was going to be held on the same race track on a sunny day, then the historical chance of the horse winning the race would be 80%. The Evolution of Warren Buffett As a young man, Buffett used quantitative probability analysis along with scuttlebutt investing, or the business grapevine method that he learned from one of his mentors Philip Fisher, to gather information on possible investments. Buffett used this method in 1963 to decide whether he should put money into American Express (AXP). The stock had been beaten down by news AmEx would have to cover fraudulent loans taken out against AmEx credit using salad oil supplies as collateral. (For more on the American Express salad oil scandal, see: What is the salad oil scandal?) Buffett went to the streets – or rather, he stood behind the cashier’s desk of a couple of restaurants – to see whether individuals would stop using AmEx because of the scandal. He concluded the mania of Wall Street had not been transferred to Main Street and the probability of a run was pretty low. He also reasoned that even if the company paid for the loss, its future earning power far exceeded its low valuation, so he bought stock worth a significant portion of his partnership portfolio and made handsome returns selling it within a couple of years. It took Warren Buffet some time to evolve the right investment philosophy for him, but once he did, he stuck to his principles. Over time, Buffett switched from buying low-quality businesses selling at dirt cheap prices and selling them once they had risen in price, to buying high-quality businesses with durable competitive advantage at a reasonable price and holding them for indefinite periods. By definition, companies with durable competitive advantage generate excess return on capital and their competitive advantage acts like a moat around a castle. The moat ensures the continuity of excess return on capital for the company because it decreases the probability of a competitor eating into the company’s profitability. (For more on Warren Buffetts method, see: What is an economic moat?) If a companys competitive advantage is its brand, it works to ensure consumers continue to associate its brand with positive associations and its competitors brands with negative feelings (usually through marketing and advertising). The classic example of branding and competitive advantage is Coca-Colas decades-long fight with Pepsi for the hearts and minds of soda drinkers. If a companys competitive advantage is its low-cost operation, then the company seeks to make its competitors bid to gain market share prohibitively expensive. One Billion Dollar Coca-Cola Bet In 1988 Buffett bought $1 billion worth of Coca-Cola stock. Buffett reasoned that with almost 100 years of business performance records, Coca-Colas frequency distribution of business data provided solid grounds for analysis. The company had generated above average returns on capital in most of its years of operation, had never incurred a loss and had a consistent dividend track record. Positive new developments, like Robert Goizueta’s management spinning off unrelated businesses, reinvesting in the outperforming syrup business and repurchasing the company’s stock, gave Buffett confidence that the company would continue to generate excess returns on capital. In addition, markets were opening overseas, so he saw the probability of continuing profitable growth as well. Wells Fargo – Buffetts Favorite Bank In the early 1990s amid a recession in the U.S. and volatility in the banking sector over anxiety about real estate values, Wells Fargo stock was trading at an historically low level. In his chairmans letter to Berkshire Hathaways shareholders, Buffett listed what he saw as the pros and cons of taking a large position in the bank. On the con side, Buffett noted three major risks: a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them ... the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run ... [and the fear] that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable. On the pro side Buffett noted that Wells Fargo earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the banks loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In retrospect, Buffetts investment in Wells Fargo in the early 90s has been one of his favorites. He has added to his holdings over the last 25 years, and in 2014 his holdings in the company were worth $21.04 billion, his stake was 8.8% and the weighting of Wells Fargo in Berkshire Hathaways portfolio is 20.1%. Buffetts decision to buy the stock rested entirely on his unique method of assessing the probability of future earnings. Focusing on Obvious, Long-term Social Trends Buffett has bet heavily on renewable energy. He believes over time, due to environmental concerns renewables are going to become the primary source of energy. These changes seem more and more probable as time passes. The Bottom Line Elementary probability, if learned well and applied to problem solving and analysis, can work wonders. Mastery over this kind of an elementary tool and applying it to real life situations could give immense advantages over the average investor, truths tested and proven by “The Oracle of Omaha.”
Posted on: Sat, 18 Oct 2014 09:11:37 +0000
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