The Art And Science Of Warren Buffett

Steve Pomeranz: This is the second installment in my series, “Investing Like Warren Buffett.”  In my first segment, I interviewed Bud Labitan who, through extensive research, devised what he calls the “Four Filters of Buffett and Munger.”  Today my guest is Scott Thompson, Chairman and CEO of Ameritrust Group, and he, as well, is a disciple of value investors Warren Buffett and Charlie Munger, among others. We’re here to discuss his book Art & Science of Value Investing: Invest Like Billionaire Warren Buffett.  Hey, Scott, first time on the show.  I welcome you to the show.

Scott Thompson: Thanks, Steve, glad to be here.

Steve Pomeranz: I see that Peter Buffett, Warren’s son, has written the forward to your book, which is quite an accomplishment on your part. I know Peter is not really an investor.  He’s chosen a completely different path.  Why did he write the forward?

Scott Thompson: Sure, Peter and I have been friends since 2009 when we met at a non-profit event in the Midwest.  And we’ve kept in touch and met maybe three or four times a year, every year since then, as well as doing video chats once a month. I discussed the book with Peter and sent him the content, and Peter was interested in the book.  But I think what really interested him and made this book more special, and the reason why Peter decided to write the forward, is because Chapter 16 of my book, Art & Science of Value Investing, has a chapter called “Responsible Philanthropy.”

And right now, Peter is very focused with his wife Jennifer on Responsible Philanthropy.  Their foundation, the Noble Foundation, is rated one of the top foundations in the world.  And I think what really interested him is, in addition to the quality content in the book, is that after readers learn how to make the money, this is really one of the few books that teach how to responsibly give it away.

Steve Pomeranz: Yeah, and Buffett had said very early on that he was going to give away the majority of his wealth, and he has done so working with Bill Gates and his foundation and the like. He’s, in a sense, written his own book, or, let’s say, forged his own path away from what common thinking was for all these multi-billionaires. Let’s get to the book. One thing that struck me is that whenever you listen to Warren Buffett, I don’t know what questions he’ll answer when you have lunch with him that you pay a million two for.  But, to the rest of us, he basically will never tell you what his investing strategies are. We kind of know, in general, we kind of know the work of Ben Graham, his mentor, and so on.  But, there was this one thing that he mentioned in his 2011 annual report for Berkshire Hathaway that you bring up.  It’s called the Two-Column Valuation Method.  And I was like, wait, what is this? This is like the first time.  So first of all, since he never specifically talks about investing formulas, what was that all about?  What can we learn from the two columns?

Scott Thompson: Sure, well, in the book Art & Science of Value Investing, in chapter 9, I discuss in detail Warren Buffett’s two column method and how it works. The two-column method is based on two valuation columns.  One column is pretax investments, which is found on the balance sheet.  And the second column is pretax operating earnings.  And investors can assign a multiple, for example, a conservative multiple might be close to 10 on the pretax operating earnings. So, if we multiply the pretax operating earnings by a multiple of, say, ten, and then the pretax investments, those two columns added together would give a valuation.  So in my valuation currently in 2016, of Berkshire Hathaway on the A shares is 285,000 a share, and that’s based on the two column method.

Steve Pomeranz: Well, for most of my listeners, I think that probably went right over their heads.  So let’s take that, and break that down just a little bit.  So when we talk about pretax earnings, that’s very simple.  It’s the earnings that a company earns, but before they pay taxes on it, right?

Scott Thompson: Correct.

Steve Pomeranz: So that’s pretty easy.  And then the value of their investments, is that what you said?

Scott Thompson: Right.  Right, and those are the assets like cash, and cash equivalents, and bonds.  And those can be found on the balance sheet at the top.  Right, and so then you want to assign a multiple, meaning that a business is going to sell for some multiple of earnings.

Steve Pomeranz: And in this case, pretax earnings, you say the multiple is 10 which is very conservative because I think the S&P 500’s probably somewhere around 18 times or more of trailing earnings.  So, 10 is a very conservative multiple. You multiply the earnings times that, but, of course, the S&P, that’s also after tax. So, it’s not quite as conservative.  Anyway, you multiply that, you get a number, you add up all the assets on the balance sheet, you get a number, you add the two together, divide it by the number of shares outstanding, and there you go.  There’s one valuation.

Scott Thompson: That’s exactly correct, and the strength of my book Art & Science of Value Investing is that it takes complex subjects like what we’re discussing and really breaks them down in a very simple elements and communicates them to the readers in ways that are very easy to understand.

Steve Pomeranz: Yeah, by the way, I will totally agree, this is a great first book, and second, and third book for anybody who’s interested in parsing out the investing strategies and ideas of Warren Buffett and Charlie Munger, and this is a great place.  He’s got examples of specific companies and how to think about the balance sheet and so on. It’s a great first book, I’m going to start recommending it.

Scott Thompson: Thank you, Steve.

Steve Pomeranz: To people who ask me for—which I get all the time—clients come in and they go, “Can you recommend a good book?”  And I have a group, and this is going to be one of them. Let me ask you this question, why doesn’t Warren Buffett buy new businesses, buy startups, buy these exciting companies like Facebook or Google?

Scott Thompson: [LAUGH].

Steve Pomeranz: Not that that’s a start-up anymore.  You think he would be on the forefront of that.  How come he’s not?

Scott Thompson: Sure, well to be consistent and take a complex subject and to communicate it simply, let’s say, you and I, Steve, are at a hospital at a maternity ward. And you and I are looking through the glass at all the rows and rows of all the newborn babies, and let’s pretend that instead of babies, they were businesses.  They’re newborns.  I’m not smart enough to know which of the babies is going to be a millionaire because they’re newborn babies. So, it’s hard to really differentiate and tell which ones are going to be the winners.  Start-up businesses are the same.  To look at a number of start-up businesses, it’s very, very difficult to look at a start-up business and decide of these 10 or 20 start up businesses, which one is going to succeed.

So what Buffett tends to do—his approach he takes in his investing—is he looks at businesses that have long established track records of increasing earnings, of free cash flow.  And free cash flow is what Warren Buffett refers to many times in his annual reports as owner earnings.  Because the free cash flow is actually the earnings that the investors would receive.

Steve Pomeranz: Yeah, well, it’s the cash you’re taking out.  Non-cash items like depreciation and capital spending and things like that.

Scott Thompson: That’s right.

Steve Pomeranz: So getting back to your analogy of the babies in the maternity ward, Scott, if it was your baby there, of course, you would know that baby’s [CROSSTALK]

Scott Thompson: [LAUGH] That’s right, and that would be the bias, but we would prefer to wait until maybe the baby grows to be seven years old and see if they get a newspaper route or a lemonade stand.  And maybe through college, and if they start a business after college and how enterprising they are. That’s the approach Warren takes with his investing.  Instead of investing when the business is a startup, he would wait and look for established businesses like Coca-Cola.  They’ve been in business for over 100 years, and they have a long-term history of increasing earnings.  And that investment has worked out very, very well for Warren obviously.

Steve Pomeranz: Well, here’s another question for you.  So back in ‘09 and 2010, gold was incredibly hot.  I think it had reached something like 18, or almost, maybe $1900 an ounce.  And, of course, everybody wanted to invest in gold, yet Warren Buffett said, no.  He would not do that. Why wouldn’t he invest in gold?

Scott Thompson: Sure, that’s a great question, Steve. Warren prefers to invest in new productive assets, like businesses.  And, for example, in 1962, when Warren first started buying shares of Berkshire Hathaway in 1962, he started buying the shares at $7.49 a share.  Well, in the same year, in 1962, gold was right around $35 an ounce. And from 1962 to today, gold has appreciated by a 35 x return, and over the same period, from 1962 to today, the Berkshire Hathaway stock has increased by almost 29,000 x return.  So when you compare the 35 x with gold, that’s a great return.  However, 29,000 x with Berkshire Hathaway, it’s really outstanding and absolutely incredible, the financial performance that Warren has been able to accomplish year after year, after year.

Steve Pomeranz: Someone said to me once, that back in Roman times or in Greek times, an ounce of gold would buy a good toga, but today it still buys just a very good suit.  [LAUGH]

Scott Thompson: Yeah, gold today is about $1240 an ounce, around there.

Steve Pomeranz: But even in $1900 or $2000, it still just buys a really good suit. I mean it’s not really that much different.  But I think the key to what you said is that Buffett is looking for assets that are productive, that actually produce something that you can measure.  And you can actually take that cash flow that you’re receiving, project it into the future, and put a number on it, and come up with maybe some inkling of a future valuation. Whereas gold doesn’t actually produce anything.  As a matter of fact, gold costs you, because you have to store it and so on.  And so it doesn’t give you a dividend, it doesn’t give you anything back.  So in a sense, gold is a speculation.  Now, what is the difference in Warren Buffett’s mind, between an investment and a speculation, where is that line?

Scott Thompson: Sure, that’s a great question, Steve. So in the difference between speculation and investing, speculation may be something more of, what we say in the business, is a whisper-stock.  If you overhear a conversation, or someone says, you should buy ABC company or XYZ company, you should invest in that stock. And investors really don’t spend the time to really delve in to do the research, and that’s more of a speculative investment.  Whereas an investment is where a value investor will actually spend the time, read through the financial statements, look at the news articles, read the annual reports, and really dig down deep into understanding the business because, after all, stocks are not lottery tickets.  And this is an important point I want to make.  Stocks are not lottery tickets.  Instead, they’re fractional ownership shares of the underlying business.  So really, that’s the key to understanding value investing is, you’re actually buying a fractional ownership share of the underlying business when you own a share of the stock.

So investors should take the time to understand the business and a lot of people with assets, they don’t have time to invest.  So if they don’t have the time, they should find professionals like yourself and others who could intelligently help them allocate that capital.

Steve Pomeranz: Yeah, it’s said that education costs money. If you do it yourself, it’s going to cost you and, I’ll tell you, in investing it can actually cost you dearly. You can go to school and you can learn it or you can pay a professional, but either way it’s going to cost you money.  So don’t think that just by doing it yourself, especially in the investing world, that it’s going to be low-cost or even free.  Which gets me to another question here is, investor’s temperament, and this is the thing. I’ve been in the investing world for 35 years, owned my own advisory practice for 20 of those years.  And the one thing that I know for certain, when it comes to investors, is that it’s not the market which fails them.  Because investing in the market over time really plugs into the growth of the American capitalist movement, so to speak. Our standards of living rise, that’s reflected in the average shares that are available to investors.  So it’s not that.  If you just kind of stay put, if you were Rip Van Winkle and fell asleep for 20 years, you’d wake up richer, but it’s the investors themselves that fail. Why do so many investors fail?  What does it have to do with temperament?

Scott Thompson: Sure, a great question, Steve. As far as temperament, most investors tend to follow the herd.  So you remember back in the late ‘90s, early 2000s, the .com stocks.  All the .com boom and a lot of investors got swept in the craze of the day and invested in these .com businesses, and there really wasn’t a business behind it. It was just an idea without any earnings.  They had extremely high price to earnings multiples.  Some had negative earnings.  And the companies went out of business and the investors lost their money.  So during that time, Warren Buffett stayed true to his value invest and beliefs and went against the crowd, and people were saying things like you’re a dinosaur, you’re washed up. But, then after the .com stocks crashed, Warren looked like a genius.

Steve Pomeranz: Well, it’s interesting because I remember that very clearly, and people were saying, “Buffett, you’re investing basically in sugar water, Coca-Cola.  What the heck is that?  That’s so old fashioned, and so on.”  And, actually, we’re seeing it today in a lot of these pre-IPO companies that are involved in this new tech revolution that we’re truly experiencing.

That’s real.  And I think that’s an actually important point, that the revolution can be real, but the companies that actually survive and thrive, you can never really predict which ones those are going to be.

Scott Thompson: Yeah, that’s true.  And to emphasize your point, Steve, for the topic of temperament is, investors should not follow the herd. And they should be able to walk away.

Steve Pomeranz: So hard.

Scott Thompson: Yeah, they should be able to walk away from any deal at any time.  And a lot of time investors, they have an inability to control their emotions.  And the best temperaments for value investing tend to be really even keel tempered people, that they don’t really get too high emotionally or never too low. They’re just very level headed, even keel people.  And during the most recent market decline in 2008, after the crash in 2009, Warren Buffett invested into Goldman Sachs around a $115 a share.  Well, what immediately happened after Warren invested billions into Goldman at 115, well, the stock went down to somewhere in the 60s.

So a decline of about 50%.  So, value investors have to have a temperament that they stay true to their investment thesis no matter what the price is.  If you know what the underlying valuation is of the business, price fluctuations are going  to occur, but investors need a temperament that’s going to allow them to make it through the price fluctuations as the stock price converges more with the underlying intrinsic value.

Steve Pomeranz: Well, I think it all comes back to understanding what it is you own.  If you don’t understand the business, and you’re just buying it because you read a good article and it seemed enticing, the growth prospect seemed good.  Don’t kid yourself, you really are speculating, you’re really not investing.

Hey, Scott, unfortunately, we’re out of time.  My guest Scott Thompson, Chairman and CEO of Ameritrust Group, and his book, The Art & Science of Value Investing: Invest Like Billionaire Warren Buffett.  I think you all got a sense of the way Scott puts things together and the value of this book.

Thank you so much for joining us.

Scott Thompson: Thanks, Steve.