In this essay paper I’m going to compare and contrast the approaches and techniques of two investment gurus of my choice. The criteria for choosing a person that can qualify for being a guru were as follows: he or she should have outstanding performance against the standard market indicators and at least a five year track record, plus be a leader or chief theoretician of a movement. Looking through the biographies of a number of well-known “gurus” I decided to focus on Warren Buffett and Peter Lynch. These two figures are well-established in the world of investment and are believed to be the greatest investors of all times.
Warren Buffett is sometimes referred as “the richest individual in America through investing.” (Spring, 1998, para.2)
Why is he considered on outstanding investor? His wealth fluctuates with the performance of the market, but for the last few years he has been reported to be worth over $30 billion, making him the second richest man in the world.” (Investopedia, 2005)
As for his investment strategy, it may sound commonplace (but the best advice often sounds commonplace), but one of the most efficient ways to increase profits is to cut expenses:
“Buffett says: ‘Managers of high-cost operations tend to find ways to continually add to overheads, whereas managers of low-cost operations are always finding ways to cut expenses.’ And every rand spent unwisely deprives the owners of the business of a rand of profit.” (Spring, 1998, “Go for high profit margins,” para.2)
Unlike some other “gurus” with doubtful record, Buffett has been very successful in implementing the philosophy he’s advocating for:
“Buffett’s principal company, Berkshire Hathaway, has no legal, public affairs or investor relations departments, no security guards, no drivers, no messengers – its overhead corporate expense is less than 1% of operating earnings.” (Spring, 1998, “Go for high profit margins,” para.3)
As for Berkshire Hathaway, “[it] is basically a holding company for his investments. Major holdings he has had at some point include Coca-Cola, American Express and Gillette. Critics predicted an end to his success when his conservative investing style meant missing out on the dotcom bull market…[but]…Buffett’s time tested strategy proved successful.” (Investopedia, 2005)
When it was bought by Buffett, the company’s performance was quite a disappointing one. “In 1962, Berkshire was one more cheap stock of the sort…” (Lowenstein, 1996, p.78)
But this strategy has proven successful in a number of other cases, too. Buffett has a unique ability to recognize hidden potential of the businesses and invest in them at the right moment.
Comparing it with average market variables, “a $10,000 investment in Berkshire Hathaway in 1965, the year Warren Buffett took control of it, would grow to be worth nearly $30 million by 2005? By comparison, $10,000 in the S&P 500 would have grown to only about $500,000.” (Investopedia Staff, 2005, para.1)
When it comes to choosing an enterprise of investing, the value of this business should be assessed by estimating the net cash flows expected to happen over the life of the enterprise, discounted at the present yield derived from long-dated gilts. And the debate between the two approaches to choosing shares, which are the “value” and “growth” ways, Buffets calls nonsense as they are “joined at the hip” (Spring, 1998, “Combine both the ‘value’ and ‘growth’ approaches to investing,” para.2):
“Value is the discounted present value of an investment’s future cash flow; growth is simply a calculation used to determine value. Irrespective of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one the investor should purchase.”
Another good advice from this guru is to put an emphasis on four- or five-year averages. When looking at the figures, the investor shouldn’t take overestimate the importance of yearly results. The investor should only deal with an enterprise when its share price is considerably below its true value. Buffett advices a strategy of “buying stakes in great businesses when they are having a temporary problem, or when the stock market declines and creates bargain prices for outstanding franchises.” (Spring, 1998, “Focus on four- or five-year averages”)
Investing in the simple and stable is another way to go. To escape blunders in valuation originating from erroneously estimating future cash flow, the investor should deal with enterprises that are simple and stable, and focus on a significant margin of safety between the share price and determined value.
One of Buffett’s most controversial principles is to ignore stock market trends. “He doesn’t care what the market has done recently or is expected to do in future. He buys value. And he doesn’t care if a stock has already risen greatly. He bought Coca-Cola after it had already risen fivefold in six years – and then made four times his initial investment over the next three years.” (Spring, 1998, “Ignore stock market trends,” para.2)
In fact, “[h]e isn’t concerned with the supply and demand intricacies of the stock market. In fact, he’s not really concerned with the activities of the stock market at all. This is the implication this paraphrase of his famous quote : ‘In the short term the market is a popularity contest; in the long term it is a weighing machine.’” (Investopedia Staff, 2005, “Buffett’s Philosophy,” para.2)
Another advice from Buffet is to be very selective, and “[n]ormally only five shares account for more than 75% of Buffett’s main investment vehicle.” (Spring, 1998, “Be extremely selective”)
In Buffett 40-year career, as he reports, there were only twelve investment decisions that have made all the difference:
“‘An investor should act as though he had a lifetime decision card with just 20 punches on it. With every investment decision his card is punched, and he has one fewer available for the rest of his life.’” (Spring, 1998, “Getting a few decisions right is what matters,” para.2)
Another element of Buffet’s approach is to pay main attention to the company not on the environment. He advises to turn away from the traditional practice of predicting the direction of the stock market, the economy, interest rates or politics. Instead of it, the financial condition of value the company’s future outlook should be analyzed.
Another feature of a successful investor is his or her ability to keep enough cash ready in the bank to use when there is a need to. Sometimes borrowing money can be practiced, but a good investor shouldn’t abuse this practice:
“Buffett’s company Berkshire Hathaway hasn’t declared a cash dividend since 1967 – shareholders get their reward through the rising value of their shares. The money that would otherwise be paid out to shareholders is used in the company to make it grow faster – and make the price of its shares grow faster.” (Spring, 1998, “Keep lots of cash ready to snap up bargains,” para.1-2)
Obviously, a good investor should possess certain outstanding personal characteristics. This person should be capable of handling market volatility both binancially and psychologically: “Buffett believes that ‘unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market’. (Spring, 1998, “Individual investors can do as well as professionals,” para.3)
Now it’s high time to pass over to discussing the approaches and techniques pioneered and practiced by Peter Lynch. In order to understand his significance as an authority in the world of investment, I’ll start with bringing some statistics about his performance:
“When he started managing the Fidelity Magellan Fund in 1978, it had assets of $20 million. When he retired in 1990, it had assets of $14 billion.” (Investopedia, 2005, “Most Famous For”)
He developed his investment strategy at Fidelity Management and Research, and acquired his significant reputation managing Fidelity’s Magellan Fund. The fund was one of highest-ranking stock funds under Lynch’s management, which started in 1977 at the fund’s launching, and came to an end in 1990, when Lynch retired.
“Lynch ran Fidelity’s Magellan Fund for thirteen years (1977-1990). In that period, Magellan was up over 2700%.” (PBS, 2005)
He is probably the most celebrated mutual fund manager, and he’s sometimes referred to as a chameleon for the reason that he tried various investment strategies, like growth or value, which worked at a certain moment. He is known for uncover the potential of Dunkin’ Donuts, Pier 1 Imports and Taco Bell. Lynch was criticized when his fund surpassed $1 billion in assets at some moment, but the fund rose to $13 billion less than seven years after that moment. Lynch agrees that he took many risks while running the Magellan Fund, but he never had a losing year. As a manager of Magellan, Lynch boasted an average annual return of 29% per year.
Lynch’s strategy is very bottom-up, with selection from the businesses with known to the investor, and then with the help of deep analysis that focuses on a fundamental understanding of the enterprise, its future, its competitive surroundings, and whether the stock can be purchased at a good price.
The key principle of Lynch’s philosophy is investing in familiar companies, sometimes referred to as a story approach:
“The more familiar you are with a company, and the better you understand its business and competitive environment, the better your chances of finding a good “story” that will actually come true. For this reason, Lynch is a strong advocate of investing in companies with which one is familiar, or whose products or services are relatively easy to understand. Thus, Lynch says he would rather invest in ‘pantyhose rather than communications satellites,” and “motel chains rather than fiber optics.’ Lynch does not believe in restricting investments to any one type of stock. His ‘story’ approach, in fact, suggests the opposite, with investments in firms with various reasons for favourable expectations. In general, however, he tends to favour small, moderately fast-growing companies that can be bought at a reasonable price.” (Scott, 1997, “The Philosophy: Invest in What You Know,” para.2-3)
When in comes to choosing stocks, Lynch advices to pay attention to the enterprises only with an understanding of the factors that will influence the stock price. Lynch advices to apply the following criteria to choosing companies to invest (Scott, 1997):
- Year-by-year earnings: Look for stability and consistency, and an upward trend.
- P/E relative to historical average: The price-earnings ratio should be in the lower range of its historical average.
- P/E relative to industry average: The price-earnings ratio should be below the industry average.
- P/E relative to earnings growth rate: A price-earnings ratio of half the level of historical earnings growth is attractive; relative ratios above 2.0 are unattractive. For dividend-paying stocks, use the price-earnings ratio divided by the sum of the earnings growth rate and dividend yield-ratios below 0.5 are attractive, ratios above 1.0 are poor.
- Debt-equity ratio: The company’s balance sheet should be strong, with low levels of debt relative to equity financing, and be particularly wary of high levels of bank debt.
- Net cash per share: The net cash per share relative to share price should be high.
- Dividends and payout ratio: For investors seeking dividend-paying firms, look for a low payout ratio (earnings per share divided by dividends per share) and long records (20 to 30 years) of regularly raising dividends.
- Inventories: Particularly important for cyclicals, inventories that are piling up are a warning flag, particularly if growing faster than sales.
These are the main criteria, while other favorable characteristics include (Scott, 1997):
The name is boring, the product or service is in a boring area, the company does something disagreeable or depressing, or there are rumors of something bad about the company; The company is a spin-off; The fast-growing company is in a no-growth industry; The company is a niche firm controlling a market segment; The company produces a product that people tend to keep buying during good times and bad; The company can take advantages of technological advances, but is not a direct producer of technology; The is a low percentage of shares held by institutions and there is low analyst coverage; Insiders are buying shares; The company is buying back shares.
Unfavorable characteristics are, according to Lynch (Scott, 1997):
Hot stocks in hot industries; Companies (particularly small firms) with big plans that have not yet been proven; Profitable companies engaged in diversifying acquisitions. Lynch terms these “diworseifications”; Companies in which one customer accounts for 25% to 50% of their sales.
When asked about his secret, he answered as following:
“I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one of two of ‘em go up big time, you produce a fabulous result.” (PBS, 2005, “Was that your secret?” para.1)
Therefore, we see that each investment guru has worked out a strategy and techniques of his own.
Lowenstein, Roger. 1996. Buffett: The Making of an American Capitalist. NY: Main Street Books.
Spring, Martin. 1998. “More pearls from the world’s most successful investor.” Available: http://www.btimes.co.za/98/0920/btmoney/money04.htm [26 December 2005]
Investopedia. 2005. “Warren Buffett.” Available: http://www.investopedia.com/terms/w/warrenbuffet.asp [26 December 2005]
Investopedia Staff. 2005 “Warren Buffett: How He Does It.” Available: http://www.investopedia.com/articles/01/071801.asp [26 December 2005]
Investopedia. 2005. “The Greatest Investors: Peter Lynch.” Available: http://www.investopedia.com/university/greatest/peterlynch.asp [26 December 2005]
PBS. 2005. “Betting on the Market: Interview with Peter Lynch.” Available: http://www.pbs.org/wgbh/pages/frontline/shows/betting/pros/lynch.html [26 December 2005]
Scott, Maria Crawford. 1997. “The Peter Lynch Approach to Investing in ‘Understandable’ Stocks.” Available: http://www.csulb.edu/~pammerma/fin382/screener/lynch.htm [26 December 2005]
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