Professor Buffett’s Investments 101 class
If you are an investment geek like me, and my friend Mr. Money, you would not have been surprised that the world’s most famous investor, Warren Buffett, was at it again last week with his purchase of H.J. Heinz for about $28 billion.
He paid 20 per cent more for Heinz than the market was advocating. Just the day before the announced purchase, Heinz was trading at $60.48 a share.
The next morning, Heinz was trading at $72.48.
In the aftermath of this purchase, the students in my investments class (Business Administration 262) pondered why someone, who is known to drive around his home town of Omaha, Neb., looking to buy his favourite drink cherry coke when it is on sale, would choose to pay such a high premium.
It is a great question.
Let’s begin answering this question by considering the philosophy of his mentor, another finance instructor, Benjamin Graham.
A professor at Columbia University, Benjamin Graham had a great influence on a number of famous investors, including Warren Buffett and Sir John Templeton, founder of the Templeton Group of Funds.
Graham discussed his investment philosophy in his book The Intelligent Investor, and while there are many tenets to his investment philosophy, the three most important are: ignore the whims of the market, invest only in companies that pay dividends, and when considering an investment in a company, always buy with a view to building in a “margin of safety.”
Graham’s admonishment to all common stock investors to ignore the whims of “Mr. Market” is essentially that age-old admonishment from our parents: I don’t care what the other kids were doing. I only care what you were doing.
In other words, when investing in stocks you should not worry about what stocks other investors are buying or selling. You need only consider the facts about the company you are considering investing in.
Buffett’s mindset when making an investment is not that he is buying a stock but that he is investing in a company at a reasonable price — the “margin of safety.”
Simply stated, margin of safety can be thought of this way — buy a good stock at $10 and it drops by 50 per cent, you lose $5; buy a good stock at $5 and it drops by 50 per cent, you lose only $2.50.
Defining what is a reasonable price is an interesting question, and one that we delve into with great detail in my investments class at the Donald School of Business.
Buffett looks for companies whose value is significantly more than what the market has priced it at. In other words, they are on sale relative to similar companies in similar industries.
So clearly, when Buffett decided to purchase H.J. Heinz at just over $72, he had determined that the company was worth more than $72.
We can get a good idea of what Buffett thinks is a good price by considering a basic fact about Heinz.
Between 2011 and 2012, Heinz’s earnings per share (EPS) fell from $3.06 to $2.85. In other words, if you owned one share of Heinz, management would have earned twenty-one cents less for each share you owned.
However, management was still able to increase the dividends paid from $1.80 to $1.92. Dividends are the share of net income that management pays out to shareholders.
In other words, Heinz’s management paid out eight per cent more to shareholders in 2012, compared to 2011.
It is an understatement to say that Warren Buffett knows a good thing when he sees it. In Heinz, he saw a company that pays a regular dividend and still manages to grow the size of its business.
So paying an additional 20 per cent was justified from his point of view. Regular cash dividend payments and growth are the key to his investment success.
Buffett clearly feels that the value of $72 a share is cheap (margin of safety) compared to the potential growth in earnings and dividends.
Heinz can achieve these results because it is in stable business that is reasonably recession proof. After all, we may not buy steak when we’re all feeling poorer but we will buy burgers and hot dogs with all of the toppings supplied by Heinz.
Dividends are also a key part of his strategy. They generally confirm that management is doing a good job at running the company, and they reduce any potential losses.
Dividends as part of a risk management tool can be thought of as a hedge against future potential losses. Remember Buffett’s quote on bad times: “You only find out who is swimming naked when the tide goes out.”
Buffett’s purchase of Heinz last week was a free lecture in Investments 101, and a guide to how we can all achieve control over our financial destinies. In the words of one of the fathers at Niagara University, “here ends the sermon, now begins the lesson.”
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.