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Page 2

From Chapter 2

How to Use This Book

Folly and discipline are the key elements of Warren Buffett's philosophy of investing -- other
people's follies and Warren's discipline. Warren commits capital to investment only when it
makes sense from a business perspective. It is business perspective investing that gives him the
discipline to exploit the stock market's folly. Business perspective investing is the theme of this

This discipline of investing from a business perspective has made Warren the second richest
business person in the world. Currently Warren's net worth is in excess of $20 billion. Warren is
the only billionaire who has made it to the Forbes list of the four hundred richest Americans
solely by investing in the stock market. Over the last thirty-two years his investment portfolio has
produced an average annual compounding rate of return of 23.8%.

As humans we are susceptible to the herd mentality, and so we often fall victim to the emotional
vicissitudes that propel the stock market and feed enormous profits to those who are disciplined,
like Warren. When the Dow Jones Industrial Average has just dropped 508 points and all the
sheep are jumping ship, it is investing from a business perspective that gives Warren the
confidence to step into that pit of fear and greed we call the stock market and start buying. When
the stock market soars to the stratosphere, it is the discipline of investing from a business
perspective that keeps Warren from foolishly allocating capital to business ventures that have
neither hope nor prospects of giving him a decent return on his investment.

This book is about the discipline of investing only from a business perspective. Together we will
explore the origin and evolution of this philosophy. We will delve into the early writings of
Warren's mentor Benjamin Graham and the ideas of other financial luminaries of this century,
and travel to the present to explore the substance of Warren's philosophy.

Warren made his fortune investing in the securities of many different types of businesses. His
preference is to acquire 100% ownership of an enterprise that has excellent business economics
and management. When he is unable to do that, his next choice is to make a long-term minority
investment in the common stock of a company that also has excellent business economics and
management. What confuses people who are trying to decipher his philosophy is that he also
makes investments in long-, medium-, and short-term income securities. And he is a big player in
the field of arbitrage.

The characteristics of the businesses that he is investing in will vary according to the nature of
his investment. A company that he is willing to invest in for arbitrage purposes may not be the
kind of business in which he wants to make a long-term investment. But regardless of the type of
business or the nature of the investment, Warren always uses the basics of business perspective
investing as the foundation for his decision.

Most people have the intellectual capacity to understand Warren's philosophy of investing from a
business perspective, but few have the dedication and willingness to work to learn the tools of

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his craft. The purpose of this book is to lay out, step by step, the foundation of Warren's
philosophy and the manner in which he applies it. This book is a tool to facilitate the task of
learning, and it is our intention to teach you Warren's philosophy so that you may acquire the
skills to practice this discipline yourself.

Before we start, I would like to introduce a few concepts and terms that will be used throughout
the book and give you an idea of where we will be heading as we voyage through the seas of
high finance.

First of all, let's take the term "intrinsic value." Its definition has been debated for the last
hundred years. It fits into our scheme because Warren will buy into a business only when it is
selling at a price that makes business sense given the business's intrinsic value.

Determining a business's intrinsic value is a key to deciphering Warren's investment philosophy.
To Warren the intrinsic value of an investment is the projected annual compounding rate of
return the investment will produce.

It is this projected annual compounding rate of return that Warren uses to determine if the
investment makes business sense. What Warren is doing is projecting a future value for the
business, say, ten years out; then he compares the price he is going to pay for the business
against the business's future, projected value, and the length of time required for the business to
reach that projected value. By using an equation that we will show you later in the book, Warren
is able to project the annual compounding rate of return that the investment will produce. The
annual compounding rate of return the investment is projected to produce is the value he uses to
determine if the investment makes business sense when compared to other investments.

In its simplest manifestation it works like this: If Warren can buy a share of stock in X
Corporation for $10 and can project that in ten years the share will be worth $50, he can then
calculate that his projected annual compounding rate of return will be approximately 17.46% for
the ten-year period. It is this projected annual compounding return of 17.46% that he will then
compare to other investments to determine whether the investment in X Corporation makes
business sense.

You may be wondering: If Warren's intrinsic value model requires a projection of a business's
future value, then how does he go about determining that future value?

That, my friends, is the crux of solving the enigma of Warren's investment philosophy. Just how
does one determine the future earnings of a business in order to project its future value and, thus,
its intrinsic value? This problem and Warren's method of solving it will be the focus of much of
this book.

In short, Warren focuses on the predictability of future earnings; and he believes that without
some predictability of future earnings, any calculation of a future value is mere speculation, and
speculation is an invitation to folly.

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Warren will make long-term investments only in businesses whose future earnings are
predictable to a high degree of certainty. The certainty of future earnings removes the element of
risk from the equation and allows for a sound determination of a business's future value.

After we have learned what Warren believes are the characteristics of a business with predictable
earnings, we will learn how to apply the mathematical calculations he uses for determining the
business's intrinsic value and what the return on his investment will be. The nature of the
business enterprise and whether it can be bought at a price that will yield a sufficient return will
determine the investment's worth and whether or not we are investing from a business

Copyright © 1997 by Mary Buffett and David Clark


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