Stig Brodersen 3:56
Yeah, so definitely, I agree with that Preston that it’s really, really hard to a…to quantify something that is so qualitative. I guess it’s, it’s like comparing to how to pick a spouse. Like you want to have a spouse that is intelligent; who has humor; who’s that good-looking perhaps, but how do we quantify that? And I think that we have the same problem here. A one…a few things that we can quantify though is the debt level. A vigilant leader is definitely not going to allow a company to have a lot of debt.

Preston Pysh 4:26
Yeah, and Stig, so I agree. So if you’re finding a business, and it has, you know, a very high debt-to-equity ratio, and that’s what Stig is referring to here. If it has that real leveraged business, you can generally assume that, hey, this is a leader who’s either trying to make the business survive because it’s getting ready to die or this person just makes very risky decisions. And so, you know I mean? Look at, look at an individual person if they’re in debt up to their eyeballs. That’s not necessarily somebody you would want to invest in if they were, if they said that they had some type of company that you wanted to invest in it. So use the exact same principle whenever you were applying this first rule that Buffett has is look at how the company is managed. Is the company having stable and predictable results? Is the company have low debt levels? And all those are kind of signs of a key leader; a decision maker within that organization that is making wise and consistent decisions to not jeopardize the future of the business. And that’s really where Buffett’s concern is, is he doesn’t want to invest in a company that has a leader that is prone to a lot of risks in his decisions because that jeopardizes the future results.

Stig Brodersen 5:36
Yeah, and I definitely agree with you, Preston. Because the inverse of risk, that would be flexibility. If you have a company that has very low debt, you also have a leader that has a lot of flexibility. So if he finds a product that is really good, or if he decides to buy another company, well, because he doesn’t have debt, he has a lot of flexibility to take the right decisions.

Preston Pysh 5:57
So Stig has a great point here. When a company does not have a lot of debt, that company has the ability to go left and right a whole lot easier. So the analogy that Stig and I like to use is think of a speedboat. That speedboat is, is representative of a company that doesn’t have a lot of debt at all. Then, think of like a cruise liner. And that would be a company that would have a lot of debt. If that business has a competitor that comes into the water, and it’s very difficult for them to, you know, beat or they need to kind of maybe take a different direction with their product or their service. That speedboat can kind of turn on a dime and go in that direction because they’re not highly leveraged and not reliant on all these dollars that they borrowed; that they got to pay back in the future. And so think of that boats. Think of that cruise liner. And now it might be going, you know, steady and straight, but if they have to change course for whatever reason, it’s going to be a major muscle movement and something that takes a lot of time. So that’s kind of how we want you to picture that, that piece of this. And it all kind of wraps into this larger rule of having a vigilant leader that would not put the company in that position. So let’s go ahead, and then jump to the second rule, so that we can continue this discussion. And if there’s anything that was covered in that first rule like the debt-to-equity ratio that was a little bit difficult for you to maybe conceptualize or understand, I, ike I said in previous episodes, I highly recommend that you go to our website: buffetsbooks.com. It has many of hours, of information, and lessons that would cover that, and it could show you graphically on your screen. And it will also show you how to look up some of that stuff on the internet, so that you can find out what the debt levels of a company are. So let’s go ahead and move into the second rule. And, Stig, go ahead and introduce the second rule here.

Stig Brodersen 7:40
Thanks, Preston. So Warren Buffett’s second rule that is, “The company must have long term prospects.” And if you think about it, it’s actually very simple. Why? You want a company that can deliver you a nice return year after year. So if a company has long-term prospect is selling product that you can expect them to be selling in like 30 years from now. And you might think, “Well, I don’t know what will be selling 30 years from now.” But instead, I would like to say, “Please disregard the products that you are not certain of 30 years from now.” So let me give you an example, starting with a Warren Buffett quote, “Will the internet change the way that we use the product?” And the example that Warren Buffett is using is actually Wrigley’s Gum. He’s saying the internet will not change the way we chew gum. So as you guys know, he’s, he owns the major stake in Wrigley’s, and he’s really fine on that because he know that this is a persistent product. He knows that this company will make money 30 years from now.

Preston Pysh 8:41
Okay, Stig. So I want to jump in, and say something here. So it’s kind of interesting what you’re talking about here as far as picking a company that has long term prospects because a lot of people will kind of have a, a counter look, and look at it from a different perspective, okay? And a lot of people are trying to find the next Microsoft. They’re trying to find that company that is emerging; that has a lot of growth. And, and Buffett kind of takes a different approach. And I thought about something that I had read in an Alice Schroeder book, which was a biography of Warren Buffett. And in that, she kind of talks about this speech that Buffett gave at a big convention at Sun Valley. And for anyone who doesn’t know what Sun Valley is, it’s this really big convention where a bunch of multimillionaires and billionaires kind of show up, and it’s kind of like a weekend event. And so Buffett gave this speech at Sun Valley to all these investors back in the early 2000s. And during the speech, he was basically telling everyone, and this is the height of the internet bubble. And Buffett knew that the market was way overvalued. And Buffett told all the people there that investing in new technology was, was often counterproductive to the investor because in the end there’s only gonna be one or two that basically survive this competitive nature. And so Buffett used an example of a car company back in the early 1900s, and he said, “There’s, there’s something like 2000 car companies back in the early 1900s. And now, how many exists?” And he said, you know, “You just had the the major three in the US.” And so the whole point of me saying this story is Buffett was trying to find the company that had long-term prospects. He didn’t want to invest in the company that was gonna be the flash in the pan; that only lasted for a couple years. And so when Stig is talking about the internet, and things like that like chewing gum; that’s something that’s gonna be around for a, for a long time. And that’s something that’s going to produce consistent profits year after year after year. And it’s just kind of an interesting way to look at things and how he took something that the common person looks at is, “I’ve got to find the next Microsoft, or I got to find the next Apple.” And kind of flips that on its head and says, “Actually, you need to find something that’s gonna be around in 30 years from now or 40 years; that you can really rely on.”

Stig Brodersen 10:57
And I definitely agree with you, Preston, because it really doesn’t take an expert. You don’t need to be an expert to realize where people would u–would use in 30 years because you’re probably using this product every day. So you can just look around in your living room, and look around your kitchen, and see which products you expect to, to use the next 30 years.

Preston Pysh 11:17
Okay, so why does Buffett have this rule? Why does he have this long-term prospects rule? And it really comes down to one thing: he wants to avoid the friction of tax. Okay? And this is very important to understand. So whenever you buy something, and then, you sell it one year later. You’re taxed at a very high rate within, within a one-year time frame. So like these day traders, they pay extremely high tax on the gains if they even make gains or owning that stock. But if you continue to own something, let’s say for 30 years. And those profits continue to mature and continue to grow within the company, he’s not taxed at all on that growth until he would eventually sell the stock, you know? One of the things that Buffett is quoted for saying is that his term for “Ownership is forever.” He plans on owning his picks forever. He doesn’t plan on ever selling them. And so if he continues to hold for 30, 40, 50 years, he never pays the effective tax on that growth from his initial purchase price. So there’s some statistics out there that show that if a person would sell their stock every single year, and pay that high tax; and the person who would just buy one time, and then let the pick grow, and never sell it till maybe like 30 years later. If you compare those 30-year analysis of each pick and both picks were growing at 10% annually, the difference at the end is enormous that you might have one person make 150,000, while the other person makes almost double that because they were able to hold that pick and not have to pay the taxes every year.

Stig Brodersen 12:52
So, guys, basically Preston is saying two different things here. He’s saying that if you sell your stocks really fast you are on another tax bracket. But what you guys need to understand is that even if the tax bracket was the same, no matter if you held the stock for one year or for five years, it’s not the same. It might sound like the same, but I’m really going to stress, it is not the same. So I think that really pretty much rounded up the second rule that Warren Buffett uses for his stock investing. The third rule that is that this stock is stable and understandable. So Preston, why don’t you introduce that rule?

Preston Pysh 13:29
So Stig, this one’s a very important one. When you go through Benjamin Graham’s books, The Intelligent Investor and Security Analysis, one common theme that you’re really gonna see that throughout both of those books is that stability is one of the most important things that you can find in a stock pick. Because without stability, you can’t determine what the trend line is; you can’t determine what you think the future cash flows of the business are. And this this rule really kind of ties to the fourth one, which is the intrinsic value calculation and finding something that’s undervalued. And without finding a business that has stable results, stable earnings, stable levels of debt; all those factors that are very crucial to properly defining and properly determining what a company is worth, you’re not going to be able to figure out and, and come up with a high level of confidence that your projections for the future are attainable or probable. So when you’re looking through some of the key factors that you want to use in order to find a stable business, you’re obviously going to start with some of the stuff that we talked about in the in the two previous episodes. So earnings or the profit is extremely important. You don’t want to find a company that has earnings that are really high in one year; really low in the following year. You want to find that company that can produce stable and consistent earnings and growing earnings over time. So it should look like a really nice clean chart. If you were going to graph it, it should look nice and clean. The other thing that you might want to look at, that’s, so that it stays nice and stable is the dividend. So you’re receiving those dividend payments, whenever you would plot that on a graph for the, for the past 10 years, and you want to look at that. And that’s typically what Stig and I would look at would be the previous 10 years. You want to see something that’s consistent; something that’s trending in the right direction. You don’t want it trending down. And then one final thing that you would maybe want to look at would be, maybe the book value or the return on equity of the business. Both two terms that we really haven’t previously discussed, but something that you can do a little research on your own. And again, go back to the Buffett’s Books website if you want to watch like, you know, videos and graphics that kind of describe how this stuff works. That you’re trying to look at different metrics, and I just named some of the big metrics that you want to refer to. And you want to see those plotted and you want to see that those are trending in the right direction, and that they are consistent and stable so that you can use that as predictive analysis of what’s going to happen into the future.

Stig Brodersen 15:54
Yeah, and guys! And again, relate to the previous rule was, which was about the long-term prospects. You really want to invest in the company that can make real consistent returns year after year. So if you only looking at the last two years or the last three years, well, you might see that product X is making a lot of money. But Warren Buffett does not like to invest in companies if it hasn’t given good returns for 10, 15, 20, or even 30 years in a row.

Preston Pysh 16:21
Okay, so that kind of, we’re just going to leave the discussion there. Pretty general. But in, in short, without that stability factor, you can’t move into this last rule; the fourth rule, which is calculating the value of the business because you’re just not going to have really anything to base it on. You’re not going to have a baseline analysis in order to project, okay? So let’s go ahead and talk about the fourth rule. And this is the big one. This is the one that he, he really truly starts with because he’s able to quickly filter out companies that he doesn’t think are going to be, you know, worthy of his purchase. So and this is by a business at a very attractive price. And I read somewhere that the only tweak or the only change that Buffett and Charlie Munger had to these four rules was in this last one. And they originally when they wrote this rule, it was by the business at an attractive price. And the thing that they did is they changed it to they need to buy a business at a very attractive price. So they haven’t adjusted these rules for, you know, decades. They’ve been investing off of these rules. So this one here’s, a kind of a trickier role to do because what you’re doing is you’re actually calculating. You–you’re using a discount cash flow calculation in order to determine the value of something today. And what I think a lot of people don’t understand is that a dollar tomorrow is not the same as a dollar today. And that’s where you need to start when you’re trying to understand, “How do I calculate the intrinsic value of a business?” And so in very short terms, and I’m just going to say this as, as briefly as I can. What Buffett is doing is he’s trying to calculate all the future cash flows of the business. So he thinks this year, the company might earn $10 a share. Next year, he might think it earns $11 a share. The year after that, 12, 13. So clear out into infinity, okay? And so he has a calculation and a formula, we have that on Buffett’s Books if you go to the website. You can use the calculator. It’s 100% free, so you don’t have to worry about giving us your email or anything like that. You just go there. It’s completely free. And what you’re going to do is you’re going to assess, and you’re going to use a trend line in trying to figure out what are these ca…future cash flows of the business. Once you figure out what all those future cash flows are, what he then does is he discounts those future cash flows; those dollars that are not the same value as today dollars. He’s going to discount those cash flows back to today, so he knows what the value of all those future dollars are today, okay? And that’s what’s really important is what’s the value of that future cash today. And when you know that, and you figure that out, then you can put the price on the company. And you might be able to say, “Hey, this company’s worth $100 a share.” Okay? And just using that simple discount cash flow calculator, and it’s very simple to use. So if you, if you check it out, you’ll, you’ll see it’s not all that difficult. It might sound difficult in concept because maybe you’ve never done something like that before. But after you get a little bit of practice, it’s going to make a lot more sense, and it’s going to be pretty easy to do.

Stig Brodersen 19:26
Yeah. So guys, I just want to add a word of caution here. I think that, Preston, I think we need to introduce the margin of safety concept here. And the way that Warren Buffett likes to introduce the concept of margin of safety is by saying, “If you would build a bridge, and you knew that 10,000 pounds trucks would drive over that bridge every day, how strong would you make that bridge?” What would you say, Preston?

Preston Pysh 19:52
I’d say, it needs to support a 20,000 pound vehicle.

Stig Brodersen 19:57
So some people might think, “Okay, let’s just make the bridge strong enough to a…what 10,001 pound because that should be sufficient. Anyways, there will only be trucks running over the bridge of 10,000 pounds. But the thing is, when we talk about intrinsic value, it’s really, really hard to have an exact value of that stock. Every time I hear people say, “Well, the value of this stock is $120.52, then I’ll probably stop listening to what they’re saying. Because it’s completely impossible to make an exact measure of the intrinsic value of a stock with two decimals. Wouldn’t you agree with that, Preston?

Preston Pysh 20:38
Yeah, I, I talked about it in more general terms like I think that company is worth about $100 if it’s discounted at 10%. So Stig brought up a great point about this margin of safety. And that’s really kind of the two points that we want to highlight here in this final fourth rule is that you got an intrinsic value that you got to determine what you think the company is worth, and then, you also have to make sure that that value that you come up with has enough variants from what it’s actually trading for on the stock market. So the margin of safety is what gives you that. So let’s say that you determine that you think that a company is worth $100 at a 10% discount rate, so you’re going to get a 10% return if you can buy it for $100, okay? And let’s say that the company is trading on the stock market for $50, okay? That’s a very large difference between what you think it’s worth and what the, what the market’s currently trading it for. And when you have that large difference, that’s a golden opportunity for you as an investor to, to purchase that stock. Now, let’s say that the…let’s say the you determine an intrinsic value of $100 at say a 3% discount rate. And the discount rate might not make a lot of sense to you right now, but if you play around with the calculator, and you maybe study this topic a little bit more, it’ll make perfect sense. But the discount rate is telling you what percent yield you think you’ll get annually by owning that particular stock at that price. So if I say this, I want the stock is worth $100 at a 3% discount rate. I buy it $100, I’ll get 3% annually for owning it, okay? So let’s say that that’s what we’re working with right now. And let’s go back to this margin of safety idea. So if the stock is trading on the stock market for $90, okay? And you think it’s worth 100 at a 3% discount rate, you’re going to have a much harder time getting a margin of safety there. You’re pretty much going to get maybe a 3% rate because it’s so close. And that’s what Stig’s referring to as you can’t go down to the decimal. It’s kind of more in general terms of what you think that the company is worth. So if you’re comfortable getting a 3% return, I wouldn’t be for a common stock. That’s something that you have to make the decision of whether you’re willing to assume that risk or if you think that you have enough margin of safety on the pick. So two very important concepts that you’ve absolutely got to understand. To cover it in the podcast, you know, to get into the depth of how the calculation’s done and all that, that’s something that I don’t think we can do through an audio medium. So I would definitely recommend that you go to the Buffett’s Books website. Watch the free videos there; use the free calculator; and see how it kind of works, and, and try to understand it more so that you can start applying it.

Stig Brodersen 23:24
Yeah, and what’s really interesting here is that intrinsic value, I would come up with, for instance, for Coca-Cola is probably not the same value as Preston has come up with. And I think that might be something that would confuse you in the beginning. You might think that if I use this calculator or no matter which form that I would use, I must come up with some kind of finite, finite value for say, Coca-Cola stock.

Preston Pysh 23:49
So even though Stig and I would come up with different values, our values aren’t going to be at a difference of, you know, a couple percent. So let’s say, I think that I’m going to get a 10% return at the current market price. Stig isn’t going to come back and say he thinks he’s gonna get a 5% return. He might say, “Oh, yeah. I think I’d get a nine or like an 11.” It’s going to be pretty close, but it’s not going to be the same.

Stig Brodersen 24:10
And I really want to encourage you guys when you make your first calculations to a, to ask the, the other users in the forum because I think it’s really interesting when I have made an analysis of a stock and see what kind of intrinsic value that the other users have found.

Preston Pysh 24:25
Okay, so this kind of concludes our introduction and our basic lessons on Warren Buffett. For next week’s show, we have a very special guest. His name is Hari Ramachandra. And what he’s going to be doing is he’s going to be talking about a billionaire investor, who has adopted very similar methods as Warren Buffett. And this gentleman’s name is Mohnish Pabrai, and he has an equity fund that is returned a cumulative of 517% to his investors, whenever the S&P 500 only did 43%, since his fund was incepted back into 2000. So that’s going to be a very interesting exchange. Hari recently went to his shareholder’s meeting just about a month ago. And so he’s going to be on the show, and he’s gonna be talking about this great investor and some of the things that he’s doing. So we can’t thank you enough for listening today. If you have an opportunity to leave us a review on iTunes, we would greatly appreciate your feedback. Also, if you would like to ask any questions on our show, go to asktheinvestors.com, and record your question there. If your question gets on the air, we’ll send you a free signed copy of the Warren Buffett Accounting Book. And we really look forward to working with you in future episodes and tuning in. So thanks for listening!

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Extro 27:31
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