Buffet's Investment Philosophy

Topics: Investment, Rate of return, Net present value Pages: 5 (1340 words) Published: August 8, 2008
Assessment of the eight major elements of Buffet's investment philosophy:

1Economic reality, not accounting reality.


One tends to agree with Buffett on this philosophy.
Accounting is a product of many estimates and judgments. It is essentially a rear-view mirror, looking back at what has happened. To add to the problem the view changes with each new accounting period. In contrast the economic reality is the view through the windshield at what lies ahead. It consists of intellectual property, creativity, know-how and the network of production and distribution systems. The brands and trademarks of a business are the symbols of the economic reality – symbols that indicate the reputation of the company. The economic reality changes much more slowly than the accounting reality as it is dependent on the response of the markets to new products and services that the company has to offer or to any substantive changes - up or down - in corporate reputation.

2The cost of the lost opportunity.


Here Buffett is building on the economic principle of the efficient use of scarce resources where the notion of opportunity cost plays a crucial part in ensuring that resources are being used efficiently. The true cost of an investment is what you give up (opportunity) to get it. This includes not only the money spent in buying that asset but also the economic benefits that one has to do without because one bought that particular asset and thus can no longer buy something else with that money.

3Value creation: time is money.


One agrees with Buffett on this philosophy. This philosophy is the positive Net Present Value(NPV) rule in finance. NPV of an asset or investment is the present value of its cash flows less the cost of acquiring the asset. Smart investors will only acquire assets that have positive NPVs and will attempt to maximize the NPV of their investments. The rate of return received from an investment is the profit divided by the cost of the investment. Positive NPV investments will have rates of return higher than the opportunity cost.

4Measure performance by gain in intrinsic value, not accounting profit.


Here the gain in intrinsic value being referred to is similar to the ‘EVA’ , ‘economic profit’ or ‘market value added,’ measures which are used by financial analysts to assess financial performance. These measures focus on the ability to earn returns in excess of the cost of capital. The difference between a company's return and its cost of raising capital is called "EVA" (Economic Value Added). Unlike traditional accounting measures, (EPS and ROI) EVA focuses on economic profit rather than accounting profit and hence calculates shareholder value creation/destruction over the relevant period of time. In other words when we measure performance by gain in intrinsic value we are estimating the amount by which earnings exceed or fall short of the rate of return shareholders and lenders could get by investing in other securities of comparable risk. Thus it builds on the concept of opportunity cost.

5Risk and discount rates.

Here one would disagree with Buffett.
Risk and return is one of the basic principles in finance. Risk and return are directly related. The greater the risk that an investment may lose money, the greater its potential for providing a substantial return. By the same token, the smaller the risk an investment poses, the smaller the potential return it will provide. Thus there are different classes of investment depending on their risks. Buffett may argue that he avoids risk by focusing on companies with predictable and stable earnings and being a large investor he can sit on the boards of directors where he obtains a candid, inside view of the company and could intervene in decisions of management if necessary but this option is not available to all investors especially small ones. Therefore it is not...
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