Learn from the legends

Timothy Middleton

• Last Updated: November 07. 2009 12:04PM UAE / November 7. 2009 8:04AM GMT

Omaha, Nebraska is the 40th largest city in the United States. But its population of nearly half a million has a surprisingly large number of millionaires – 15,000, to be exact. It was their good fortune and sense to have been early investors alongside the city’s most famous citizen, Warren Buffett.

The Oracle of Omaha is the second-richest person in the world, according to Forbes magazine, and shares of stock in his company, Berkshire Hathaway, are the most expensive in the world. Class A shares changed hands this week for US$100,450 (Dh369,000).

Mr Buffett made his fortune – and increases it year in and year out – solely through investing. He is happy to share the half-dozen principles that guide his investments, and an entire industry has sprung up to analyse his methods and, hopefully, employ them to duplicate his success. Last year alone three new books about him were published, and Amazon sells more than 5,000 about him and his adventures.

There are only a couple of other investors who can be spoken about in the same breath as Mr Buffett.

George Soros is the world’s most successful hedge-fund operator, and almost single-handedly brought down the British pound on Black Wednesday – as September 16, 1992 came to be known.

And John C Bogle founded Vanguard Group, which has become the world’s second-largest mutual fund complex. Like Mr Buffett, both men have long been eager to share their investing insights and turn up regularly in print and on the small screen imparting their particular takes on matters financial.

While their paths to prosperity may differ, their views and philosophies converge on many points, most notably this one – know what you’re investing in.

This notion is glaringly obvious, but it is remarkable how regularly both pro and amateur investors ignore it.

When investment banks began to topple like dominoes in 2008, they were brought down by synthetic mortgage securities that were literally not worth the paper on which they were printed. When the internet bubble burst in 2000, it demonstrated how much investors misunderstood the way that technology companies make money.

Indeed, very few of us can ever expect to achieve the wealth and stardom of these investing legends. But perhaps we can prosper in their footsteps, just like the millionaires of Omaha.

With the help of some professional followers, here are the rules that guide their investments – and some specific picks that meet their tough standards.

Warren Buffett

Before he was the Oracle of Omaha, Mr Buffett was a student – literally – of Benjamin Graham.

Mr Buffett took Mr Graham’s class at New York’s Columbia Business School. Mr Graham’s most famous book, Security Analysis, was published in 1934 and established its author as the leading proponent of what has come to be called the value style of investing.

Mr Buffett later worked for Mr Graham’s money management business, and even named his son after him.

The first and most important principle to which Mr Buffett adheres is this one: “When you buy a share of stock you’re buying a share of the business. The value resides in the business, not in the price of the stock in the marketplace,” says William H. Browne, managing director of Tweedy, Browne Co., a money manager built on Graham’s principles.

From this principle flows the others Mr Buffett deems necessary for success:

* The business model must be straightforward and easy to grasp.

* The enterprise must deliver a high return on invested capital.

* Management must be honest and capable, and must own a significant portion of the business.

* The company’s core products must be protected by a “moat” that shields it from competition.

* Valuations must be reasonable, based on what Mr Buffett calls “owner earnings.”

Steven M Rogé is a portfolio manager with RW Rogé & Co. in Bohemia, NY, who confesses he’s been following Mr Buffett “since high school.”

Based on how it reflects Mr Buffett’s priorities, Mr Rogé recommends – and owns – Nestlé SA, the consumer staples company headquartered in Switzerland. (And never forget that investing is indeed a global game – your portfolio is almost never limited by your place of residence.)

Nestlé’s business model is crystal clear: It produces nutrition, health and wellness products. These goods are household names, such as Gerber baby food and different varieties of bottled water, almost always the No 1 or 2 brand in their niche, and their reputations provide that “moat” Mr Buffett insists on.

The company’s return on capital has averaged 20 per cent annually since 1995, Mr Rogé says, and gross profit margins have averaged nearly 55 per cent. Nestlé’s management comes from within the company, so bosses are thoroughly imprinted with the corporate culture and wedded to the idea of long-term strategic planning, rather than focusing on quarterly profit forecasts.

“Owner earnings” are similar to free-cash flow, but factors in capital re-invested in the business. Once they’ve been calculated, Mr Buffett analyses the value of these earnings over time, using a meaningful discount rate, such as the yield on long-term U.S. Treasury bonds, as well as a reasonable estimate of how much earnings will increase.

Mr Rogé estimates that, if Nestlé’s profits remain flat in the future, the stock is currently worth around $50 a share. It was trading in the middle of July on Germany’s Xetra exchange for 28 euros, or roughly $38.40.

If Nestlé continues to grow earnings slightly ahead of inflation, which Mr Rogé says is “a more realistic assumption,” the shares are worth $93.

John Bogle

“Jack” Bogle, as he prefers to be called, cut his investing teeth at Wellington Management, a well-known value-orientated American investment shop.

But he made his name when he left to launch the world’s first index mutual fund, Vanguard 500 Index, in 1975.

Ever since, Mr Bogle has preached that investors are wise to own not individual securities, but index funds. Earlier this year, in an article in the Wall Street Journal, he explained why, in direct, if not exactly eloquent, terms. Basically, he warns investors against paying management too much to manage your investments.

Because the heavy costs incurred by investors in actively managed equity funds can easily amount to 2 per cent to 3 per cent annually, typical expense ratios run from 1 per cent to 1.5 per cent; the hidden costs of portfolio turnover often come to 0.5 per cent to 1.0 per cent; a 5 per cent front-end sales load, amortised over a holding period of five to 10 years, adds another 0.5 per cent to 1 per cent per year in costs. All of this adds up and cuts profit.

As a group, investors are by definition indexers. (That is, they own the entire market.) So indexing wins, not because markets are efficient (sometimes they are, sometimes they are not), but because its all-in annual costs amount to as little as 0.1 per cent to 0.2 per cent.

For Mr Bogle, “the market” is the Standard & Poor’s 500 Index, and that’s what Vanguard’s flagship fund follows.

With assets of nearly $78 billion, the fund’s expenses are extremely low – 0.18 per cent in annual fees. Vanguard’s fees are usually the lowest in the industry because the company is mutually owned, by its shareholders, and therefore doesn’t have to turn a profit.

But Vanguard has been undercut in price on indexing the S&P 500. Rival Fidelity Investments offers its Spartan 500 Index Investor Fund for 0.10 per cent, and SPDR Trust, an exchange-traded fund, also charges only 0.10 per cent, and it doesn’t have the $10,000 minimum investment required by Fidelity.

Says Daniel P Wiener, a long-term follower of Mr Bogle as editor of the Independent Adviser for Vanguard Investors newsletter, “Jack would say (to buy) the lowest-cost index fund, so it could be Fidelity’s or an ETF, but not a Vanguard fund, since it wouldn’t be the cheapest.”

Mr Wiener also notes that the 500 fund looks like an increasingly parochial idea – especially for expatriates, who know about global markets first-hand because they work in them.

So he would recommend a global stock-index fund. Vanguard happens to manage one of the largest of these, Vanguard Total World Stock ETF.

Total World Stock, whose expense ratio is 0.30 per cent, has about 40 per cent of its assets in the US. Nearly 30 per cent are in Europe, 15 per cent in the Pacific and more than 13 per cent in emerging markets. The index upon which the fund is based, the FTSE All-World Index, comprises nearly 2,900 large and mid-size companies.

Mr Bogle’s approach to investing relies strictly on asset allocation, or deciding which indices to own, and in what proportion. The overarching decision is how much to allocate to stocks and to bonds. “How much in bonds?” he asked in his Journal article.

“A good place to start is a bond percentage that equals your age.” Mr Bogle recommends high-quality bonds, which can be owned directly or in the form of mutual funds.

One classic way to own individual bonds is to construct a “ladder” of holdings that mature in consecutive years.

Using this method, they can be rolled over into fresh bonds at the then-prevailing rate of interest, which keeps your overall portfolio in sync with current conditions.

George Soros

Mr Soros, whose shorting of the UK pound sterling netted him a $1.1 billion profit on Black Wednesday, made his name at the Quantum Fund, which between 1969 and 2000 claimed to have delivered an annualised return of 32 per cent, a phenomenal figure. (The hedge fund industry is so lightly regulated that independent numbers aren’t available.)

But he doesn’t merely invest in currencies. According to GuruFocus.com, a website that tracks Mr Soros as well as a handful of other famed investors, the most recent portfolio disclosure of Soros Fund Management filed with the US Securities and Exchange Commission shows the firm’s largest stake was in a single stock, Petroleo Brasileiro SA, or Petrobras.

Expatriates in the Gulf region would be wise to avoid Brazil’s oil giant, however, since they are already heavily exposed to the price of oil by geography.

“Portfolios should be integrated with other risks people are exposed to,” says David E Hultstrom of Financial Architects, a planning firm in Woodstock, Georgia, in the US, that has many expatriate clients.

And as an investor, Mr Soros is the opposite of both Mr Buffett and Mr Bogle, who freely disclose what they own and almost never sell anything. “He is much more of a frequent trader than Warren Buffett,” says Eric Kuang, editorial director of GuruFocus.com. “He takes heavy bets on certain sectors and then gets in and out.”

So what can you learn from Mr Soros? “He focuses on a theory of ‘reflexivity,’ which is based on the premise that individual investor biases affect market transactions and the economy,” Mr Kuang says.

In short, Mr Soros is a consummate contrarian who profits from irrational exuberance. Investors tend to flock together behind the idea du jour, as the Wall Street Journal wryly notes in its “Herd on the Street” feature.

Right now, they are flocking to US Treasury bonds, because they are viewed as a safe haven in a world full of economic misery. Since they are bought with US dollars, the greenback staged a rally last year. In the five years prior to that, it had declined in value against the euro by about 35 per cent. In the 12 months ended this March, by contrast, the US dollar rose 15.2 per cent, according to the Bank for International Settlements.

In the following three months, however, the greenback slipped 5.7 per cent, indicating the dollar rally has expired.

With its budget deficits growing to gargantuan proportions – potentially rivalling those of the period around World War II as a percentage of gross domestic product – the US will have a hard time holding up the dollar. No less an investor than the government of China has expressed public concern about the currency.

How to make a buck on a declining buck? Outside of the currency pits themselves, most investors get access to them through ETFs, such as PowerShares DB US Dollar Bearish, which rose 2.2 per cent in the first half of this year, after falling 4.5 per cent last year.

But the easiest way to profit from dollar misery is to own assets that are denominated in other currencies, namely non-US stocks and bonds. Also, some investors turn to commodities to protect against a weaker dollar, but that’s unwise for expatriates in the Gulf, since oil completely dominates world commodity markets and GCC residents are already hostage to them.