Warren Buffett's Probability Analysis is His Key to Success
Warren Buffett is synonymous with wealth. At the core of his investing philosophy, one basic principle – elementary probability – has been the north star of his strategy.
Stable-boy selection.
Warren Buffett began applying probability to analysis as a boy. He devised a tip sheet called “stable-boy selections” that he sold for 25 cents a sheet. The sheet contained historical information about horses, racetracks, weather on race day, and instructions on how to analyze the data. For example, if a horse had won four out of five races on a certain racetrack on sunny days, and if a race was going to be held on the same race track on a sunny day, then the historical chance of the horse winning the race would be 80%.
The Evolution of Warren Buffett.
As a young man, Buffett used quantitative probability analysis along with "scuttlebutt investing," or "the business grapevine" method that he learned from one of his mentors Philip Fisher, to gather information on possible investments. Buffett used this method in 1963 to decide whether he should put money into American Express (AXP). The stock had been beaten down by news AmEx would have to cover fraudulent loans taken out against AmEx credit using salad oil supplies as collateral. (For more on the American Express salad oil scandal, see What is the salad oil scandal?)
Buffett went to the streets – or rather, he stood behind the cashier’s desk of a couple of restaurants – to see whether individuals would stop using AmEx because of the scandal. He concluded the mania of Wall Street had not been transferred to Main Street and the probability of a run was pretty low. He also reasoned that even if the company paid for the loss, its future earning power far exceeded its low valuation, so he bought stock worth a significant portion of his partnership portfolio and made handsome returns selling it within a couple of years.
It took Warren Buffet some time to evolve the right investment philosophy for him, but once he did, he stuck to his principles. Over time, Buffett switched from buying low-quality businesses selling at dirt cheap prices and selling them once they had risen in price, to buying high-quality businesses with durable competitive advantage at a reasonable price and holding them for indefinite periods. By definition, companies with a durable competitive advantage generate excess return on capital and their competitive advantage acts like a moat around a castle. The moat ensures the continuity of excess return on capital for the company because it decreases the probability of a competitor eating into the company’s profitability. (For more on Warren Buffett's method, see What is an economic moat?)
If a company's competitive advantage is its brand, it works to ensure consumers continue to associate its brand with positive associations and its competitors' brands with negative feelings (usually through marketing and advertising). The classic example of branding and competitive advantage is Coca-Cola's decades-long fight with Pepsi for the hearts and minds of soda drinkers. If a company's competitive advantage is its low-cost operation, then the company seeks to make its competitors' bid to gain market share prohibitively expensive.
One Billion Dollar Coca-Cola Bet
In 1988, Buffett bought $1 billion worth of Coca-Cola (KO) stock. Buffett reasoned that with almost 100 years of business performance records, Coca-Cola's frequency distribution of business data provided solid grounds for analysis. The company had generated above average returns on capital in most of its years of operation, had never incurred a loss and had a consistent dividend track record.
Positive new developments, like Robert Goizueta’s management spinning off unrelated businesses, reinvesting in the outperforming syrup businessman.
........
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Warren Buffett is synonymous with wealth. At the core of his investing philosophy, one basic principle – elementary probability – has been the north star of his strategy.
Stable-boy selection.
Warren Buffett began applying probability to analysis as a boy. He devised a tip sheet called “stable-boy selections” that he sold for 25 cents a sheet. The sheet contained historical information about horses, racetracks, weather on race day, and instructions on how to analyze the data. For example, if a horse had won four out of five races on a certain racetrack on sunny days, and if a race was going to be held on the same race track on a sunny day, then the historical chance of the horse winning the race would be 80%.
The Evolution of Warren Buffett.
As a young man, Buffett used quantitative probability analysis along with "scuttlebutt investing," or "the business grapevine" method that he learned from one of his mentors Philip Fisher, to gather information on possible investments. Buffett used this method in 1963 to decide whether he should put money into American Express (AXP). The stock had been beaten down by news AmEx would have to cover fraudulent loans taken out against AmEx credit using salad oil supplies as collateral. (For more on the American Express salad oil scandal, see What is the salad oil scandal?)
Buffett went to the streets – or rather, he stood behind the cashier’s desk of a couple of restaurants – to see whether individuals would stop using AmEx because of the scandal. He concluded the mania of Wall Street had not been transferred to Main Street and the probability of a run was pretty low. He also reasoned that even if the company paid for the loss, its future earning power far exceeded its low valuation, so he bought stock worth a significant portion of his partnership portfolio and made handsome returns selling it within a couple of years.
It took Warren Buffet some time to evolve the right investment philosophy for him, but once he did, he stuck to his principles. Over time, Buffett switched from buying low-quality businesses selling at dirt cheap prices and selling them once they had risen in price, to buying high-quality businesses with durable competitive advantage at a reasonable price and holding them for indefinite periods. By definition, companies with a durable competitive advantage generate excess return on capital and their competitive advantage acts like a moat around a castle. The moat ensures the continuity of excess return on capital for the company because it decreases the probability of a competitor eating into the company’s profitability. (For more on Warren Buffett's method, see What is an economic moat?)
If a company's competitive advantage is its brand, it works to ensure consumers continue to associate its brand with positive associations and its competitors' brands with negative feelings (usually through marketing and advertising). The classic example of branding and competitive advantage is Coca-Cola's decades-long fight with Pepsi for the hearts and minds of soda drinkers. If a company's competitive advantage is its low-cost operation, then the company seeks to make its competitors' bid to gain market share prohibitively expensive.
One Billion Dollar Coca-Cola Bet
In 1988, Buffett bought $1 billion worth of Coca-Cola (KO) stock. Buffett reasoned that with almost 100 years of business performance records, Coca-Cola's frequency distribution of business data provided solid grounds for analysis. The company had generated above average returns on capital in most of its years of operation, had never incurred a loss and had a consistent dividend track record.
Positive new developments, like Robert Goizueta’s management spinning off unrelated businesses, reinvesting in the outperforming syrup businessman.
........
Follow:-more on
www.investopedia.com
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