Chapter 4
The Equity Bond Concept: Buffett's Revolutionary Investment Framework
Warren's breakthrough insight was recognizing that companies with durable competitive advantages have such predictable earnings that their stocks function more like bonds with variable coupons-"equity bonds." Unlike traditional bonds with fixed interest, these equity bonds offer returns that expand over time as earnings grow.
In Warren's framework, an equity bond's return equals the company's annual net profits. A company with $100 book value per share earning $8 annually produces an 8% return. If earnings grow at 10% annually, this creates an "expanding equity bond" where the initial 8% return keeps increasing.
When buying at a premium to book value (say $150), the initial return drops (to 5.3%), but still grows over time. Warren demonstrated this concept with his 1988 Coca-Cola purchase at $5.22 per share, which by 2011 was earning $3.85 per share-delivering a 1,145% total return or 11.59% annually for 23 years.
This equity bond concept allows Warren to project future returns with remarkable accuracy. Using Coca-Cola as an example at its 2011 price of $65 per share, he calculates both the current return (5.9%) and its potential growth based on historical performance.
To project returns, Warren examines at least ten years of earnings data to identify consistent growth patterns. For Coca-Cola, calculating from 2001 ($1.60 per share) to 2011 ($3.85 per share) shows a 9.18% annual growth rate. This allows projecting that by 2021, Coca-Cola might earn $9.27 per share. Multiplying by a conservative P/E ratio of 16 (the lowest in the period) yields a potential future share price of $148.32, representing an 8.6% annual return on a $65 investment.
Adding Coca-Cola's dividend component enhances projected returns. If Coca-Cola merely maintains its 2011 dividend of $1.88 per share through 2021, the accumulated $18.80 in dividends plus the projected $148.32 share price would yield a total return of $167.12-improving the annual return to 9.9% over the ten-year period.
This projection method works only for companies with durable competitive advantages and consistent earnings histories, using historically low P/E ratios. Applying this approach to companies with erratic profit histories like Ford or United Continental can seriously damage your investment portfolio.
Chapter 5
American Express: Turning Crisis Into Opportunity
American Express perfectly illustrates Buffett's genius for finding opportunity in crisis. Founded in 1850, American Express is a global financial services company handling 24% of U.S. credit card transactions. Berkshire owns 12.6% (151,610,700 shares), purchased between 1994-2000 at an average price of $8.44 per share. By 2011, with shares at $45, Berkshire's $1.28 billion investment had grown to $6.82 billion-a $5.54 billion gain.
Warren first invested in American Express during the 1963 Salad Oil Scandal when the company discovered loans backed by non-existent collateral. Despite $80 million in losses that devastated its net worth and dropped shares from $80 to $30, Buffett recognized that its travelers checks and charge card franchises remained valuable. He invested $13 million (40% of his partnership's money) and sold three years later for nearly $20 million profit.
Warren's insight was that a company with a durable competitive advantage can survive severe one-time losses because its underlying business strength will quickly restore profitability. This pattern repeated in the early 1990s when American Express faced losses from its Shearson Lehman Brothers brokerage operation. Berkshire purchased $300 million in convertible preferred stock when AmEx needed capital.
After Shearson reported a $116 million loss in 1993, Warren increased his position, calculating that divesting Shearson would allow AmEx's core businesses to thrive. American Express sold Shearson for $1 billion later that year, and Warren continued adding to his position through 2000.
American Express benefits from inflation-as prices rise, the company earns more since it collects 2.5% of each transaction. For example, $100 million in 1975 sales would generate $2.5 million in fees, while the same goods costing $400 million in 2011 would yield $10 million. From 1994-2011, American Express's revenue grew from $14 billion to $29 billion (4.8% annually), with roughly half that growth attributable to inflation-requiring no additional capital investment.
From 2001 to 2011, AmEx showed a 216% increase in earnings per share, growing at a compounding annual rate of 12.2% over the decade, including through the 2009 banking crisis. In 2011, American Express had a per share book value of $16.60 and earnings of $4.05, representing a 24% after-tax return on equity. With a market price of $45, investors would earn an initial after-tax return of 9%. Projecting the 12.2% historic growth rate forward ten years yields estimated 2021 earnings of $12.81 per share, potentially delivering a 13.95% annual return-attractive enough for Warren to maintain his $6.82 billion position.
Chapter 6
Coca-Cola: The Perfect Buffett Investment
Coca-Cola represents Warren's ideal investment-a product that conquered the world through its simple yet powerful business model. From its humble beginnings in 1886 when pharmacist John Pemberton created it as a medicinal tonic and sold only 25 gallons the first year, to becoming the world's best-selling beverage under visionaries like Asa Candler and Robert Woodruff. Candler's early marketing genius established the brand, while Woodruff's leadership from 1923 to 1954 transformed it into a global phenomenon.
The company's brilliance lay in its franchise model-selling concentrated syrup to independent bottlers rather than handling the capital-intensive bottling business itself. This approach allowed rapid expansion with minimal investment, first across America and then globally. The model proved particularly effective during WWII when Woodruff made his famous promise that "every man in uniform gets a bottle of Coca-Cola for five cents, wherever he is and whatever it costs the company." He backed this by building 64 bottling plants near combat zones, cementing Coca-Cola's global presence. This wartime strategy helped establish Coca-Cola as America's first truly global brand.
Warren began investing during the 1987 market crash, recognizing an opportunity when others saw chaos. He eventually acquired 200 million shares for $1.299 billion-an investment worth $13 billion by 2011. The timing proved masterful, as Coca-Cola's business model demonstrated remarkable resilience. From 2001 to 2011, Coca-Cola achieved impressive growth with a 140% increase in per share earnings, compounding at 9.18% annually. Earnings grew steadily from $1.60 per share in 2001 to $3.85 in 2011, showing the consistent growth Buffett prizes.
The company's financial strength was further evidenced by its 219% increase in per share book value from 2001 to 2011. Notably, it never experienced a losing year during this period, growing at a compounding annual rate of 12.32%. This consistent growth in underlying value year after year exemplified Warren's investment criteria of predictable, sustainable earnings growth.
By 2011, Coca-Cola had achieved a per share book value of $14.60 while earning $3.85 per share, representing a remarkable 26.3% return as an equity bond. Though investors must pay the market price of $65 rather than book value, this still yields an attractive initial return of 5.9%, projected to grow at 9.18% annually. At this growth rate, earnings should reach $9.27 per share by 2021, providing a 14.2% return on the original investment-exactly the kind of predictable returns Buffett seeks.
With a conservative price-to-earnings ratio of 16 (below historical averages), the stock could reach $148.32 by 2021. Adding ten years of projected dividends totaling $18.80 per share brings potential proceeds to $167.12, yielding a 157% total return or 9.9% annually. These compelling economics, combined with the company's unassailable market position and simple, understandable business model, explain why Warren was comfortable investing $13 billion in Coca-Cola stock, making it one of his largest and most successful investments.
Chapter 7
The Pharmaceutical Advantage: GSK and Sanofi
Warren has found particular value in pharmaceutical companies with strong vaccine businesses. GlaxoSmithKline (GSK) is the world's third-largest manufacturer of pharmaceuticals, biologics, consumer healthcare products, and vaccines by revenue. In the pharmaceutical world, GSK enjoys powerful durable competitive advantages through its vaccine business.
With manufacturing costs of approximately $1.50 per vaccine dose and selling prices around $9, GSK earns about $7.50 profit per shot. This business is particularly attractive because GSK has established relationships with governments worldwide and the capital to operate globally. With approximately 133 million babies born annually worldwide and each child receiving 34 recommended vaccine shots, the profit potential is enormous-roughly $34 billion annually worldwide.
Patents provide 20-year monopolies on new vaccines, and even after expiration, government relationships help maintain profit margins. Additionally, in the US, vaccine manufacturers are legally protected from lawsuits, creating an exceptionally profitable business model.
GSK maintains an extensive portfolio of well-known medications and consumer brands. The company's product list includes dozens of household names spanning prescription medications (Paxil, Wellbutrin, Valtrex), over-the-counter products (Tums, Sensodyne), and various healthcare staples. From 2001 to 2011, GSK increased earnings per share by 163%, growing at a compounding annual rate of 10.19% without a single losing year.
Similarly, Sanofi is the world's third-largest pharmaceutical company, with a significant vaccine business through Sanofi Pasteur. Sanofi Pasteur stands as the world's largest company focused exclusively on vaccines, producing 1.6 billion doses in 2010 to immunize over 500 million people globally. With the broadest product range covering more than twenty infectious diseases, it generated $5.5 billion in vaccine sales in 2011.
Since merging with Aventis in 2004, Sanofi has increased earnings per share by 128%, growing at a compound annual rate of 12.52% without a single losing year. At 2011's market price of $35 per ADR share with earnings of $2.90, Sanofi offered an initial after-tax return of 8.2%, projected to grow at 12.52% annually. Ten-year projections show potential earnings of $9.43 per share by 2021, which at Sanofi's 2011 P/E ratio of 11 would value shares at $103.73. Including the company's consistent dividends, an investor could expect a total return of 247% over ten years, or a 13.27% annual compound return.
Chapter 8
Banking on Quality: Wells Fargo and U.S. Bancorp
Warren's banking investments reveal his preference for quality over quantity. Founded in 1852 during California's gold rush, Wells Fargo grew into America's second largest bank by assets. Berkshire owns 358,936,125 shares (6.8%) worth approximately $10 billion, with an average cost of $22.32 per share.
Warren initially invested $289.4 million during the 1989-1990 banking crisis and has increased his position during subsequent banking crises, making it his second largest holding after Coca-Cola. Warren considers Wells Fargo the best-run large bank in America, praising its management team's cost discipline and focus on their areas of expertise.
Warren made his first Wells Fargo investment during the 1989-1990 real estate crash when banking stocks were decimated. While other investors fled, Warren recognized value, purchasing a 10% interest for $290 million-less than five times after-tax earnings. He praised managers Carl Reichardt and Paul Hazen for their cost discipline, appropriate staffing, and focus on their areas of expertise.
From 2001 to 2011, Wells Fargo grew its per share earnings 187%, at a compounding annual rate of 11.15%, reaching $2.85 per share in 2011. During the same period, the bank grew its per share book value by 188%, at an average annual compounding rate of 11.19%, reaching $22.45 in 2011.
In 2011, Wells Fargo had a per share book value of $22.45 and earnings of $2.85, representing a 12.6% return on equity. At the market price of $28, investors received a 10.1% initial return projected to grow at 11.15% annually. Using future value calculations, by 2021 earnings would reach $8.20 per share-a 29.2% return on the original investment. At Wells Fargo's 2011 P/E ratio of 12.7, this projects to $104.14 per share, yielding a 271% total return or 14.04% annually.
Similarly, U.S. Bancorp, the fifth largest commercial bank in America, has impressed Warren with its money-making ability and smart acquisition strategy. The bank consistently delivers returns on equity in the 20% range and industry-leading returns on assets around 2%, outperforming all of Warren's other banking investments. U.S. Bancorp demonstrated remarkable stability in its book value growth, increasing 96% from $8.43 in 2001 to $16.55 in 2011 without a single down year.
In 2011, U.S. Bancorp earned approximately $2.05 per share on a book value of $16.55, representing a 12% return on equity. At the 2011 market price of $24, investors received an initial after-tax return of 8.5%, projected to grow at 4.5% annually. Over ten years, earnings could reach $3.18 per share, potentially valuing the stock at $39.11 (using a P/E of 12.3). Including dividends of $0.50 annually, the total return projects to 6.28% compounded annually-attractive enough for Warren to invest $2.4 billion.
Chapter 9
The Next Generation: Buffett's Investment Successors
As Warren approaches his ninth decade, attention has turned to his investment successors. Charlie Munger, Warren's longtime partner, primarily influences Warren as an advisor, but occasionally pushes investments outside Warren's comfort zone. One such example is BYD Company Ltd., a Chinese battery and automobile manufacturer.
Berkshire owns 9.9% of BYD, purchased in 2008 for $232 million ($1.03/share), worth $816.7 million by 2011. Munger considers founder Wang Chuanfu "a combination of Thomas Edison and Jack Welch" and invested $25 million personally before convincing Warren. Founded in 1995 with $300,000 borrowed from relatives to manufacture rechargeable batteries, BYD expanded into cell phone manufacturing and eventually automobiles, becoming China's top-selling car brand by 2008.
Todd Combs joined Berkshire in January 2011 as a money manager and potential CEO successor. His initial investments include MasterCard and Dollar General. Berkshire purchased 200,000 MasterCard shares in 2011 for $46 million ($233/share), worth $64.6 million by fall 2011. MasterCard demonstrates durable competitive advantage with high returns on equity and capital (both 37%), zero long-term debt, and 21% annual earnings growth over four years.
Berkshire also acquired 1.5 million Dollar General shares in Q2 2011 for $46.5 million ($31/share), worth $54 million by fall 2011. Operating in towns too small for Walmart, Dollar General's 9,496 stores achieve better margins than both Walmart and Costco. Though new to Berkshire, Combs shows Buffett-like investment choices focusing on companies with durable competitive advantages.
Ted Weschler joined Berkshire in early 2012 after his hedge fund, Peninsula Capital Advisors, averaged 26% annual growth over eleven years. Like Warren, he's obsessed with reading corporate reports and maintains a concentrated portfolio with long holding periods, but unlike Warren, he shorts stocks.
The selection of these successors demonstrates Warren's commitment to preserving his investment philosophy beyond his lifetime. By choosing managers who understand the concept of durable competitive advantage and the equity bond approach, Warren ensures that Berkshire's investment strategy will continue to generate exceptional returns for shareholders long into the future.
Warren Buffett's investment philosophy is deceptively simple yet profoundly effective. By focusing on companies with durable competitive advantages, treating stocks as equity bonds with growing coupons, and having the patience to buy when others are fearful, he has created one of history's greatest investment records. The principles outlined in this book provide a roadmap for any investor willing to adopt Warren's long-term perspective and disciplined approach. As Warren himself might say, successful investing doesn't require a high IQ, just the temperament to control urges that get others into trouble.
