How to Invest Like Buffett - Understand the Figures

In training yourself to be a first-class investor, the first step is to learn basic accounting. Like a chess player, the investor is playing a competitive game. By the nature of any competitive game, the number of top players must be limited. So if you lack a crucial skill that the best players have, you greatly diminish your chances.

Without an adequate knowledge of accounting, the investor cannot understand the subject being discussed, let alone determine where the truth lies. Without it, the investor is at the same disadvantage as an aspiring orchestra who cannot read music. Musical notation is the language of music and figures the language of business. Great musicians may have existed who could not read music, and there may be some skillful investors who are baffled by accounting, but they are very, very few.

We all understand instinctively what it means when in baseball the Little League announces that it is excluding Japanese trams from the competition: The Japanese have been winning too many of the games. The investor, similarly, needs to notice changes in the accounting system of a company he is interested in and be able to interpret the significance of that change. Why has management switched from LIFO to FIFO? Is it in order to manufacture inventory profits to offset a lack of operating profits? Why, in the investment portfolio of one of the conglomerate’s insurance subsidiary, were capital gains being realized and recognized as ordinary income – much more heavily taxed at that time – at the parent company level? An owner of a company should try to minimize taxes, so why does the conglomerate suddenly develop a craving to pay them? Is it because operating earnings are faltering elsewhere in the system and the parent company wants to keep up appearances, even at the price of unnecessary tax? And if so, what does that say about its management as curator of our assets? Questions of this sort emerge from careful study of the figures.

Thanks to the SEC, most public companies divulge an extraordinary amount of information, not only in annual reports, proxy statements, and quarterly earnings report, but also in the 10k, which is a treasure house of insight into a company’s affairs. The skillful investor as a matter of course works his way through all the figures in each of these reports. He uses them as a starting point for more detailed inquiries, which he conducts directly with the company, its competition and other sources.

Many investors hope to make more than their share of money in the stock market, but have neither the energy nor the skill to extract or interpret all this information. In an information contest their situation is hopeless, like pygmies playing basketball against Watusis. They are reduced to flair and exciting impressions, being seduced by intriguing images – exactly how you lose your money in the market.

The worst of it is that often the investor who cannot read figures is well flattered by stockbrokers into thinking that he actually does have a hope of competing in this game. The stockbroker will be delighted to do your work for you. However, the successful investor should in due course become more skillful at his craft than most of the stockbrokers he talks to.

And alas, very often the stockbrokers themselves do not read the figures closely. Stockbroking is a difficult trade, and to survive the broker can not afford to spend great amounts of time overengineering the solution to his problem, which is simply to trade stock. He needs to know enough about a company’s prospects to get a customer sufficiently excited to buy, but he has little need for answers to questions that the customer will never ask. Furthermore, the selling personality is different from the analytical personality.

Two further points on this subject: The customer always hopes that the stockbroker’s research department will do the necessary work and then give him the answers, but perforce the brokerage house will share those answers with all its other customers – often in the tens of thousands – and then, involuntarily with all the customers of other stockbrokers who read its reports. The good investor, however, should be almost alone when he is buying stock in a company whose merits he has discovered ahead of the pack.

There are services that will do the job of analyzing a company’s financial reports for you and tell you what they find. However, the good ones have a large number of subscribers, usually institutional investors running large amounts of capital. So, once again, the subscriber is sharing the news with a great many of his competitors and the publishers of such reports were skillful enough to do what Buffet does, they would very likely go out of the market-letter business and become great investors themselves. The man who discovers how to turn lead into gold isn’t going to give you the secret for $100 a year.

An adviser who really has the Midas touch won’t share it with you for any modest emolument. He will want what he is worth, which is nearly everything. So you must develop the touch yourself. And in business that means understanding figures.

Buffett goes further. "When managers want to get across the facts of the business to you, it can be done within the rules of accounting. Unfortunately, when they want to play games, in at least some industries, it can also be done within the rules of accounting. If you can’t recognize the differences, you shouldn’t be in the equity-picking business". The equity investor needs to understand the nuances of accounting he stresses.

This previous excerpt was from "The Midas Touch" by John Train. The book focuses on the strategies that have made Warren Buffett "America’s Pre-eminent Investor".