Getting Inside Buffett's Head

 | Feb 27, 2012 | 7:00 AM EST  | Comments
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For as long as I have worked in financial services, the reading of Warren Buffett's annual letter has been something done with a coffee in one hand and a pen in the other. No doubt, this ritual is practiced by many: business school students, finance and economics professors trying to find inspiration for exam questions and investors of all kinds the world over. It has always amazed me that one person, year after year, could attract so many people's attention through his offerings of wisdom on investing and on life in general.

With every year's letter I learn new things -- either cool new ways to express investment concepts, or the reinforcing of ideas I didn't quite appreciate wholeheartedly. Like many others, when I've viewed Mr. Buffett's common stock investments I've tended to wonder such things as, "Should I purchase American Express (AXP), Coca-Cola (KO) and IBM (IBM) now even though I know the Oracle of Omaha got in at a cheaper price?" Surely if Warren Buffett proclaims that these high-profile names are near-indestructible businesses for as far into the future as the eye can see, than certainly I must take some money from savings and put it to work, no?

Well, in running down the common stock holdings list this time around, I was left with a rebellious thought that had not arisen in years past: "Who cares about the ownership stakes in Wal-Mart (WMT), Tesco (TESO), Johnson & Johnson (JNJ) and IBM? These are so yesterday's news."

Yes, these are fine companies that will indeed outlive us all. In the process, they'll dole out hefty dividends to shareholders and, one would hope, the type of bottom-line performance that allows for expansion of multiples. But I just couldn't help wondering, if I were born today, would I want my parents investing in those companies? Or would I prefer them to plunk down cash left from their wedding gift on the next great Warren Buffett-esque investments?

  • Old-School Warren Buffett: KO
  • New-School Warren Buffett: SBUX

When Warren Buffett began accumulating a stake in Coca-Cola back in 1988, it was a company offering the drink of choice. Caffeine addicts generally visited the soda machine midday instead of the office's empty coffee pot. At the time, coffee was nothing more than the cheaply ground beans found on grocery store shelves -- or, for the higher-end stuff, a visit to the local café.

Starbucks (SBUX) went public in 1992, and in my view Buffett made a miscalculation here: He failed to foresee that consumers would be willing to embrace the idea of buying this caffeinated beverage at inflated prices on a daily basis. Buffett likes to look 20 years in advance for investments, so I suppose he didn't buy into the idea that people would pay $4 for an iced coffee in 2012 (20 years past the IPO date) instead of settling for a cheap blend of joe from a deli. If I look at Starbucks today and look into my crystal ball to gauge its future, this is what surfaces:

1. Starbucks has the makings of the next Coca-Cola via increased penetration into grocery stores with different coffee blends and non-coffee products. (Where is the Starbucks granola bar?) In fact, Starbucks' new logo basically says "diversified international brand."

2. The company has significant, and growing, global channels of distribution that pump out coffee to customers who show little willingness to give up their daily ritual in fluctuating economic periods.

3. Starbucks' founder is still very actively involved in the company, and he's set high standards that a successor will be expected to adhere to. This sounds comparable to Berkshire-Hathaway (BRK.A).

  • Old-School Warren Buffett: WMT; runner-up, AMZN
  • New-School Warren Buffett: FDO

First, I view Wal-Mart as yesterday's news in retail. Amazon (AMZN) is in a similar boat, only in the online arena. Regarding the Family Dollar (FDO) idea, what inspired it was Buffett's mention in the letter of wanting a "high-volume retailer" to reach out to him. Mr. Buffett was referencing the likely open space on a 433-acre plot where a humungous, Berkshire-owned Nebraska Furniture Mart is slated to open in 2013. But there are other reasons for my choice here.

1. Family Dollar stock is surely out of favor at the moment, relative to Dollar General (DG) and Dollar Tree (DLTR). The market is concerned about near-term operating margin compression as management embarks on an aggressive campaign of store openings and remodeling. In other words, the company is partaking in financial suppression now in order to set itself up for strong future earnings power, and that factor is going unappreciated in the current stock quote.

2. Dollar stores are the ultimate play on key long-term macro theses, including the retirement of baby-boomers, potential cuts to entitlements and the evaporated wealth -- and changed spending mindsets, might I add -- of baby-boomers following the 2008 recession.

  • Old-School Warren Buffett: AXP; IBM
  • New-School Warren Buffett: AAPL

It's really easy to jump on the Apple (AAPL) bandwagon under the premise that it's selling pieces of plastic with glass screens from Corning (GLW) and chips by Broadcom (BRCM) to obsessed consumers around the world. But I believe that would be telling only 33% of the Apple investment thesis. Another 33% slug would be that Apple products are fundamentally altering how classes are taught and how business presentations are given. If IBM servers are in schools and businesses, rest assured that Apple products are there, too.

Another 33% chunk would be how people are increasingly paying for goods and services, and that's not necessarily by swiping an Amex card. Smartphone banking apps allow for the shifting of money first. Then, those funds could be transferred to, say, a Starbucks account that is accessed via a Starbucks app; the purchase is paid by waving the phone under a scanner.

There is nothing wrong with being an old-school Warren Buffett investor, trying to buy weakness of the names he has owned for years. Still, there is much to be said for thinking anew here if one aspires to obtain a miniscule, teensy fraction of the wealth amassed by this man.

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