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SIX ESSENTIAL ELEMENTS

TO BUYING COMPANIES LIKE

WARREN BUFFETT

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$39.95 USA | $47.95 CAN

“Buy a business, don’t rent stocks.”—Warren Buff ett

While you’ve probably heard numerous “fi nancial experts” talk about the many ways to make money in the markets, the fact is, there’s only one strategy that has truly proven itself over the years. Thanks to the foundation laid out by Benjamin Graham and expanded upon by Warren Buff ett and others, value investing—which consists of buying the stock of companies that trade for less than their intrinsic value in order to maximize return while minimizing risk—has helped countless individuals consistently build wealth by avoiding permanent capital loss.

Successful value investors have an ingrained mental framework through which all investment decisions are made. This framework, which stems from Graham’s belief that “investment is most intelligent when it is most businesslike,” can put you in a better position to improve the overall performance of your portfolio.

Written by Sham Gad—founder of the Gad Partners Funds, a value-focused investment partnership inspired by the 1950s Buff ett Partnerships—The Business of Value Investing eff ectively examines the fundamental tenants of this approach and skillfully illustrates the six essential elements of the entire process. Opening with informative discussions of how value investing focuses more on buying a piece of a business and less on buying a company’s stock, this reliable resource quickly moves on to detail exactly what it takes to become a successful value investor.

Develop a sound investment philosophy1. Have a good search strategy2. Know how to value a business and assess the 3. quality of managementHave the discipline to say no4. Practice the art of patience5. Have the courage to make a signifi cant invest-6. ment at the point of maximum pessimism

[ C O N T I N U E D O N B A C K F L A P ]

[ C O N T I N U E D F R O M F R O N T F L A P ]

Along the way, you’ll become familiar with spe-cifi c case studies that illustrate how to approach investing in an intelligent, businesslike fashion. Each one—all of which were actual investments made by the author at one time or another in his career—off ers a diff erent way to determine whether a company under investigation is indeed a bargain investment opportunity.

For those willing to put forth the eff ort and show some patience, the stock market off ers the greatest forum for wealth accumulation. Filled with in-depth insights and practical advice, this reliable resource can help you make the most of your time in today’s markets, by following a value-oriented approach to investing that continues to make sense.

HESHAM M. GAD, an up-and-coming value investor, is the Managing Partner of the Gad Partners Funds. Prior to managing the Gad Partners Fund, he ran the Gad Investment Group from 2002 to 2005, a concentrated

value fund that delivered annualized returns of 22 percent. He has written hundreds of investment articles and currently contributes to TheStreet.com and Investopedia.com. Gad holds an MBA in fi nance from the University of Georgia, during which time he met with Warren Buff ett for lunch.

JACKET DESIGN: CHRIS WALLACE

Praise for The Business of Value Investing

“Sham Gad’s The Business of Value Investing is anexcellent primer on value investing. The book chronicles the

step-by-step process of successful value investing. It willkeep you reading and learning. And learn you will.”

—VITALIY KATSENELSON

Director of Research at Investment ManagementAssociates, Inc., and author of Active Value Investing:

Making Money in Range-Bound Markets

“Sham Gad’s new book does a great job ofteaching the most important lesson in the business world:discipline, a predefi ned and strictly adhered-to philosophy,

temperament, hard work, and a willingness to learn from mistakes are much more important than innate IQ. The Business of Value Investing spells out exactly what Warren Buff ett means whenhe says, ‘I am a better businessman because I am an investor;

I am a better investor because I’m a businessman.’”—MARK SELLERS

Managing Partner, Sellers Capital, LLC

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The Business of Value Investing

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The Business of Value Investing

SIX ESSENTIAL ELEMENTS TO BUYING COMPANIES LIKE WARREN BUFFETT

Sham Gad

John Wiley & Sons, Inc.

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Copyright © 2009 by Sham Gad. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data

Gad, Hesham, 1978— The business of value investing: six essential elements to buying companies like Warren Buffett / Sham Gad. p. cm. Includes index. ISBN 978-0-470-44448-1 1. Value investing. 2. Corporations-Valuation. 3. Stocks. I Title. HG4521.G16 2010 332.63'22—dc22 2009025052

Printed in the United States of America

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To my mom and dad, Seham and Moustafa Gad, and my wife,

Maggie Allen Gad. You are the best.

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vii

Contents

Acknowledgments xiii

Introduction xvii

Chapter 1 Invest in the Business, Buy the Stock 1

Stock Prices Are More Noise Than Information 4

A Businesslike Approach to Valuing the Business 6

The Making of a Legend 11

A Simple Idea, Really 14

Chapter 2 The Only Three Types of Investments You Need to Know 15

Stocks Prices Aren’t Always Rational 16

The Business Side of Investing 17

Three Buckets: Undervalued, Overvalued, and Fairly Valued 21

Price Determines Value 24

Key Takeaways 31

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viii Contents

Chapter 3 The Six Elements of Intelligent Investing 33

All Investing Is Value Investing 35

Learn from the Masters 38

The Sum of Its Parts: A Fundamental Framework 39

A Mental Latticework 42

Overview of the Six Elements 43

Emphasize the Process, Not the Outcome 46

Key Takeaways 46

Chapter 4 Establish a Sound Investment Philosophy The First Element 47

Preservation of Capital Is the Name of the Game 49

Price Paid Determines Value Received 52

The Starting Point Matters 54

Avoid Using Margin 61

Focus on Absolute Returns 64

Key Takeaways 66

Chapter 5 Develop a Search Strategy The Second Element 67

Ignore the Media 69

Imitation Is the Sincerest Form of Flattery 72

Basic Search Strategies 75

Advanced Search Strategy 85

Key Takeaways 89

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Contents ix

Chapter 6 Effective Business Valuation The Third Element 91

Value Investing 101: Margin of Safety 92

Value Investing 201: Intrinsic Value 95

Value Investing 301: Seek Businesses with a Wide Moat 101

Value Investing 401: Calculating a True Intrinsic Value 106

The Value of Management 111

Understanding Return on Equity: Microsoft Corporation 121

Key Takeaways 124

Chapter 7 Have the Discipline to Say No The Fourth Element 125

In Investing, Discipline is Everything 126

Discipline Affects the Price Paid, Which Determines the Value You Get 128

Be Prepared to Look Stupid 132

Don’t Split Hairs 137

Unveiling Investor A: Warren Buffett 139

Discipline Is Simple but Rarely Easy 145

Key Takeaways 146

Chapter 8 Practicing the Art of Patience The Fifth Element 147

Swimming against the Current 150

The Benefits of Waiting for a Good Pitch 151

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x Contents

Ignorance Can Be Bliss 158

The Benefits of a Buy-and-Hold Approach 162

Conservative Tests of Safety a Must 171

Key Takeaways 172

Chapter 9 Invest Significantly at the Maximum Point of Pessimism

The Sixth Element 173

Putting It All Together 174

Pessimism Leads to Value 179

Avoid That Which Is Most Valuable 181

Remain Flexible in the Approach 186

All or Nothing 192

Key Takeaways 193

Chapter 10 More Than One Way to Find Value Case Studies Showing the Approach

at Work 195

A Reminder: Process First, Outcome Second 197

Case Study #1: Finding Value in an Unloved Industry

Sunrise Senior Living (SRZ) 198

Case Study #2: Money Machine South of the Border

Ternium Steel 205

Case Study #3: A Tale of Two Shares Mueller Water Products 214

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Contents xi

Fertile Hunting Ground 216

Conclusion 219

Key Takeaways 220

Chapter 11 Avoiding Common Stumbling Blocks 221

Growth and Value: Two Sides of the Same Coin 225

Book Value: More Than Meets the Eye 232

What Matters Most 240

Key Takeaways 242

Chapter 12 Starting an Investment Partnership 243

Two Key Considerations 244

Service Providers 245

Quality Matters Most 247

Notes 249

About the Author 253

Index 255

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xiii

Acknowledgments

As I began writing this book, it very quickly became evident that this project would not be possible without the aid of many people. As this is a book about investing, specifi cally value investing, sub-stantial credit goes to the late Ben Graham, the educator and prac-titioner who formulated the fundamental concepts of what is now commonly referred to as value investing. It was Ben Graham who taught Warren Buffett, and it was Warren Buffett who sparked my investment passion as early as high school.

When I was an MBA student at the University of Georgia (UGA) in 2006, three accomplishments occurred during that year that I consider akin to winning the Triple Crown. My fi rst victory came in Omaha, when, after writing a letter to Warren Buffett, he invited my classmates and me to visit him. Mr. Buffett typically hosts the students for a morning Q&A session followed by lunch. However, as luck would have it, we also got to spend over three hours with Mr. Buffett the night before. Getting two days of face time with Mr. Buffett was like winning the grand prize. The golfi ng equivalent would be showing up to play 9 holes with Tiger Woods and instead playing 36. Thank you, Mr. Buffett.

The visit to Omaha would not have been possible had it not been for Geoffrey Cole, M.D., whom I met at the University of Georgia’s Terry College of Business. Jeff is one of the smartest guys I’ve met and a walking encyclopedia on Warren Buffet. I’m fortu-nate to have him around to pick his brilliant brain. Thanks, Jeff.

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