Warren Buffett The Greatest Investor in the World
All the passages below are taken from the book by Robert G Hagstrom, “The Warren Buffett Way.” The 3rd Edition was published in 2014.
He is often called the world’s greatest investor, but how do we know for sure? How exactly would one go about determining such a claim? It seems to me all we need do is look at two simple variables: relative outperformance and duration. Both are needed. It is not enough to just beat the stock market over the short run. Countless people have done that at one time or another. Doing so over a long period of time is what counts. As Michael Mauboussin aptly describes in his book The Success Equation (Harvard Business School Press, 2012), there is a measure of both luck and skill in business, in sports— and in investing. And the only way to distinguish whether luck or skill prevails is by examining the results over time. Luck may play a role in the short run, but Father Time will let us know whether skill was involved. Here Buffett is unmatched.
Warren Buffett’s career managing money spans nearly 60 years. It is divided between the time he managed the Buffett Investment Partnership, Ltd. (1956 to 1969) and the much longer period of managing Berkshire Hathaway, starting in 1965, the year he took control of the company.
At the relatively young age of 25 with a relatively small amount of money (his own investment was only $ 100), Buffett started his partnership. Although the objective of the partnership was to generate at least a 6 percent annual return, Buffett set himself a much tougher goal: to beat the Dow Jones Industrial Average by 10 percentage points a year. He did much better: Between 1965 and 1969, Buffett grew the partnership at a compound annual rate of 29.5 percent, 22 percentage points higher than the Dow. An investor who put $ 10,000 in Buffett’s partnership at the beginning and held until the end would have netted, after Buffett’s profit share, $ 150,270. The same amount invested in the Dow would have grown to $ 15,260. Over that time period, the Dow lost money five different years. Buffett made a profit and beat the index every single year.
In those days, there were very few hotshot managers Buffett could compare himself to. Gerald Tsai and Fred Carr, the two best-known mutual fund managers, burst on the scene in the mid-1960s near the time Buffett was thinking about shutting down the partnership. They built and then destroyed their reputations buying the 1960s “Go-Go” stocks. In one of Carol Loomis’s earliest articles for Fortune magazine, titled “The Jones Nobody Keeps Up With” (April 1966), she compared Buffett’s partnership performance to the famous hedge fund manager Alfred Winslow Jones. At the time, A.W. Jones & Company had a 10-year record but Buffett had only nine years managing money. Carol examined the trailing five-year returns for both investors and found that Buffett eked out the win, besting Jones 334 percent to 325 percent. But as Carol pointed out, Buffett soon shut down his partnership whereas Jones stayed in the game, suffering along with everyone else who could not see that stocks had become grossly overvalued.
Putting aside the incredible track record of the Buffett Investment Partnership, the claim that Buffett is the world’s greatest investor could easily hang on what he has accomplished at Berkshire Hathaway, as Table 8.1 makes clear. Over 48 years, between 1965 and 2012, the book value of Berkshire Hathaway has grown from $ 19 per share to a staggering $ 114,214 per share, a 19.7 percent annual rate of return. By comparison, the S& P 500 index, with dividends included, grew at 9.4 percent. In those 48 years, the S& P 500 index lost money 11 years— nearly one in five years; Berkshire posted just two negative years.
Table 8.1 Berkshire’s Corporate Performance versus the S& P 500
On sheer numbers, then— superior performance sustained over long periods— it’s hard to argue with the statement that Warren Buffett is the world’s greatest investor. But what if we look beyond the numbers?
The Private Buffett
How should we think about a man who began managing money when Dwight Eisenhower was president and continues to play the game well almost six decades later?
When he was not yet a teenager, young Buffett announced to anyone and everyone that he was going to be a millionaire by age 30 and if not he would jump off the tallest building in Omaha. He was joking, of course— about the jumping-off part— and even the millionaire ambition wasn’t what we might expect. Today, he has far exceeded that youngster’s goal, but those who know Buffett well know he cares little for the billionaire’s lifestyle. He still lives in the same Omaha house he bought in 1958, he drives late-model American cars, and he much prefers cheeseburgers, Cokes, and ice cream to fancy cuisine. His only vice is his beloved private jet. “It’s not that I want money,” Buffett has said. “It’s the fun of making money and watching it grow.” 1 And, as we know from Chapter 1, these days he derives enormous pleasure from giving it away.
In a world where patriotism is too often turned into a shallow cliché, Warren Buffett is unabashedly bullish on the United States of America. He has never been shy to express his belief that the United States offers tremendous opportunity to anyone who is willing to work hard. He is upbeat, cheerful, and optimistic about life in general. Conventional wisdom holds that it is the young who are the eternal optimists and as you get older pessimism begins to tilt the scale. But Buffett appears to be the exception. And I think part of the reason is that for almost six decades he has managed money through a long list of dramatic and traumatic events, only to see the market, the economy, and the country recover and thrive.
It is a worthwhile exercise to Google the noteworthy events of the 1950s, 1960s, 1970s, 1980s, 1990s, and the first decade of the twenty-first century. Although too numerous to list here, the front-page headlines would include nuclear war brinkmanship; presidential assassination and resignation; civil unrest and riots; regional wars; oil crisis, hyperinflation, and double-digit interest rates; and terrorist attacks— not to mention the occasional recession and periodic stock market crash.
When asked how he navigates the treacherous episodes that can disrupt markets and inevitably scare away most investors, Buffett, with his folksy style, confesses he simply tries to be “greedy when others are fearful and fearful when others are greedy.” But I think there is much more to it. Buffett has a well-developed ability not merely to survive the dangerous times that make headlines, but to aggressively invest through these rough periods.
The Buffett Advantage
For years, academicians and investment professionals have debated the validity of what has come to be known as the efficient market theory. As you may remember from Chapter 6, this controversial theory suggests that analyzing stocks is a waste of time because current prices already reflect all available information; so, in a sense, the market itself does all the research you need. Those who adhere to this theory claim, only partly in jest, that investment professionals could throw darts at a page of stock quotes and pick winners just as successfully as a seasoned financial analyst who spent hours poring over the latest annual reports or quarterly statements.
Yet the success of some who continually beat the major indexes— most notably Warren Buffett— suggests that the efficient market theory is flawed. Others, Buffett included, argue that the reason most money managers underperform the market is not because it is efficient, but because their methods are faulty.
Management consultants believe successful businesses have three distinct advantages: a behavioral advantage, an analytical advantage, and an organizational advantage. 2 Studying Warren Buffett, we can see each of these components at work.
Buffett tells us that successful investing does not require having a high IQ or taking the formal courses taught at most business schools. What matters most is temperament. And when Buffett talks about temperament he means rationality. The cornerstone to rationality is the ability to see past the present and analyze several possible scenarios, eventually making a deliberate choice. That, in a nutshell, is Warren Buffett.
Those who know Buffett agree it is rationality that sets him apart from the rest. “There were a thousand people in my Harvard law school class,” Charlie Munger said. “I knew all the top students, and there was no one as able as Warren. His brain is a superbly rational mechanism.” 3 Carol Loomis of Fortune magazine, who has known Warren Buffett for over 50 years, also believes rationality is the single most important trait in his investment success. 4 Roger Lowenstein, the author of Buffett: The Making of an American Capitalist, says, “Buffett’s genius [is] largely a genius of character— of patience, discipline, and rationality.” 5
Bill Gates, a member of the Berkshire Hathaway board, likewise believes rationality is Buffett’s distinguishing characteristic. This point was made demonstrably clear when the two friends spent an afternoon answering questions from students packed into an auditorium at the University of Washington in Seattle. One of the first questions a student asked was, “How did you get here? How did you become richer than God?” Buffett took a deep breath and began: “How I got here is pretty simple in my case. It is not IQ, I’m sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output— the efficiency with which the motor works— depends on rationality. A lot of people start out with 400 horsepower motors but only get 100 horsepower of output. It’s way better to have a 200 horsepower motor and get it all into output.
“So why do smart people do things that interfere with getting the output they’re entitled to?” Buffett continued. “It gets into the habits and character and temperament, and behaving in a rational manner. Not getting in your own way. As I have said, everybody here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For those who won’t, it will be because you get in your own way, not because the world doesn’t allow you.” 6
All who know him, and Buffett himself, agree: The driving force of Warren Buffett is rationality. The driving force of his investment strategy is the rational allocation of capital. Determining how to allocate a company’s earnings is the most important decision a manager will make; determining how to allocate one’s savings is the most important decision an investor will make. Rationality— displaying rational thinking when making that choice— is the quality Buffett most admires. Despite its underlying vagaries, there is a line of reason that permeates the financial markets. Buffett’s success is a result of locating that line of reason and never deviating from its path.
When Buffett invests, he sees a business. Most investors see only a stock price. They spend far too much time and effort watching, predicting, and anticipating price changes and far too little time understanding the business they partly own. Elementary as this may be, it is the root of what distinguishes Buffett.
Owning and operating businesses has given him a distinct advantage in analytical thinking. He has experienced both success and failure in his business ventures and has applied to the stock market the lessons he has learned. Most professional investors have not been given the same beneficial education. While they were busy studying capital asset pricing models, beta, and modern portfolio theory, Buffett studied income statements, capital reinvestment requirements, and the cash-generating capabilities of his companies. “Can you really explain to a fish what it’s like to walk on land?” Buffett asks. “One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.” 7
Buffett believes the investor and the businessperson should look at the company in the same way, because they both want essentially the same thing. The businessperson wants to buy the entire company, and the investor wants to buy portions of it. If you ask businesspeople what they think about when purchasing a company, they are likely to answer, “How much cash can be generated from the business.” Finance theory dictates that, over time, there is a direct correlation between the value of a company and its cash-generating capability. So, to make a profit, the businessperson and the investor should be looking at the same variables.
“In our view,” says Buffett, “investment students need only two well-taught courses: How to Value a Business, and How to Think about Market Prices.” 8
The stock market, remember, is manic-depressive. Sometimes it is wildly excited about future prospects and at other times it unreasonably depressed. Of course, this creates opportunities, particularly when shares of outstanding businesses are available at irrationally low prices. But just as you would not take direction from an adviser who exhibited manic-depressive tendencies, neither should you allow the market to dictate your actions. The stock market is not a preceptor; it exists merely to assist you with the mechanics of buying or selling shares of stock. If you believe that the stock market is smarter than you are, give it your money by investing in index funds. But if you have done your homework and are confident that you understand your business, turn off the market.
Buffett is not glued to a computer, watching every uptick or downtick on the screen, and he seems to get by just fine without it. If you plan on owning shares in an outstanding business for a number of years, what happens in the market on a day-to-day basis is inconsequential. You will be surprised to discover that your portfolio weathers nicely without you constantly looking at the market. If you don’t believe it, give yourself a test. Try not to look at the market for 48 hours. Don’t look at your computer or cell phone, don’t check the newspaper, and don’t listen to a stock market summary on television or radio. If after two days your companies are well, try turning off the stock market for three days, and then for a whole week. Pretty soon you will be convinced that your investment health will survive and your companies will continue to operate without your constant attention to stock quotes.
“After we buy a stock, we would not be disturbed if markets close for a year or two,” says Buffett. “We don’t need a daily quote on our 100 percent position in See’s Candies to validate our well-being. Why then do we need a quote on our interest in Coke?” 9 Very clearly, Buffett is telling us that he does not need the market’s price to validate Berkshire’s common stock investments. The same holds true for individual investors. You know you have approached Buffett’s level when your attention turns to the stock market and the only question on your mind is: “Has anybody done anything foolish lately that will allow me an opportunity to buy a good business at a great price?”
Just as people spend fruitless hours worrying about the stock market, so too do they needlessly worry about the economy. If you find yourself discussing and debating whether the economy is poised for growth or tilting toward a recession, whether interest rates are moving up or down, whether there is inflation or disinflation, stop! Give yourself a break. Buffett is a casual observer of the economy, but he dedicates no significant time or energy analyzing with the intent of predicting what the economy will do.
Often investors begin with an economic assumption and then go about selecting stocks that fit neatly within this grand design. Buffett considers this thinking foolish. First, no one has economic predictive powers any more than they have stock market predictive powers. Second, if you select stocks that will benefit only in a particular economic environment, you inevitably invite turnover and speculation. Whether you correctly predict the economy or not, you’ll find yourself continuously adjusting your portfolio to benefit in the next economic scenario. Buffett prefers to buy a business that has the opportunity to profit regardless of the economy. Of course, macroeconomic forces may affect returns on the margin, but overall, Buffett’s businesses are able to profit nicely despite the vagaries in the economy. Time is more wisely spent locating and owning a business that has the ability to profit in all economic environments than by renting a group of stocks that do well only if a guess about the economy happens to be correct.
Winston Churchill, addressing the House of Commons in 1944 in a building that had sustained heavy damage from air strikes the day before, said, “We shape our dwellings, and afterwards the dwellings shape us.” This eloquent truth, beloved by generations of architects, also helps us understand the shape of Berkshire Hathaway and its builder. As we dissect the Buffett advantage, it’s helpful to look at the organizational structure of the company he has built.
When Buffett bought his first share of Berkshire Hathaway for $ 7, I am not sure he had a grand vision of what Berkshire would become a half-century later. But as Churchill predicted, the company did indeed reflect the characteristics of its architect, and Warren Buffett the investor epitomizes the characteristics of his company.
The success of Berkshire Hathaway rests on three fundamental pillars. First, the company’s subsidiaries generate mountain-loads of cash that are sent upstream to corporate headquarters in Omaha. This cash comes from the float of its massive insurance operations as well as the cash-generating capabilities of its nonfinancial wholly owned subsidiaries.
Second, Buffett, the capital allocator, takes this cash and reinvests it into more cash-generating opportunities. This in turn allows him to buy still more cash-generating businesses, which generate cash, which allows him to . . . I am sure you the get the picture.
The last pillar is decentralization. Each of the subsidiaries is managed by very talented operators who need no help from Buffett to run their businesses. All for the better, as this allows Buffett to focus nearly 100 percent of his energies on capital allocation, his best talent. Buffett’s management manifesto can be summarized as “hire well, manage little.” Today, Berkshire Hathaway is a company with 80-plus subsidiaries and more than 270,000 employees, but the corporate headquarters is staffed by just 23 people.
The architecture of Berkshire Hathaway has led to something that is more powerful than a simple business strategy, says William Thorndike, author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. “Buffett has developed a worldview that at its core emphasizes the development of long-term relationships with excellent people and businesses and the avoidance of unnecessary turnover, which can interrupt the powerful chain of economic compounding that is the essence of long-term value creation,” wrote Thorndike. 10
Thorndike believes Buffett is best understood as a “manager/ investor/ philosopher whose primary objective is turnover reduction.” 11 Why? Because there is a cost to turnover, and I am not speaking just of trading commissions and capital gains taxes. In Buffett’s mind, the cost of turnover is more human in nature. If you have assembled the best businesses, run by some of the best managers, financed by some of the best shareholders, why would anyone want to disrupt the long-term value creation that comes from this potent combination?
Learning to Think Like Buffett
In the 20-some years I have been writing and lecturing about Warren Buffett and his unparalleled success, one comment I hear often is some variation of this: “Well, if I had his millions I could make lots of money in the stock market, too.” I never understood this thinking. If you follow the logic, what they are saying is you first have to be rich before you can achieve the talents of becoming rich. But I would remind readers that Buffett developed a unique investment process long before he made millions, much less billions.
I’m going to do my best to convince you that, within your own financial parameters, there is no reason you cannot achieve Buffett-style success, if you integrate his tenets into your thinking and base your investment decisions on them. I can’t guarantee that you can start with $ 100 and end up many years later with billions, but I can guarantee that you will do better than someone with the same financial resources who depends on any one of the many speculator’s schemes floating around.
So let’s walk through the steps, using a hypothetical situation. Let’s pretend that you have to make a very important decision. Tomorrow you will be given an opportunity to pick one business— and only one— to invest in. To make it interesting, let us also pretend that once you have made your decision, it cannot be changed and, furthermore, you have to hold the investment for 10 years. Ultimately, the profit from this enterprise will support you in your retirement. Now what are you going to think about?
Is the Business Simple and Understandable?
You cannot make an intelligent guess about the future of your business unless you understand how it makes money. Too often people invest in stocks without a clue as to how a company generates sales, incurs expenses, and produces profits. If you can understand the economic process, you are ready to intelligently proceed further in your investigation.
Does the Business Have a Consistent Operating History?
If you are going to invest your family’s future in a company, you will need to know whether the company has stood the test of time. It is unlikely that you will bet your future on a new company that has not experienced different economic cycles and competitive forces. You should be assured that your company has been in business long enough to demonstrate an ability, over time, to earn significant profits.
Does the Business Have Favorable Long-Term Prospects?
The best business to own, the one with the best long-term prospects, is what Warren Buffett terms a franchise— a business that sells a product or service that is needed or desired, that has no close substitute, and whose profits are not regulated. A franchise typically possesses a great amount of economic goodwill that allows the company to better withstand the effects of inflation. The worst business to own is a commodity business. A commodity business sells products or services that are indistinguishable from competitors. Commodity businesses have little or no economic goodwill. The only distinction in a commodity business is price. The difficulty of owning a commodity business is that sometimes competitors, using price as a weapon, will sell their product below the cost of business to temporarily attract customers in hopes that they will remain loyal. If you compete against other businesses that occasionally sell their products below cost, you are doomed.
Generally, most businesses fall somewhere in between: They are either weak franchises or strong commodity businesses. A weak franchise has more favorable long-term prospects than a strong commodity business. Even a weak franchise still has some pricing power that allows it to earn above-average returns on invested capital. Conversely, a strong commodity business will earn above-average returns only if it is the lowest-cost supplier. One advantage to owning a franchise is that a franchise can endure management incompetence and still survive, whereas in a commodity business, management incompetence is lethal.
Is Management Rational?
Since you do not have to watch the stock market or the general economy, watch your company’s cash instead. How management reinvests cash earnings will determine whether you will achieve adequate returns on your investment. If your business generates more cash than is needed to remain operational, which is the kind of business you want, observe closely the actions of management. A rational manager will invest excess cash only in projects that produce earnings at rates higher than the cost of capital. If those rates are not available, the rational manager will return the money to shareholders by increasing dividends and buying back stock. Irrational managers constantly look for ways to spend excess cash rather than return the money to shareholders. They are ultimately revealed when they invest below the cost of capital.
Is Management Candid with Its Shareholders?
Although you may never have the opportunity to sit down and talk to the chief executive officer of your business, you can tell much about CEOs by the way they communicate to their shareholders. Does your manager report the progress of the business in such a way that you understand how each operating division is performing? Does management confess its failures as openly as it trumpets its success? Most important, does management forthrightly proclaim that the company’s prime objective is to maximize the total return of their shareholders’ investment?
Does Management Resist the Institutional Imperative?
There is a powerful unseen force that allows managers to act irrationally and supersede the interests of owners. The force is the institutional imperative— mindless, lemming-like imitation of other managers who justify their actions based on the logic that if other companies are doing it, it must be all right. One measure of managers’ competence is how well they are able to think for themselves and avoid the herd mentality.
Focus on Return on Equity, Not Earnings per Share
Most investors judge a company’s annual performance by earnings per share, watching to see if they set a record or make a big increase over the previous year. But since companies continually add to their capital base by retaining a portion of their previous year’s earnings, growth in earnings (which automatically increases earnings per share) is really meaningless. When companies loudly report “record earnings per share,” investors are misled into believing that management has done a superior job year after year. A truer measure of annual performance, because it takes into consideration the company’s ever-growing capital base, its return on equity— the ratio of operating earnings to shareholders’ equity.
Calculate “Owner Earnings”
The cash-generating ability of a business determines its value. Buffett seeks out companies that generate cash in excess of their needs as opposed to companies that consume cash. But when determining the value of a business, it is important to understand that not all earnings are created equal. Companies with a high ratio of fixed assets to profits will require a larger share of retained earnings to remain viable than companies with a lower ratio of fixed assets to profits, because some of the earnings must be earmarked to maintain and upgrade those assets. Thus accounting earnings need to be adjusted to reflect the business’s cash-generating ability.
A more accurate picture is provided by what Buffett calls “owner earnings.” To determine owner earnings, add depreciation, depletion, and amortization charges to net income and then subtract the capital expenditures the company needs to maintain its economic position and unit volume.
Look for Companies with High Profit Margins
High profit margins reflect not only a strong business but management’s tenacious spirit for controlling costs. Buffett loves managers who are cost-conscious and abhors managers who allow costs to escalate. Indirectly, shareholders own the profits of the business. Every dollar that is spent unwisely deprives the owners of the business a dollar of profit. Over the years, Buffett has observed that companies with high-cost operations typically find ways to sustain or add to their costs, whereas companies with below-average costs pride themselves on finding ways to cut expenses.
For Every Dollar Retained, Make Sure the Company Has Created at Least One Dollar of Market Value
This is a quick financial test that will tell you not only about the strength of the business but how well management has rationally allocated the company’s resources. From a company’s net income, subtract all dividends paid to shareholders. What is left is the company’s retained earnings. Now, add the company’s retained earnings over a 10-year period. Next, determine the difference between the company’s current market value and its market value 10 years ago. If your business has employed retained earnings unproductively over this 10-year period, the market will eventually catch up and set a lower price on the business. If the increase in the company’s market value is less than the sum of the retained earnings, the company is going backward. But if your business has been able to earn above-average returns on retained capital, the gain in market value of the business should exceed the sum of the company’s retained earnings, thus creating more than one dollar of market value for every dollar retained.
What Is the Value of the Business?
The value of a business is the estimated cash flows expected to occur over the life of the business, discounted at an appropriate interest rate. The cash flows of a business are the company’s owner earnings. By measuring owner earnings over a long period, you will understand whether they are consistently growing at some average rate or merely bobbling around some constant value. If the company has bob-around earnings, you should discount those earnings by the long-term interest rate.
If owner earnings show some predictable growth pattern, the discount rate can be reduced by this rate of growth. Don’t become overly optimistic about a company’s future growth rate. It is better to use a conservative estimate than allow enthusiasm to inflate the value of the business. Buffett uses the long-term U.S. Treasury rate as his discount factor. He does not add an equity risk premium to this discount rate, but he will adjust the discount rate upward when interest rates are declining.
Can the Business Be Purchased at a Significant Discount to Its Value?
Once you determine the value of a business, the next step is to look at the market price. Buffett’s rule is to purchase the business only when its price is at a significant discount to its value. Take note: Only at his final step does Buffett look at the stock market price.
Calculating the value of a business is not mathematically complex. However, problems arise when an analyst wrongly estimates a company’s future cash flow. Buffett deals with this problem in two ways. First, he increases his chances of correctly predicting future cash flows by sticking with businesses that are simple and stable in character. Second, he insists that with each company he purchases, there must be a margin of safety between the company’s purchase price and its determined value. This margin of safety helps create a cushion that will protect him— and you— from companies whose future cash flows are changing.
• • •
Now that you are a business owner as opposed to a renter of stocks, you are ready to expand your theoretical portfolio from just one stock to several. Because you are no longer measuring your success solely by price change or comparing annual price change to a common stock benchmark, you have the liberty to select the best businesses available. There is no law that says you must include every major industry within your portfolio, nor do you have to include 40, 50, 60, or 100 stocks in your portfolio to achieve adequate diversification.
Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favorable long-term prospects?
Is management rational?
Is management candid with its shareholders?
Does management resist the institutional imperative?
Focus on return on equity, not earnings per share.
Calculate “owner earnings.”
Look for companies with high profit margins.
For every dollar the company retained, make sure the company has created at least one dollar of market value.
What is the value of the business?
Can the business be purchased at a significant discount to its value?
Buffett believes that wide diversification is required only when investors do not understand what they are doing. If these “know-nothing” investors want to own common stocks, they should own a large number of securities and space out their purchases over time. In other words, the know-nothing investor should use an index fund and dollar-cost average purchases. There is nothing shameful about becoming an index investor. In fact, Buffett points out, the index investor will actually outperform the majority of investment professionals. “Paradoxically,” he notes, “when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” 12
“On the other hand,” says Buffett, “if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense to you.” 13 Buffett asks you to consider: If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?
Now, consider how your theoretical portfolio, now broader than one stock, is doing. You can measure the economic progress of the businesses you own by calculating their look-through earnings, just as Buffett does. Multiply the earnings per share by the number of shares you own to calculate the total earnings power of your companies. The goal of the business owner, Buffett explains, is to create a portfolio of companies that, in 10 years, will produce the highest level of look-through earnings. Because the growth of look-through earnings, not price changes, now becomes the highest priority in your portfolio, many things begin to change. First, you are less likely to sell your best businesses just because you have a profit. Ironically, corporate managers understand this when they focus on their own business operation. “A parent company,” Buffett explains, “that owns a subsidiary with superb long-term economics is not likely to sell that entity regardless of price.” 14 A CEO wanting to increase the value of the business will not sell the company’s crown jewel. Yet this same CEO will impulsively sell stocks in his or her personal portfolio with little more logic than the idea that “you can’t go broke taking a profit.” “In our view,” Buffett explains, “what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.” 15
Now that you are managing a portfolio of businesses, not only will you avoid selling your best businesses, but you will also pick new businesses for purchase with much greater care. As the manager of a portfolio of businesses, you must resist the temptation to purchase a marginal company just because you have cash reserves. If the company does not pass your tenet screen, do not purchase it. Be patient and wait for the right business. It is wrong to assume that if you are not buying and selling, you are not making progress. In Buffett’s mind, it is too difficult to make hundreds of smart decisions in a lifetime. He would rather position his portfolio so he only has to make a few smart decisions.
Finding Your Own Way
“Something about the mind, wired to find patterns both real and imaginary, rebels at the notion of fundamental disorder.” 16 Those words, written by George Johnson in his book Fire in the Mind, reveal the dilemma that all investors face. The mind craves patterns, Johnson believes; patterns suggest order, which allows us to plan and make sense of our resources.
What we have come to understand about Buffett is that he is continually seeking patterns— patterns that can be found when analyzing a business. He also knows that these business patterns will, at some point, reveal the future pattern of the stock price. Of course, a stock price pattern will not obligingly follow every change in the business pattern, but if your time horizon is long enough, it is remarkable how the price patterns eventually match up with the business patterns.
Too many investors are seeking patterns in the wrong places. They are certain that there is some predictable pattern for gauging short-term price changes. But they are mistaken. There simply are no predictable patterns for guessing the future direction of the stock market. The exact patterns do not repeat. Still, these investors keep trying.
How do investors maneuver in a world that lacks pattern recognition? The answer is to look in the right place at the right level. Although the economy and the market as a whole are too complex and too large to be predictable, there are recognizable patterns at the company level. Inside each company, there are business patterns, management patterns, and financial patterns. If you study these patterns, in most cases you can make a reasonable prediction about the future of the company. Warren Buffett focuses on those patterns, not on the unpredictable behavioral patterns of millions of investors. “I have always found it easier to evaluate the weights dictated by fundamentals,” said Buffett, “than votes dictated by psychology.” 17
One thing we can say with certainty is that knowledge works to increase our investment return and reduces overall risk. I believe we can also make the case that knowledge is what defines the difference between investment and speculation. In the end, the more you know about your companies, the less likely it is that pure speculation will dominate your thinking and your actions.
The financial writer Ron Chernow claims that “financial systems reflect the values of societies.” 18 I believe that is largely true. From time to time, we seem to misplace our values, and then our markets succumb to speculative forces. Soon, we right ourselves and continue on with our financial walk, only to trip and fall back into destructive habits. One way to stop this vicious cycle is to educate ourselves about what works and what does not work.
Buffett has had his share of failures and no doubt will have a few more in the years ahead. But investment success is not synonymous with infallibility. Rather, it comes from doing more things right than wrong. The Warren Buffett Way is no different. Its success as an investment approach is as much a result of eliminating those things that you can easily get wrong, which are many and perplexing (predicting markets, economies, and stock prices), as requiring you to get certain things right, which are few and simple (mainly, valuing a business). When Buffett purchases stocks, he is focusing on two simple variables: the price of the business and its value. The price of the business can be found by looking up its quote. Determining the value requires some calculation, but it is not beyond the ability of those willing to do some homework.
Because you no longer worry about the stock market, the economy, or predicting stock prices, you are now free to spend more time understanding your businesses. More productive time can be spent reading annual reports and business and industry articles that will improve your knowledge as an owner. In fact, the degree to which you are willing to investigate your own business lessens your dependency on others who make a living advising people to take irrational actions.
Ultimately, the best investment ideas will come from you doing your own work. However, you should not feel intimidated. The Warren Buffett Way is not beyond the comprehension of most serious investors. You do not have to become an MBA-level authority on business valuation to use it successfully. Still, if you are uncomfortable applying these tenets yourself, nothing prevents you from asking your financial adviser these same questions. In fact, the more you enter into a dialogue on price and value, the more you will begin to understand and appreciate the Warren Buffett Way.
Over his lifetime, Buffett has tried different investment gambits. At a young age he even tried his hand at stock charting. He was tutored in securities analysis by the brightest financial mind in the industry, Benjamin Graham. He benefited early on by studying the investment strategies of Phil Fisher. And he was most fortunate to have partnered with Charlie Munger, putting into practice all he had learned. Over a career that is six decades and counting, Buffett has confronted countless economic, political, and military challenges and navigated his way to the other side. Through all the distractions, he found his niche, that point where all things make sense: where investment strategy cohabits with personality. “Our [investment] attitude,” Buffett says, “fits our personalities and the way we want to live our lives.” 19
This harmony is easily found in Buffett’s attitude. He is always upbeat and supportive. He is genuinely excited about coming to work every day. “I have in life all that I want right here,” he says. “I love every day. I mean, I tap dance in here and work with nothing but people I like.” 20 He adds, “There is no job in the world that is more fun than running Berkshire and I count myself lucky to be where I am.” 21
1. Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Random House, 1995), 20.
2. John Pratt and Richard Zeckhauser, eds., Principals and Agents: The Structure of Business (Boston: Harvard Business School Press, 1985).
3. Carol Loomis, Tap Dancing to Work: Warren Buffett on Practically Everything, 1966– 2012 (New York: Time Inc., 2012), 101.
4. Conversation with Carol Loomis, February 2012.
5. Lowenstein, Buffett.
6. Loomis, Tap Dancing to Work, 134.
7. Carol Loomis, “Inside Story of Warren Buffett,” Fortune, April 11, 1988, 34.
8. Berkshire Hathaway Annual Report, 1996, 16.
9. Berkshire Hathaway Annual Report, 1993, 15.
10. William N. Thorndike Jr., The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Boston: Harvard Business Review Press, 2012), 194.
12. Berkshire Hathaway Annual Report, 1933, 16.
16. George Johnson, Fire in the Mind: Science, Faith, and the Search for Order (New York: Vintage Books, 1995), 104.
17. Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett (Birmingham, AL: APKE, 1998), 794.
18. Ron Chernow, The Death of the Banker: The Decline and Fall of the Great Financial Dynasties and the Triumph of Small Investors (New York: Vintage Books, 1997).
19. Berkshire Hathaway Annual Report, 1987, 15.
20. Robert Lenzner, “Warren Buffett’s Idea of Heaven: ‘I Don’t Have to Work with People I Don’t Like,’” Forbes, October 18, 1993, 40.
21. Berkshire Hathaway Annual Report, 1992, 16.