Summary

Warren Buffett is one of the most successful stock market investors of the past 30 years. His entire approach is to focus on the value of the business and its market price. Once Buffett finds a business he understands and feels comfortable with, he acts like a business owner rather than a stock market speculator.

He studies everything possible about the business, becomes an expert in that field and works with the management rather than against them. In fact, often his first act on buying shares in any company is to grant the managers his proxy vote for his shares to assure them that he has no intention to try and move the company away from its core values.

Buffett champions the value investment strategy, and puts no credence in day-to-day movements in share prices, the impact of the economic mood overall or any other external factors. He maintains a long-term perspective at all times, and never loses sight of the underlying value of a business.

Buffett’s Mentors

Warren Buffett’s investment methodology is a hybrid mix of the strategies put forward by two 1930s-style investment advisers, Ben Graham and Philip Fisher.

Ben Graham

From Graham, Buffett learned the margin of safety approach — that is, use strict quantitative guidelines to buy shares in companies that are selling for less than their net working capital. Graham also emphasized that following the short-term fluctuations of the stock market is pointless, and that stock positions should be long term.

Graham described several approaches to investing in common stocks:

  • The Cross-Section Approach: The investor buys some shares in companies in every sector of the market. Then, whatever happens in the economy, at least one stock will be performing well.
  • Short-Term Selectivity: This is the investment in companies which have the most favorable outlook in the next 6 months to a year. Although this is volatile and superficial, this is the dominant approach used by most stock brokers.
  • Growth Investing: These are companies whose sales and earnings are expected to grow at a rate above those of the average business. The trick is to buy stock in any company whose products were at an early stage of their life cycle, when profits and revenues were just about to take off. The difficulty here is in accurately forecasting rates of growth.
  • Margin of Safety Approach: Invest only in companies which have a large margin between earnings and fixed costs. In a downturn, that company is most likely to ride out a recession well. Applying this concept to a stock, buy shares only in a company for which the share price is below its intrinsic value as determined by assets, earnings, dividends and future prospects.

Graham strongly advocated the margin of safety approach with investment in common stock of growth companies. His approach to investment was to purchase growth company shares when the overall market is trading at a low price or when growth company shares are trading below their intrinsic value. However, since buying at market lows is everyone’s objective, there is no competitive advantage in that approach. Therefore, Graham suggested that identifying undervalued stocks, regardless of market sentiment, was the key to stock market investment success. Intrinsic value is closely linked to a company’s future earning power and fixed costs. It is hard or real assets plus the future value of the earnings those assets will produce.

Philip Fisher

From Fisher, Buffett added an appreciation for the effect that management can have on the value of any business, and that diversification increases rather than reduces risk as it becomes impossible to closely watch all the eggs in too many different baskets.

  • Fisher focused on companies with an ability to grow sales and profits over the years at rates greater than the industry average. He looked at profit margins and accounting controls.
  • Fisher studied a company’s sales organization in addition to its research and development capabilities. He saw as a good sign any management who communicated freely with shareholders when the company was experiencing unexpected hard times. The management should also have an ability to develop good working relations throughout the company.
  • He also looked for companies which could grow without requiring additional equity financing. If a company expanded on the strength of its products and services rather than by expanding its capital base, Fisher thought that boded well for the future.
  • He looked for companies which were dedicated to maintaining their competitive advantage and strengthening their market position.

Fisher suggested it was better to hold stock in a few outstanding companies than a large number of average companies. He always invested within his own circle of competence — that is, with companies he understood and felt comfortable with.

Charlie Munger

Buffett’s long-term partner, who also brought psychology and misjudgment into investing.

The Buffett Way

Never Follow the Day-to-Day Fluctuations of the Stock Market

In essence, a stock market exists simply to facilitate the buying and selling of shares. Any time an investor tries to turn the market into a predictor of future prices, they run into problems. The essential question is whether you’ve done your homework or not. If you know more about a company than the market does, then why give any attention to what the market says?

Secondly, if you buy a share because you believe a company has sound financial prospects and you intend owning it for a number of years, what happens in the market on a day-to-day basis is totally inconsequential. An investor does not need the market’s validation for any share purchase they have completed. The only use for a regular glance at the market is to check whether anyone is foolish enough to sell a good business at a great price.

Remember the Mr. Market Allegory: Imagine you are the owner of a small business in partnership with Mr. Market. Every day, Mr. Market quotes you a price at which he is willing to buy your half of the business or sell you his half. While the business is sound and makes good progress, Mr. Market’s quotes vary widely according to the mood he is in. When he is in an upbeat mood, his price is exceptionally high. Conversely, strike him on a bad day and he is very pessimistic and quotes an unusually low price. If you were in business with Mr. Market and you tried to take advantage of his wisdom, you would be on an emotional roller coaster ride. Rather, it is Mr. Market’s pocketbook you should take advantage of, not his wisdom. It is disastrous if you fall under his influence. A successful stock market investor should put aside the emotional whirlwind Mr. Market unleashes on the general market every day and exercise sound business judgment.

Don’t Try and Analyze or Worry about the General Economy

If it is impossible to predict what the stock market will do from day to day, how can it be even remotely achievable to forecast what the economy as a whole will do in the next few years? The problem is some investors begin with an economic assumption about the direction of the economy and select only stocks which fit their model. In this way, the predictions become both self-fulfilling and limiting. A superior approach is to buy a business which has a realistic opportunity to progress regardless of whether the overall economy is expanding or contracting. A business which has the ability to profit in any economic environment is very valuable.

Buy a Business, not its Stock

An investor should only buy shares in a company which he would be willing to purchase outright if he had sufficient capital. From this perspective, an investor should look for a company with business operations that are understood, has favorable long-term prospects, is operated by honest and competent people and is available at an attractive price.

Treat a stock purchase as if you were buying the entire business. The first question any business person will ask is, “What is the cash generating potential of this company?” Over time, there will always be a direct correlation between the value of a company and its cash generating capacity. The investor would benefit by using the same business purchase criteria as the businessperson.

Relationship investing is critically important. With this approach, investors act like owners of the companies they own shares in. They provide patient capital allowing management to pursue long-term growth opportunities. Stock is held long-term and investors work with management to improve corporate performance.

The Investment Tenets

Business Tenets

Is the business simple and understandable?

Do you understand how the company generates sales, incurs expenses and produces profits? That means you need to understand revenues, expenses, cash flow, labor relations, pricing, flexibility and capital requirements — an exceptionally high level of knowledge. It means that investors should buy shares only in companies within their own circle of financial and intellectual understanding. An investor needs to be realistic about what they do not know. Above-average results are most often achieved by doing ordinary things exceptionally well.

Does the business have a consistent operating history?

In general, the best level of profits over the long-term is achieved by companies that have been producing the same product or service for a number of years. One-off windfalls generated by unusual events are just too hard to reasonably predict. An investor should never ignore a current business reality because of some vision of future success. Look to buy a business which has shown it can reasonably weather different economic cycles and competitive forces. The best time to buy any business is when profitability has been interrupted for some external short-term reason. This can create a rare one-time opportunity to purchase a sound business at an unusually low price.

Does the business have favorable long-term prospects?

The economic world is divided into a large group of commodity companies and a small group of companies that own the franchise for their product or service.

  • Commodity companies compete solely on price, with no differentiation between suppliers. As well as the traditional oil and gas companies, the commodities group now includes computers, automobiles and airlines.
  • By contrast, companies which own the franchise have a product or service which is needed, has no close substitutes and for which an unregulated market exists. Ideally, a business purchaser will want to buy a franchise type of company. These companies have an appreciable margin of safety whereby prices can be raised to offset management mistakes.

The only problem is a strong franchise holder soon attracts competitors and substitute products, which in turn leads to the creation of a commodity market around that product or service. Whenever that happens, the value of the management becomes even more critical to the economic performance of the company. If it is not possible to purchase a franchise company, the next best option is to buy the lowest cost supplier in a commodity market. Over the long-term, the lowest cost supplier always comes to dominate a commodity market.

Management Tenets

Is management rational?

Does the management unfailingly act and think like an owner of the company? In particular, how is capital allocated by the company? Rational managers will invest any excess cash generated by the company in projects that produce earnings at rates higher than the cost of capital. Over the long-term, allocation of capital determines the value of the company.

All companies move through an economic life cycle. In the development stage, the company loses money while establishing markets and improving its products. During the next stage of rapid growth, the company requires cash to grow and retains earnings and borrows or issues more equity. In the third stage (maturity), the company generates more cash than it needs as sales expand. In the last stage, excess cash tapers off as sales decline.

The key question is what managers do with the excess cash in the maturity and decline stages. A rational management will invest this cash in projects that earn a higher rate of return than the cost of capital on the open market — otherwise the funds should be returned to shareholders as dividends or by buying back the company’s own shares. By contrast, irrational managers are often overcome by their own prowess and continue to reinvest in projects with diminishing returns.

Is management candid with the shareholders?

The ideal business manager reports financial performance openly and genuinely, with an ability to admit mistakes and report the progress of all aspects of the company. The management should also be able to reaffirm that the company’s prime objective is to maximize the return on shareholders’ investment. This concept should color every action taken. The tendency to include every piece of information that owners would deem valuable when judging the company’s economic performance is a characteristic of a strong management team.

Does management resist the institutional imperative?

The institutional imperative is the tendency of corporate managers to mimic the actions of other companies, even when those actions are destructive or irrational. Most managers are so influenced by what other companies are doing that they are unwilling to do anything which results in short-term pain in exchange for long-term profit.

A measure of any company’s management skill is how effectively they think for themselves rather than settle for mindless imitation of what everyone else is doing. In essence, successful companies have managers who refuse to follow the herd into mediocrity.

Financial Tenets

Focus on return on equity, not earnings per share

Companies are continually adding to their capital base by retained earnings. Therefore, you expect earnings per share to increase year by year. A better measure of a company’s performance is return on equity — the ratio of operating earnings to shareholder equity.

This measures the management’s ability to generate a return on the operations of the business given the capital employed. When calculating return on equity, value marketable securities at cost, not market value (as market value is beyond management’s control). Exclude all non-recurring extraordinary items which are unrelated to the business.

A good management team will consistently achieve good returns on equity while employing little or no debt, or at least employing a manageable debt level for the nature of the business.

Calculate “Owner Earnings”

The ultimate value of any company is its ability to generate a surplus of cash. However, a company with a high fixed-asset-to-profit ratio will require a larger share of retained earnings to stay profitable than a company with a low fixed-asset-to-profit ratio.

“Owner earnings” is calculated by adding depreciation, depletion and amortization charges to net income and subtracting the capital expenditure required to maintain economic position and unit volume.

“Owner earnings” reflects the true cash flow position of a company. Some enterprises (like a real estate development for example) require heavy expenditure at the start and very little later on. Others, like manufacturing, require regular expenditure on plant upgrades or the business slips. “Owner earnings” is an attempt to provide a cross-industry analysis measure.

Search for companies with high profit margins

Paradoxically, managers of high-cost companies tend to find ways to continually add to their overheads whereas the managers of low-cost operations take pride in lowering their expenses. Any money spent on unnecessary costs deprives shareholders of extra profits. The culling of unnecessary expenses is a consistent theme of effective managers.

For every dollar of retained earnings, has the company created at least one dollar’s extra market value?

Over the longer term, stock market value will accurately reflect the economic value of the company. The same is true for increased market value created by retained earnings. A well-managed company will add at least one dollar of market value for every dollar of retained earnings.

To estimate this factor, subtract all dividends from a company’s net income over the last ten years. This is the total retained earnings. Add that figure to the company’s market value at the beginning of the ten-year period to get a Total X. If the company has employed retained earnings effectively, the market value at the end of the ten-year period will exceed Total X. If it doesn’t, beware.

Market Tenets

What is the value of the business?

Buffett calculates the value of a business as the net cash flows expected to occur over the life of the business discounted at an appropriate interest rate.

  • Net cash flows are the company’s owner earnings over a long period.
  • Something like the thirty-year U.S. treasury bond rate can be used as a measure of the interest rate for this calculation.

By calculating the business value this way, vastly different business enterprises can realistically be compared. If the business is growing rapidly but has unpredictable future revenues, then the company is not classified as simple and understandable and this formula cannot be applied. The discounted cash-flow approach described is very conservative as long as an appropriate discount rate is applied.

Can the business currently be purchased at a significant discount to its value?

Armed with an accurate calculation of the value of the business, you should now look at the asking price. The rule for market success is purchase only when the current market price is at a significant discount to value. The intention of any investor is to earn above-average returns. The difference between business value and price is the investor’s margin of safety. Most investors set their own margin of safety. Buffett generally aims for a 25-percent discount as his margin of safety. Additionally, a well-chosen stock will have sound fundamentals, which over the longer term will lead to an above-average growth in the company’s share price. This, in effect, becomes an additional reward for the intelligent investor who purchases at a discount.

Manage a Portfolio of Businesses

“As time goes on, I get more and more convinced that the right method in investments is to put fairly large sums into enterprises which one thinks one knows something about and in management of which one thoroughly believes.

It is a mistake to think that one limits one’s risks by spreading too much between enterprises about which one knows little and has no special reason for special confidence. One’s knowledge and experience is definitely limited and there are seldom more than two or three enterprises at any given time.”

— John Maynard Keynes

Intelligent investing means having the priorities of a business owner (focused on long-term value) rather than a stock trader (focused on short-term gains and losses). The ability to say “no” unless all the facts are in your favor is a significant advantage for any stock market investor. Rather than constantly buying and selling shares in mediocre businesses on the strength of a rumor, Buffett buys and holds shares permanently in just a few outstanding, well-managed businesses. His approach is always to wait patiently until a truly great investment opportunity surfaces and then go to it.

The book’s simulations found focused investing to be the best way to invest.

“Most investors are better off with a simpler approach that’s still very effective: Invest in index funds. But if you are willing to put in the work to study businesses, focus investing in a few high certainty bets for the long-term is a proven way to be successful.”

— paraphrasing Warren Buffett

Other Notable Ideas

  • Deferring capital gains rather than paying them off lets them compound.