In recent decades, Warren Buffett, once little known even in his hometown, has become the sage of Omaha, one of the most successful investors and richest men in America. His ups and downs– mostly ups– and even casual utterances make news in the business press.
Buffett started out as a disciple of Benjamin Graham, the most eminent theoretician of the value (as distinct from growth) technique of investing. He has edited Graham’s The Intelligent Investor, an outstanding exposition of that technique. But when a disciple becomes in turn a master himself, or when times change, he rises above the previous orthodoxy and breaks new ground. As we will see, Buffett is no exception.
If you had put $10,000 in Buffett’s original partnership at its inception in 1956, you would have collected about $267,691 by the time he dissolved it a the end of 1969. He had never suffered a down year, even in the severe bear markets of 1957, 1962, 1966, and 1969. When the partnership was would up, you could have elected to stay with Buffett as a shareholder of Berkshire Hathaway, Inc., which was spun off from the partnership and became Buffett’s investing vehicle. In that event, your $10,000 would have grown to about $50 million by 2000.
The essence of Buffett’s investment thinking is that the business world is divided into a tiny number of wonderful businesses–well worth investing in– and a huge number of bad or mediocre businesses that are not attractive as long-term holdings. Most businesses are usually not worth what they are selling for, but on rare occasions the wonderful businesses are almost given away, based on current gloomy economic and stock market forecasts. When that happens, buy boldly! Buffett likes to sit with half a dozen or so core holdings plus a dozen or so held for possible resale. He characterizes traditional diversification as the ’Noah’s Ark approach: You buy two of everything in sight and end up with a zoo instead of a portfolio.’
For Buffett, the key to a good business is its business franchise– the extent to which it is surrounded by a moat, so that another company can’t muscle in to squeeze its prices and profits. The competitiveness built into the American economic system inhibits the creation of great franchises. Buffett explains, The test of a franchise is what a smart guy with a lot of money could do to it if he tried. If you gave me a billion dollars, and first draft pick of fifty business managers throughout the US, I could absolutely cream both the business world and the journalistic world. If you said, ’Go take the Wall Street Journal apart,’ I would hand you back the billion dollars. Reluctantly, but I would hand it back to you. The real test of a business is how much damage a competitor can do, even if he is stupid about returns. The trick is to find the ones that haven’t been identified by someone else.
The businesses that Buffett thinks are worth owning– those with powerful franchises– sometimes fall into the category he calls ’gross profits royalty’ companies, perhaps better called ’gross revenues royalty’ companies. These have included TV stations, newspapers, international advertising agencies, and the largest insurance brokerage companies. Other valid franchises Buffett has liked include insurance and reinsurance, financial companies such as Wells Fargo Bank and Freddie Mac, some specialized situations such as Sperry & Hutchison Green Stamps, furniture and jewelry retailing and candy manufacturing, but there aren’t many that enjoy both a substantial and a well-secured niche. In recent decades he has branched out of Graham-style value situations in favor of huge multinational consumer companies, such as Coca-Cola and Gillette, both surrounded by very deep and wide moats indeed.
What about buying and holding the bargain stocks listed in financial publications from time to time? Buffett is not too excited about their prospects longer-term saying, If you buy and hold on, you will do only about as well as the companies themselves do. Since they have a low return on capital, that means not outstandingly. To grow fast you need a high return on capital. So, you must be sure to sell a ’Graham’ investment at the right time, whereas you can hold on to a higher-growth company for as long as it goes on developing rapidly.
He thinks of a stock only as a fractional interest in a business and always begins by asking himself, How much would I pay for all of this company? And on that basis, what will I pay for 1% or 10% of it? There are very few companies he considers interesting enough to buy at all, and even those he will look at only when they are very unpopular. Then, if one knows for certain what the values really are, one can have the confidence to buy in the teeth of general gloom.
Buffett’s Six Qualities of a Good Investor
- You must be animated by controlled greed, and fascinated by the investment process. You must not, however, let greed take possession of you so that you become in a hurry. If you are too interested in money, you will kill yourself; if not interested enough, you won’t go to the office. And you must enjoy the game.
- You must have patience. Buffett often repeats that you should never buy a stock unless you would be happy with it if the stock exchange closed down for the next ten years.
- You must think independently. Jot down your reasons for buying: ’XYZ is undervalued by the market at $500 million because…’ When you have them all down, make your decision and leave it at that, without feeling the need to consult other people: no committees. Buffett reasons that if you don’t know enough to make your own decisions, you should get out of decision-making. He likes to quote Ben Graham’s dictum: ’The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct.’
- You must have the security and self-confidence that comes from knowledge, without being rash or headstrong. If you lack confidence, fear will drive you out at the bottom. As an example of the folly of being too market-conscious, Buffett cites nervous investors who don’t know the facts and thus make a habit of selling stocks when they go down. Crazy, he says. It’s as though you bought a house for $1 million and immediately told the broker that you would sell it again if you got a bid for $800,000.
- Accept it when you don’t know something.
- Be flexible as to the types of businesses you buy, but never pay more than the business is worth. Calculate what the business is worth now, and what it will be worth in due course. Then ask yourself, ’How sure am I?’ Nine times out of ten you can’t be. Sometimes, though, the bell rings and you can almost hear the cash register. However, nobody is clever enough to buy stocks he doesn’t really want and resell them to someone else at a profit. The bigger fool in the ’bigger fool theory’– accepting a bad buy to sell it to someone dumber than you are– is usually the original buyer, not his intended victim.
Buffett’s Eleven Characteristics of Wonderful Businesses
- They have a good return on capital without accounting gimmicks or lots of leverage.
- They are understandable. One should be able to grasp what motivates the people working in them, and why they appeal to their customers. Even IBM, which looks straightforward, has changed character several times, such as when it went from punch cards to magnetic tape, and again when it introduced the 360, betting the future of the whole company on the success of one system.
- They see their profits in cash.
- They have strong franchises and thus freedom to raise prices. The number of truly protected areas in the US economy is minute. Their very rarity is the greatness of capitalism. Start a Japanese restaurant and, if it works, the neighborhood soon has two, four, eight, then sixteen Japanese restaurants. Their profitability declines until the owners just have a job, not an exploitation.
- They don’t take a genius to run.
- Their earnings are predictable.
- They are not natural targets of regulation.
- They have low inventories and high turnover. In other words, they require little continuing capital investment. There are many high-growth businesses that require large infusions of capital as they grow and have done little or noghing for their owners– a lesson investors periodically relearn.
- The management is owner-oriented. Buffett observes that one can sense quickly when management thinks of itself first and the shareholder second. In such a case the investor should stay away. He considers it an atrocity when controlling shareholders go public at high prices in a bubbling market, then fail to perform, and eventually force the public investors out at 50 cents on the dollar. He insists on managements who regard stockholders as partners, not adversaries. This attitude is of course the opposite of that of certain economists who consider shareholder distributions just another cost of doing business. As interesting theory, but no way to attract capital!
- There is a high rate of return on the total of inventories plus plant. (Receivables usually offset payables.) This test, applicable only in certain industries, exposes many bad businesses that seem to have high earnings but in fact are wormy–some of the conglomerates, for example. Stock promoters during frothy markets crudely but successfully dress up ordinary companies to fit the current fashion of the investment world, but return on capital is hard to fake. This is an extremely important way in which Buffett’s approach differs from standard brokerage house analysis.
- The best business is a royalty on the growth of others, requiring little capital itself.