I’ve been rewriting some version of this article for a long time now, but maybe this is the time I’m able to get everything out on paper where it makes sense. Essentially, the reason I keep attempting it is that the older I get, the more Warren Buffett’s investing philosophy appeals to me.
Of course, the way I interpret his philosophy might differ from what he actually does, or the way that other people think he invests. Likely, an investment will look attractive to me that evidently seems unattractive to him. And what’s more likely, he will be attracted to certain investments for reasons that just aren’t obvious to me. So, what I’m saying is, I’m trying to be like Buffett, but in my own way. Buffettesque.
I’ve written before that Buffett seems to seek out investments based primarily on their predictability of cash flows. I suspect that it’s this predictability, above all other metrics, that signals the quality of a company’s business model or “moat.” He talks about this a lot. In fact, there’s a great video of him relating a conversation he once had with Bill Gates, where his friend “Bill” tries futilely to explain to him how computers will change the world. Here’s that conversation paraphrased:
Gates: Computers are going to change the world in ways we can’t even imagine right now in 1990.
Buffett: Will it change whether people still chew gum?
Gates: What? Probably not I guess
Buffett: How about the type and flavor of gum people chew?
Gates: Not that I can think of?
Buffett: Computers sound great and all, Bill. But what I’m hearing is that I don’t need to be able to understand this technology stuff to know whether people are going to keep buying Wrigley’s chewing gum.
Everyone is looking for the next big thing, trying to guess how the future will unfold, and making investments based on that. Maybe you’ve seen that Motley Fool ad proclaiming, “This stock could be like buying Amazon in 1997!” Why do they keep running it? Because it works. People love anticipating and speculating on what the future will be. They want not only to make money, but to guess the right answer and to feel smart! And because of that, they tend to get paid in feelings instead of in cash money.
Such behavior is more like gambling than like investing. Sure, you could strike it lucky and win big, but what happens if you’re wrong? Your investment goes to zero and you’re out of the game. Either you win 20x or you lose it all and start over. Admittedly, if you play that game enough, you might win a couple times, but if you keep playing, you’ll inevitably lose it all later. The main reason for Buffett’s wealth, as pointed out by Morgan Housel here, is that he started when he was 11 and managed to stay in the game without losing for 81 years straight. That’s many, many, many years of small or moderate wins.
Most people come late to investing, often panicking and trying to make up for lost time. As a result, they make big, risky bets hoping to get lucky and negate a lifetime of poor financial behavior. “Bad decisions got me into this mess,” they reason, “and bad decisions will get me out of it!” Even those who have made hitherto good decisions often struggle to resist the temptation to throw a Hail Mary in attempts leapfrog themselves ten years ahead.
Buffett meanwhile, allows time to work for him, rather than against him. And the way you ensure that time remains valuable is by putting it into businesses that will almost certainly thrive for many years to come. That is why predictability is the first and most important hurdle his investments must overcome. Not “growth,” nor “cheapness” any other ratio. Predictability. He cannot afford to lose time in poor investments. Neither can you.
Since I mentioned value, I want to mention a misconception about Buffett. Buffett today is not, first and foremost, a value investor. He spent his early days following the Ben Graham method of “cigar butt” investing, often buying businesses for less than the value of the cash on their books. But that was sixty years ago. As markets have changed, so has Buffett. Today, Buffett invests in quality, specifically in predictability. He still tries to buy cheap, and he always demands a healthy risk premium in proportion to the riskiness of his investments, but that is not to say he will only buy cheap companies. In fact, with excellent companies, he appears willing to sacrifice a bargain today for having a great business over the coming ten years.
What makes a great business? The ability to expand margins by raising prices faster than costs. According to Alice Schroeder in The Snowball: Warren Buffett and the Business of Life, “Munger had always kidded Buffett that his management technique was to take out all the cash from a company and raise prices.”
This is the magic of operating leverage, the ability to make more money relative to the size of your asset base. When costs remain low, each additional dollar of revenue becomes a full dollar of earnings. In other words, none of that extra money needs to be spent on increasing factory capacity, marketing to more customers, or solving the logistical challenges that come with distributing a higher volume of product. As a result, on a percentage basis, earnings will grow faster than revenues, and your investment will grow exponentially in value even with small, linear price hikes.
Here’s the math. Let’s say you sell a product to a customer for $100. And suppose that after all your expenses are paid, you get a $10 profit (so you have $90 in expenses). Do you follow so far? Make sure you do. Imagine then, that you are able to raise prices 10% so that you charge your customer $110 for the product, but all your costs stay the same. So your profit becomes $20 ($110 minus $90 expenses). Even though you raised prices only 10%, your profits grew 100%! Since your profits are twice as high, your business should be worth twice as much. This provides a nice tailwind to investment results.
To enable this, what you want is a company whose expenses are minimal, and unlikely to increase going forward. You want assets that don’t require much maintenance, or at least, assets whose maintenance costs are not expected to increase linearly with the volume of business you do.
It’s a sweet gig, if you can get it. But of course, most businesses can’t. They can’t because they sell products that aren’t much different from what their competitors offer. If they raise prices even a little bit, their customers will go next door to shop at their competitors. Too, if they want to do more business, they usually have to spend a lot of money to increase their production as well as to grow their customer base. This is risky, and not consistently lucrative.
Management teams are often incentivized to grow by any means necessary: acquisitions, operational improvements, new product lines, marketing…just to name a few. All these things cost money. The question is, how much do they cost, and how do these initiatives impact earnings over time? Specifically, how do they impact the predictability of earnings over time? That’s the rub. For a long time, Google did really well by focusing entirely on advertising related to search results. They continued to improve their product and strengthen their position in the marketplace, while making only incremental investments in their core offering. That’s Buffettesque.
Today, Google is a tale of two companies. One is Very Buffettesque. Growing youtube and search revenues takes almost no money, and this is where most of the company’s profits come from. These businesses are not quite as monopolistic as they once were, but the risk/reward for growth remains attractive.
But the other side of Google’s business is not nearly as attractive. They’re building out enormous server farms for Google Cloud, and they’re investing boatloads of cash in their “Moonshots” segment (now called X). Google Cloud may secure decent margins over time, but the amount of money required for this to pay off is unclear, as is the size of the expected payoff. As for the “Moonshots” category, these are expensive science experiments.
I have no doubt that some valuable innovations will come out of these projects, but it’s unclear whether they’ll ever make money. Both the risk and the reward are hard to estimate because we just don’t know what the business landscape will look like when these projects hit the market. Furthermore, it seems that these investments are highly speculative, such that any reward remains highly uncertain. Which just isn’t a reliable way to compound your wealth, and it certainly isn’t Buffettesque.
Side note: Recently, an angel investor told me (and I haven’t fact checked this) that the median rate of return for all Venture Capital funds is 0%. A few produce huge returns, but most do not. It’s an interesting base-rate situation. As skilled as Buffett is as an investor, he seems to acknowledge that since he is also a human like all the other “future-guessers” out there, his own returns are more likely to be closer to 0% than 30% for that kind of endeavor.
So how does Buffett do it? How does he evaluate the quality and predictability of an investment? As you might expect, actually implementing this approach is the hard part. It takes an incredible depth of understanding of each particular business. Being good at that, and being good at it consistently, across many industries, is hard. Copying Buffett’s approach here is not a matter of repeating his aphorisms, or looking at historic stock returns for a company. It’s about replicating his wealth of business knowledge, and 81 years of experience.
I think when you’ve been around the block a few times, as Buffett has, you start to notice some patterns. Not only do you see some promising businesses go bust, but you see star managers fall back down to earth. Many investors want a “business savior,” someone who can come into a business, fix everything, and generate massive returns for investors. Some of these people exist, certainly, but even in my short lifetime as an investor, it seems like yesterday’s genius is often tomorrow’s dud. Circumstances and luck converge to create larger-than-life reputations, often beyond what any human is capable of. Rather than bet on a great manager who will solve any problems facing the business, Buffett prefers to pick businesses that don’t need a hero. This saves him a lot of pain.
He has a great adage, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” This would suggest that managerial ability is something he looks at only after determining that a business is fundamentally sound.
Yet, many of Buffett’s acquisitions are structured so that managers retain a personal interest in their businesses. Clearly he sees some connection between the performance of the management and the success of the underlying business.
So how to reconcile this? I think this is another area where Buffett’s thinking is a little different from our own, specifically in his preference for predictability. In line with the same trend I mentioned before, the rest of us have a tendency to idolize the most intelligent and talented leaders, betting on the positive change they will create in their organization. We eagerly ask, “is this person exceptional?” But Buffett asks, “are they reliable?” He doesn’t want people who will shake things up, he wants people who will consistently execute on what has already proven to be a winning strategy.
Here are some examples:
- Every year, it seems, Buffett praises Ajit Jain in the Berkshire Hathaway annual letter (Jain is leader of Berkshire’s insurance division). Usually this praise focuses on Jain’s careful risk management and underwriting abilities. Not very sexy or exciting, but very important for Berkshire’s continued success.
- Buffett is also appreciative of the value of keeping costs down. In his last letter he singled out the Blumkin family’s work at Nebraska Furniture Mart, especially their ability to operate at lower costs than their competitors. Or, consider his acquisition of Precision Castparts, whose leader is famously ruthless about keeping the costs of operations down. Still more evidence can be found in Buffett’s collaboration with 3G Capital, a firm whose claim to fame lies in their ability to cut costs to the bone.
- Or, consider Buffett’s advice for retail investors. He often recommends investors buy an index fund, because doing so offers diversified exposure to equities, with fairly low probability of total failure. By contrast, many actively managed funds, especially the most aggressive ones experience massive drawdowns from which they never recover. Because of this tendency, star managers are actually some of the riskiest selections because, as I mentioned before, they get too much credit in good times. And good times don’t last forever. Often, these managers were taking massive risks that happened to be rewarded by their macroeconomic environment. Eventually, those risks manifest themselves as massive bear markets.
Finally, and only after all these other considerations, comes the process Buffett is best known for, buying companies cheaply. And this is actually the thing people get most wrong about Buffett. They see him as this “buy low, sell high” kind of guru who has made billions by picking the best times to buy the cheapest, most under-appreciated companies. But as I’ve said, that’s not what he does. Buffett buys reliable companies with predictable cash flows whose profits can either be reinvested productively in their own growth or returned to Berkshire to buy other assets. He is, at heart, a slow and steady compounder, not an “asset flipper.”
This last step is almost an afterthought. Just by getting through all the previous steps, you develop an intuitive understanding of what the business is worth, and what it should be worth over the long term. Having a qualitative understanding of the business is the most important part of Buffett’s approach. Yet, valuation is where the majority of investors spend most of their time. They look for stocks trading at objectively low valuation ratios (price/earnings, price/cash flows, EV/EBITDA, price/sales), and they create elaborate cash flow models to see just how cheap a company is, all before they really understand what they’re even looking at. They generate outputs before they understand their inputs.
Value investing is like rummaging through a garbage dumpster, trying to find stuff that people were too lazy to donate to charity. Sure, you can find something good once in a while, but think about it. Is this the universe you want to be selecting your investments from? Hardly. Don’t do your clothes shopping (or your investing) in the dumpster.
If you want to maximize the value you get out of your clothes, go to a good store, like a Nordstrom’s, or a Macy’s (or whatever your regional medium-high quality clothier is). Then, sort through and see if you can find something you really like and will get good use out of. If it’s worth it to you, buy it. That’s what Buffett really does with his investments. And it’s what we should strive to do when attempting to emulate him. Put yourself in a store with a wonderful selection of quality items, but buy only one or two things that represent a great value to you.
Until recently, I used to be a “dumpster diver.” I ran screen after screen looking for cheap companies, without studying whether they were anything I’d like to own for any period of time. After all, I had read from Buffett and his mentor Ben Graham about the virtues of investing in companies with “temporary difficulties.”
The problem, when you do that, is that you find a lot of companies that, while certainly out of favor today, are unlikely ever to become “in favor” in the future. There are many mediocre businesses unlikely to compound wealth at anything close to what the broad market can accomplish. In ten years, the broad indexes will be worth more, but these companies often will not. They are still tempting though, because they will appear to be offering a one dollar bill in exchange for fifty cents. That dollar, though, only exists if management can improve the quality of their business so that it will be able to sustain itself in the future. That may sound simple, but increasingly, I suspect it is anything but.
Furthermore, remember when I mentioned how you can get paid in excitement, or you can get paid in cash money? Well, as hard as it is to correctly predict the success of a turnaround, it can be very exciting. Everyone wants to look like a genius for betting on the underdog, after all. Of course, in markets, as so-called “contrarians” pile into it, a “cheap” company can actually become overpriced relative to its prospects for success, and remain a poor investment.
So what to do?
Proponents of value investing will tell you stories of misunderstood companies whose stock prices dropped 50%+ as Wall St allegedly “over-reacted” and “mis-priced” a big-news event. And these may be great stories, but they are really unlikely ways for you to make money. Why? Because the market is swamped with people playing that game. Everyone wants yesterday’s winners at bargain prices. It’s an exciting buy, but not a profitable one.
What’s less exciting is buying into a company or sector that has struggled for four or more years due to a challenging business environment. That could mean a profit recession for John Deere’s agriculture customers, weak demand in SUVs for GM, or weak housing demand for a homebuilder. The key is that these challenges are temporary, not existential. For predictable, quality companies, these circumstances will rarely threaten their survival. The only real casualty is investor confidence. Over a period of 4+ years, people “forget” that it is fundamentally a great company. They may or may not have accounted for the difficult operating environment facing their company, but such investors frequently get tired of holding what feels like a comatose asset, and sell at the worst time. They forget, of course, that most things in the world are cyclical. The very factors causing such underperformance are actually sowing the seeds of a new cycle where the company will fare better.
Here’s a great story Buffett told in his 2014 Annual Letter to illustrate how he thinks about cheap investments:
“This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath as in our recent Great Recession.
In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.”
This investment needed no guessing about the future because conditions were unlikely to deteriorate further, and what’s more, the investment already had a satisfactory cash yield. These are the situations you want to look for, because they are already good, and will only improve with time. Often, they present themselves in the years after a once-hot sector has lost its fire.
So, to review, Buffett deserves tremendous credit as an investor, but he often gets credit for the wrong things. Many people frame his success in terms of value-investing, but cheap stocks alone aren’t what have created the compounding machine that is Berkshire Hathaway. Instead, he buys companies based on the predictability of their future earnings because predictability is the ultimate measure of a company’s “moat” or ability to withstand competition and earn continued profits. This is what makes Buffett different from the rest of us, he makes investments based on what won’t change, rather than on what might happen in the future. He eschews excitment, and bets big on boring. This is true not just of the businesses he buys, but of the managers who run them. There are no “hot-shots” at Berkshire Hathaway, because Buffett does not play that game. Instead, he picks people who can reliably, if not relentlessly, execute year after year after year.
It is only after an investment clears all these hurdles that Buffett looks at price. And here, in the final step, he still won’t touch a spreadsheet. Because he has done his homework, he knows intuitively whether an investment is likely great or not. And if it looks great, he buys it.