“You only have to be able to evaluate companies within your circle of competence.”
—Warren Buffett, 1996 Letter to Berkshire Hathaway Shareholders
In the last chapter, we went over the basics of the stock market. Things such as how a stock is “born” and winds up on an exchange, what a dividend is, what an index fund is, and why it's hard to “beat the market.” This chapter will make additional inroads into getting a better understanding of the stock market. We'll discuss two important topics. First, how to estimate the true value of a stock—what's known as a price target on Wall Street. As we'll see, there can be a huge difference between your price target and the current price of a stock. The second key part of the chapter is that we'll provide some more detail on Buffett's approach to the stock market. The stock market is Buffett's bread and butter, so you'll see a heavy dose of Tips in this chapter. Let's get started.
Estimating the value of a stock, or any other investment, really gets into the heart of investing. Unlike the laws of physics, which work 99.9999% of the time (weird cases of quantum mechanics aside), there are no magic formulas that will enable you to value a stock with a high degree of precision. Most investment classes teach techniques that might be right, on average, over long periods of time. Using a baseball or softball expression, nobody bats a thousand in the world of investing. Even Buffett. Let's go over two approaches investment analysts commonly use to estimate what should be the price target of a stock. One approach is related to the “time value of money” concept we covered in Chapters 2 and 4. The other technique will be as easy as pie, since it simply multiplies two numbers together to get a price target.
As usual, we'll do our best to avoid any formulas or relegate them to a endnote or appendix. A formula can give you a precise number, but if the formula is wrong, it doesn't matter if you get an answer to the tenth decimal point. In Buffett's 2008 Letter to Berkshire Shareholders, he essentially said the same thing, summing it up with the quote “Beware of geeks bearing formulas.” Let's put that quote as our first Tip for the chapter.
Let's tackle the first approach we alluded to, which is called a discounted cash flow (DCF) model. It basically involves applying the time value of money, a concept we previously covered to valuing a company. The DCF approach says the price of the stock is equal to what we called the present value of future cash flows. Buffett calls this approach the intrinsic value, a term we briefly came across in Chapter 3. In his 1993 Letter to Shareholders, he wrote, “We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.”
There's a lot going on in that Buffett quote, but it's of huge importance. We'll summarize it by saying that intrinsic value is the best way to think about valuing an investment, even though there will be some debate about the cash flows and discount rate. That's certainly worthy of a Tip.
For a bond, it is a piece of cake to determine the cash flow. It's just the coupon payments and the face value, or principal. It's usually a finite period lasting from less than one year to up to 30 years. However, a stock has no expiration date. That is, it exists forever or in perpetuity unless it goes out of business or is bought out by another company. For example, The Bank of New York Mellon was founded in 1784 by Alexander Hamilton and is still thriving today. We wouldn't be surprised to see it around another 230 years from now!
How do you value something that goes on to infinity? Good question. Fortunately, there is a handy formula, known as the Gordon growth model, that involves only simple algebra. All we need are three things: the discount rate, next year's dividend, and the long-term, or steady-state, growth rate.
We've covered the basics of the discount rate in Chapters 2 and 4. For bonds, we said the appropriate discount rate is the yield to maturity (YTM) on the firm's debt. YTM can be approximated for a firm by taking the US Treasury Bond yield at the same maturity and then adding an extra amount for credit risk. For stocks, it's related to how risky they are. The discount rate for the stock market as a whole is roughly 10% per year. It's not a coincidence that this discount rate of 10% is close to the US stock market's historical average annual return. Of course, with any given average, some firms will have a discount rate less than 10%, and others will have a discount rate greater than 10%. A beverage company such as Coca-Cola may have a discount rate of 7%. A more volatile technology-oriented stock such as Amazon.com might have a discount rate closer to 12%. The discount rate for stocks is often obtained from the Capital Asset Pricing Model (CAPM), which is covered in Chapter 8.
A pretty good estimate for next year's dividend is equal to this year's dividend times one plus the long-term growth rate. What if the firm doesn't pay dividends? No problemo. We can use a term called free cash flow as an estimate. It's basically the cash the firm generated during the year minus what the firm needs to reinvest in itself so it doesn't fall apart down the road.
The long-term growth rate is typically close to the rate the economy grows net of inflation—usually around 2% to 4% per year. Let's try out this handy little formula with a real stock, AT&T, a large telecommunications firm. You may know AT&T since it's one of the largest cell phone carriers, the owner of DirecTV, and owner of Time Warner. Time Warner is famous for its Batman, Superman, Wonder Woman, and Harry Potter movies, among other things.
Let's assume a growth rate of 2%, the average growth of the US economy in recent years. It has a current dividend of $2.05 a share. So next year's dividend is simply $2.05 times one plus 2%, or $2.09. AT&T has been around a long time and has a history of stable earnings, so its discount rate should be less than 10%. Let's say it's 8%.
Putting it all together, we get our price target for AT&T as next year's estimated dividend of $2.09 divided by the difference between its discount rate of 8% and growth rate of 2%, or $34.83 a share. Now let's compare this number to the current price of the stock, as of the time we're writing this book. It's about $31 a share. Since the upside is about 12%, and there's another 6% in dividends, we'd say AT&T is a buy. If a forecasted return is between 0% and 10%, including the return from the dividend, Wall Street analysts typically would rate it a hold. If a price target is less than the current price, Wall Street analysts would typically rate it a sell and try to avoid the stock, especially since we mentioned in the last chapter that Buffett thinks it is dangerous to sell short a stock. Of course, if you already own the stock, a sell rating means sell it.
We prefer multiplication to division, so we'll give you an even easier approach to getting a price target. We're just going to multiply two numbers. The first is our estimate of the company's earnings per share next year. Professional analysts often build a detailed financial model to do this. In the interest of time and simplicity we're going to ditch that approach and use something like CliffsNotes or Shmoop for Finance. Not ideal, but often good enough.
One handy approach is to use the average of professional analysts' estimates, formally known as a consensus estimate. Another simple approach is to use the company's own estimate, which it gives to professional analysts, formally known as management's earnings guidance. Management's numbers tend to be a lowball estimate, since they want to underpromise and overdeliver; otherwise, the stock will often get crushed. In practice they’ll say they are being prudent or conservative with their estimates. If the actual reported earnings number is higher than the consensus estimates, it's called an earnings surprise. The second number we need to get our price target is the long-run, or sustainable, P/E ratio that the firm should trade at. If the firm has been around a long time, such as AT&T, taking its 10-year average or median value is usually a pretty good estimate.
To get our price target we just multiply the two numbers, the one-year-ahead earnings estimate and the long-run P/E ratio estimate. This approach is known as the P/E relative valuation model. We prefer the term Wall Street P/E model, since it's the most common way professional analysts come up with a price target. When Buffett does a similar calculation, he likes to look at least five years ahead rather than just one, since he focuses on the long term.
Let's compute a price target using the Wall Street P/E model for AT&T. The consensus analyst earnings estimate for AT&T next year is $3.70. Its median P/E over the past 10 years has been about 10. Multiplying these two numbers together we get $37. Since the number plus the dividends is more than 10% greater than the current price of $31, we'd put it in the buy territory.
It's okay if the DCF model and Wall Street P/E model give different stock price estimates. In fact, it's pretty common. One approach to getting a final price target is to simply take the average of the two techniques. Buffett prefers the DCF approach, which he calls intrinsic value, but the P/E approach is more common in Wall Street since it's less subject to sensitivity analysis errors, which means that a small change in the inputs to the model may result in wild changes to the output (price target). Kind of like the analogy of a butterfly flapping its wings in South America ultimately setting off a hurricane in North America.
Now, for the moment you have been waiting for! You can't boil Buffett's approach to investing down to a simple equation, like the two approaches we just discussed. It can't even be discussed in a single chapter. However, he has laid out a number of principles that he looks for when making a purchase. We'll discuss many of these principles for the remainder of this chapter and include them in our growing Tip list.
The word “purchase,” for Berkshire, may be an entire company or a big chunk of a company's stock. The fact that Buffett is investing billions shouldn't concern you too much. Remember, both he and his mentor Ben Graham said you shouldn't purchase a single share of stock if you aren’t willing to buy the entire company, if you have enough money. One of Graham's and Buffett's fundamental principles is stock equals ownership in a business. We previously labeled it as Tip 22 in this book. We also discussed a key aspect of Buffett's investment approach back in Chapter 1 with Tip 7: Buy things at attractive prices. But these tips merely scratch the surface of Buffett's awesome investment skills.
Yes, Buffett has a framework for investing, but he gets a lot of his investment ideas from just reading. Reading is part of the learning process and harkens back to his quote (Tip 3) in Chapter 1, “The more you learn, the more you earn.” When one interviewer asked him about the source of his investment ideas, he said, “I just read. I read all day. I mean, we put $500 million in PetroChina. All I did was read the annual report.”
To make this chapter more digestible, we're going to organize Buffett's investing approach according to three broad categories: (1) Getting into the Buffett mindset on investing; (2) the types of businesses Buffett likes, and (3) Buffett's thoughts on when to sell.
Having the proper mindset is essential for success in investing and almost all other fields. Maybe you've seen or read about athletes having a case of the “yips,” which refers to a loss of fine motor skills due to mental, rather than physical, reasons. For example, there have been professional baseball pitchers (e.g., Steve Blass and Rick Ankiel) who couldn't consistently throw the ball over home plate, infielders that couldn't consistently throw the ball to first base (e.g., Steve Sax and Chuck Knoblauch), or kickers (e.g., Blair Walsh) who couldn't consistently kick the football through the goal posts. There was a slightly happy ending in Rick Ankiel's case as he went from being a wild pitcher to a moderately successful outfielder and batter.
Remember our Buffett Tip 12, “The most important quality for an investor is temperament, not intellect.” This gets the ball rolling on the importance of the proper mindset to help drive success. Although this book is mostly about financial literacy and Buffett, the most successful self-help or motivational speaker today is Tony Robbins. Robbins has sold tens of millions of books on the topic, and millions more have participated in his live seminars. A key part of Robbins's motivational philosophy is having the proper mindset.
Everyone knows a lot about something. It could be sports, music, fashion, video games, apps, or tons of other things. Buffett applies the same concept to investing. He knows a lot about certain industries, such as insurance, banking, food, beverages, shoes, and airlines, to name a few. However, he doesn't know a lot about many other industries. He has famously shied away from investing in technology firms since he believes the industry changes rapidly, giving him less confidence in a tech firm's ability to succeed in the future. However, in recent years Berkshire has made investments in Apple and Amazon.com. Whether these investments were made by Buffett or his two junior investment managers, Todd Combs or Ted Weschler, is unknown. Our sense is the junior guys made the case to Buffett, who then “supersized” the positions. Apple is currently Berkshire's largest stock holding.
Just because technology is out of Buffett's circle of competence, it doesn't mean it will be outside of your circle of competence. Many young people can run circles around their parents and grandparents when it comes to technology-related things. Buffett refers to sticking to areas that you know well as staying within your circle of competence. If you understand the product and the firm's business, you're less likely to make a mistake.
In Buffett's 1996 Letter to Berkshire Shareholders, he wrote, “Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” Let's summarize that with a fundamental Tip.
Staying within your circle of competence is important for long-term investment success. However, what if everything in your circle of competence seems expensive? Buffett has advice in that case too. He says wait for a “fat pitch.” For those not familiar with baseball or softball terminology, it means wait until the timing is right. Buffett provides further detail on this thought by telling a story about Hall of Fame baseball player Ted Williams. Props to Mike Trout, Aaron Judge, and Bryce Harper, but Ted Williams was perhaps the greatest hitter ever to play major league baseball. He was the last major leaguer to hit over .400, back in 1941. He also hit 521 homeruns in his career, despite missing three years of his prime due to military service as a fighter pilot in World War II.
In his 1997 Letter to Berkshire Shareholders, Buffett wrote, “In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.” So don't feel compelled to buy a particular investment. Be patient. Wait until the price is right and for the investment to be within your circle of competence. It's great advice and similar to Tip 14 on being patient, so we won't duplicate it here.
Buffett had a lot of success early in his career by strictly following the techniques of his mentor, Benjamin Graham. Graham would focus mostly on quantitative measures of value, hoping to buy companies at a very cheap price, even if he wasn't optimistic about the company's long-term future. He called these companies “cigar butts.” Smoking cigars is a pretty disgusting habit, especially if you pick up someone's mostly smoked cigar off the street and try to get a few free puffs out of it. Graham looked for the equivalent of these cigar butts in the investment world. He held on to them for awhile and then looked to get out. One way Buffett eventually diverged from his mentor is that Buffett liked to buy high-quality companies even if he had to pay more for them. He learned this approach from Charlie Munger and another well-regarded growth investor, Philip Fisher. This new philosophy for Buffett became even more important as he started to manage large sums of money, since “cigar butt” stocks tend to be small in market cap. However, even using this new approach, Buffett would still stay disciplined and not overpay.
Here's how Buffett described it in his 1989 Letter to Berkshire Shareholders:
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns… . Time is the friend of the wonderful business, the enemy of the mediocre.
Let's use the last sentence of that quote as a Tip, especially since it implies holding onto stock in a good company, despite short-term problems.
One last thought on this Tip using a Buffett quote to further illustrate the point. In his 2014 Letter to Berkshire Shareholders, he wrote, “It's better to have a partial interest in the Hope Diamond than to own all of a rhinestone.” To save you a minute searching Wikipedia or asking your smart speaker, the Hope Diamond is one of the largest and most valuable diamonds in the world. It's bluish in color and currently resides at the Smithsonian Institute in Washington, DC.
Perhaps you've heard the quote, attributed to the ancient philosopher Heraclitus, “The only thing constant is change.” Well, change is a constant in the investment world too, but industries change at different rates. Wrigley's chewing gum and Oreo cookies haven't changed much in the past 100 years, but the cell phone industry has changed dramatically. In the past, the phone was used mostly to talk to someone. Today, your smartphone is the equivalent of a phone plus a supercomputer in your pocket. Not surprisingly, Buffett has weighed in on how to think about change in an industry.
In his 1991 Letter to Berkshire Shareholders, he said, “While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic P/E ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost.”
Now you can see why he prefers industries that don't change a lot. It's harder to invest in industries that change since you have the difficult task of trying to predict the future. That's not to say it can't be done with more than a coin flip of accuracy, but it's just not Buffett's cup of tea. Let's combine these thoughts into another Tip.
It's not easy being in business. If you're a profitable firm, other competitors will be gunning for your business. Amazon's Jeff Bezos famously said, “Your [profit] margin is my opportunity.” Companies with consistent earnings, profit margins, and growth over time, according to Buffett, have moats around their businesses. They have found ways to fend off their competition. You've almost certainly seen a picture of a moat around a castle. For those just arriving from Mars, a moat is a body of water around a castle, often with dangerous animals, such as crocodiles, swimming within to discourage an enemy invasion. Typically, the only way to enter the castle is by having the drawbridge opened from the inside.
In his 2005 Letter to Berkshire Shareholders, Buffett described in some detail how he hopes Berkshire Hathaway widens its moat. He wrote:
Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs, and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now.
Since the concept of a moat is essential in the types of businesses and stocks that Buffett loves, let's summarize it with a Tip.
A moat around a business can come from many sources, some of which were mentioned in Buffett's quote. For example, “Delighting the customer” is an example of great customer service. It's one of Jeff Bezos's philosophies for Amazon.com. Some companies have great marketing, while others have a great distribution network. Others have patents, or legal protection, for their products lasting up to 20 years. And others produce their goods or services at the lowest price among the competitors in the industry, what is known as the low-cost producer. Let's look at some examples of a moat in the context of a favorite Buffett investment, Coca-Cola.
Coca-Cola is an example of a firm that Buffett often cites as having a moat. Almost anyone can make soda. It's basically fizzy water plus sugar and some flavoring. Yet, Coca-Cola has remained a dominant beverage firm for about 100 years. Their moat comes from not just a good product, but also their great brand name and exceptionally strong marketing and distribution network.
Coca-Cola beverages are distributed in more than 200 countries around the world. Almost everyone recognizes the Coca-Cola logo, which is a sign of effective marketing. They sell a consumable product, which means repeat business if their customers like the product. In contrast, if you buy a pair of scissors or a piece of furniture, it can often last for decades without replacement. Coke also has a great distribution network with supermarkets and restaurants, such as McDonald's. There's practically no way a start-up firm can supplant them.
It's true that people are consuming less carbonated and sugary beverages today than in years past. That's okay with Coca-Cola. It also owns Vitamin Water, Dasani bottled water, Minute Maid juices, and big chunks of Monster Energy and Keurig, the single-serving coffee company. As long as you're drinking liquid, Coca-Cola, the company, will be fine. Lastly it benefits from population growth—more customers around the world are born each day.
On Coca-Cola Buffett once remarked, “If you gave me $100 billion and said to take away the soft drink leadership of Coca-Cola in the world, I'd give it back to you and say it can't be done.” Really, with $100 billion? Now that's a savage moat!
If the company hasn't survived the ups (known as an expansion) and downs (known as a recession) of the economy, you can't tell how durable it is. Or, as Buffett said more colorfully, “You can't tell who is swimming naked until the tide comes out.” Coca-Cola certainly falls in this category as well Dairy Queen and perhaps Kraft Heinz, despite some recent missteps. People need to eat regardless of how the economy is doing. Even GEICO would fit the bill here as well. Anyone with a car needs to drive, Uber and Lyft aside, and GEICO is one of the more inexpensive sellers of auto insurance.
You might find it amazing that Berkshire Hathaway has almost 400,000 employees, yet there are only 25 people in Berkshire's corporate headquarters in Omaha. How can he manage so many people with a staff slimmer than Snoop Dogg's waistline? The trick is when he buys a company, he largely leaves it alone. He plays a role in big-picture things, such as how to invest the firm's money, a term that goes by the formal name of capital allocation. He likes it when there is good management in place. Buffett lets them do their thing. That's how he likes to roll at Berkshire. The lean, not-so-mean approach of Buffett and Berkshire merits a Tip.
You may ask, “What is good management?” It's hard to define precisely, but good management increases sales, earnings, and market share (i.e., a firm's revenues as a percentage of total industry revenues) over time. If the stock is publicly traded, it should have historically outperformed the market and its industry peers. Good management usually is able to underpromise and overdeliver on earnings expectations, as we noted earlier. In other words, they consistently exceed expectations when reporting their quarterly financial statements. In recent years, Apple, Facebook, Microsoft, Amazon.com, JPMorgan Chase, and Google/Alphabet would fall into this category.
The retail industry (i.e., stores in your local strip mall or shopping mall) is one area where good management can make a big difference. In Buffett's 1995 Letter to Berkshire Shareholders, he joked, “Buying a retailer without good management is like buying the Eiffel Tower without an elevator.” With this quip, Buffett implies that many retailers sell the same stuff, so the point of differentiation is how the firm is run by its management.
But good management can't help sinking industries.
Sometimes Superman, Iron Man (Tony Stark), or [insert your favorite superhero here] cannot overcome a business saddled by poor profitability. Some industries have intense competition and require large and continual expenditures to survive. The airline industry is one that Buffett likes to cite that would fall into this category. Few airline firms have consistently made profits (Southwest Airlines is the main exception), despite strong overall revenue growth for the industry over the past roughly 100 years.
In Buffett's 2007 Letter to Berkshire Shareholders, he wrote, “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
The Wright brothers joke is one of Buffett's most widely cited. Let's put the first sentence down as a Tip. Speaking of jokes, he has another on management that is also Tip worthy. Let's round out our discussion of management with Tip 37 on the limits of management's powers.
We've discussed inflation at various times in this book. It's a measure of rising prices, or how much your standard of living is falling if your income is flat. Investors like it when companies show rising profits. However, if a firm struggles to raise prices, especially during periods of high inflation, the company's earnings will probably take a hit, and that can't be good for its stock price.
In his 1980 Letter to Berkshire Shareholders, Buffett wrote, “A disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses.”
We'll simplify this quote for you since it's heavy in accounting speak. According to Buffett, two types of firms are particularly well suited to survive, or even thrive, during inflationary periods. The first type is comprised of firms that have strong intangibles or brand names. The second is comprised of firms that are among the lowest-cost producers or sellers in their industries. The first type is fairly obvious. A company selling a product protected by a patent is one example of an intangible asset. It usually has the power to raise prices, since there may not be a good substitute. For example, if someone needed a certain patented medicine to remain healthy, they'd probably have to pay the higher price.
People often will pay up for a brand name, preferring, for example, an Oreo or Chips Ahoy! cookie over a “no name” similar cookie sold in their local supermarket. Buffett places Berkshire subsidiary See's Candy in the strong brand category. They are known for their scrumptious chocolates and candies. See's has been able to raise prices virtually every year since Berkshire purchased the firm in 1971. Plus, See's doesn't require a ton of cash to invent new products. Popular flavors may change, but chocolate has stood the test of time.
GEICO is a good example of a low-cost producer or seller of car insurance. Historically, most car insurance was sold through a network of branch offices. It's fairly costly to operate this branch network since you have to pay rent or buy real estate for the office and pay for a bunch of insurance agents, as well as many other expenses. GEICO sold auto insurance mostly through the mail, and in later years, over the Internet, largely avoiding the cost of building a branch network. This lower-cost structure enables GEICO to offer lower prices to its customers, providing it with an edge. In the event it has to raise prices, it would still be among the lowest-cost choices for purchasers of car insurance. Let's summarize the concepts in this section with a Tip.
Products and industries come and go over time. Before there were cars, the buggy was the main mode of personal transportation, especially if you didn't live near a railroad. It was basically a carriage or stagecoach pulled by some horses. Someone over the age of 40 probably learned how to type on a typewriter, rather than on a computer or tablet. Car phones used to be popular until the business was supplanted by a cell phone you could carry in your pocket that could be hooked up “hands free” to your car.
Kodak became one of the most powerful firms in the world through its creation of film used in many cameras, until the advent of digital photography. The film that turned Kodak into a powerhouse was largely made of chemicals and plastic. Digital film is a totally different business; it's a type of computer chip called flash memory. The evolution of the film business and Kodak's inability to effectively adapt to a new world for its core product resulted in the once iconic firm's bankruptcy in 2012.
Joseph Schumpeter, a Harvard economist during the first half of the 20th century, called the tendency of certain industries to supplant or destroy old industries “creative destruction.” Usually, the firm that creates the new product or service benefits. The consumer also usually benefits. But the firm that relies on the older product or service is harmed and sometimes mortally wounded. For example, Walmart's business model (i.e., the way it tries to make money) of having huge stores selling at low prices and backed by a very sophisticated computerized inventory management system, negatively affected retail stores such as Sears and Kmart from the 1980s through 2000. Sears and Kmart eventually merged but declared bankruptcy in 2018. Since the mid to late1990s, Amazon.com's business model of selling a huge range of goods online at low prices has negatively affected not only Walmart but virtually all other retail stores. The “retail apocalypse” is a phrase used to describe a long list of firms that have gone bankrupt due to the inability to compete with Amazon and Walmart. This graveyard of firms includes Toys “R” Us, Forever 21, Payless ShoeSource, Fred's, Barneys New York, Gymboree, Claire's Stores, RadioShack, HH Greg, and many others. The closing of many retail stores in the aftermath of the COVID-19 pandemic may accelerate the retail apocalypse.
In more recent years, Clayton Christensen, also a former Harvard economist, adapted Schumpeter's theory to the rapidly evolving world of technology. Christensen used the term “disruptive technology” or “disruptive innovation” to describe better, faster, or cheaper products or services that make it likely a firm will overtake the current market leader. For example, Tesla's pioneering development of the electric car has given it a larger market cap than Ford and GM combined, companies that have been around for more than 100 years!
You might be thinking, “Why does the government allow companies to be negatively affected, if not destroyed?” The government generally allows such behavior to occur since the consumer usually benefits by lower prices and a wider selection of goods. Most economies around the world are based on the economic system of capitalism. Capitalism is an ideology, or set of beliefs, based on the private ownership of resources and the pursuit of profit. It is analogous to Charles Darwin's “survival of the fittest” theory that describes the process which occurs in many areas of nature. In recent years, there has been momentum to add environmental, social, and governance (ESG) factors to the goal of the firm and not to single-mindedly focus on profits.
Thus, the ability to think carefully about the changing factors facing firms and industries is an important topic. Not surprisingly, Buffett has weighed in on the subject. In his 1987 Letter to Berkshire Shareholders, he wrote:
Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities.
What kind of firms offer a better chance for exceptional returns? In one interview, he said, “I look for businesses in which I think I can predict what they're going to look like in 10 or 15 or 20 years. That means buying businesses that will look more or less as they do today, except that they'll be larger and doing more business internationally… . So I focus on absence of change… . That doesn't mean I don't think there's a lot of money to be made from that change, I just don't think I'm the one to make a lot of money out of it.” Let's also put the first sentence in this quote as a Tip.
Much of what you might read about on investing focuses on which securities to buy. Very little has been written on when to sell. Not surprisingly, Buffett has made some comments on the topic. Some investors say to sell after you've made a profit. Buffett disagrees, saying, “Of Wall Street maxims the most foolish may be ‘You can't go broke taking a profit.'” Buffett says don't sell simply because an investment has gone up in value, especially if it's a strong firm.
In his 1987 Letter to Berkshire Shareholders, Buffett expounded on when to sell in more detail, writing, “We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.” Let's summarize these thoughts with a Tip.
The fundamentals of the business changed for Kodak when digital photography became popular. The fundamentals changed for Sears and Kmart when they first had to deal with the threat of Walmart, and now they also have to deal with the threat from Amazon.com and other online competitors. Kodak, Sears, and Kmart lost their “moats” in Buffett speak. Sometimes Buffett will sell if he needs the money for another investment that he thinks has more upside. For example, in 2017 he sold his stock in IBM and used some of the proceeds to add to his position in Apple. So far, that swap has paid off big time for Berkshire!
We covered a lot of ground in this chapter, but it's crucial to building wealth because it lays out many of the core principles that Buffett considers in his investment approach. If it seems overwhelming, don't worry, we'll end with a couple of tips that summarize Buffett's overall investment approach. In his 1978 Letter to Berkshire Shareholders, Buffett wrote, “We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.”
He said something similar, and more succinctly, in his 1994 Letter to Berkshire Shareholders, writing, “We believe that our formula—the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people—is certain to produce reasonable success.”
Charlie Munger, we noted earlier, convinced him of the value of buying great businesses rather than just fair ones. In his 1997 Letter to Berkshire Shareholders, Buffett wrote, “More than 50 years ago, Charlie told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.”
Let's end this chapter by summarizing this section with two important Tips.