Figure 3.1 Anatomy of a Long-Term Stock Price
There is no fundamental difference, according to Warren Buffett, between buying a business outright and buying a piece of that business, in the form of shares of stock. Of the two, he has always preferred to directly own a company, for it permits him to influence the business’s most critical issue: capital allocation. Buying its common stock instead has one big disadvantage: You can’t control the business. But this is offset, Buffett explains, by two distinct advantages: First, the arena for selecting noncontrolled businesses—the stock market—is significantly larger. Second, the stock market provides more opportunities for finding bargains. In either case, Buffett invariably follows the same strategy. He looks for companies he understands, with favorable long-term prospects, that are operated by honest and competent people, and, importantly, are available at attractive prices.
“When investing,” he says, “we view ourselves as business analysts, not as market analysts, not as macroeconomic analysts, and not even as security analysts.”1 This means that Buffett works first and foremost from the perspective of a businessperson. He looks at the business holistically, examining all quantitative and qualitative aspects of its management, its financial position, and its purchase price.
If we go back through time and review all of Buffett’s purchases, looking for commonalities, it is possible to discern a set of basic principles, or tenets, that guide his decisions. If we extract these tenets and spread them out for a closer look, we see that they naturally group themselves into four categories:
Not all of Buffett’s acquisitions will display all the 12 tenets, but taken as a group, these tenets constitute the core of his equity investment approach.
These 12 tenets also serve as the principles by which Buffett runs Berkshire Hathaway. The same qualities he looks for in the businesses he buys, he expects to see when he walks through the front door of his office each day.
For Buffett, stocks are an abstraction.2 He doesn’t think in terms of market theories, macroeconomic concepts, or sector trends. He makes investment decisions based only on how a business operates. He believes that if people are drawn to an investment because of superficial notions rather than business fundamentals, they are more likely to be scared away at the first sign of trouble and, in all likelihood, will lose money in the process. Instead, Buffett concentrates on learning all he can about the business under consideration. He focuses on three main areas:
In Buffett’s view, investors’ financial success is correlated to how well they understand their investment. This is a distinguishing trait that separates investors with a business orientation from most hit-and-run types—people who are constantly buying and selling.
Over the years, Buffett has owned a vast array of businesses in many different industries. Some of these companies he controlled; in others, he was or is a minority shareholder. But he is acutely aware of how all these businesses operate. He understands the revenues, expenses, cash flows, labor relations, pricing flexibility, and capital allocation needs of every single one of Berkshire’s holdings.
Buffett is able to maintain this high level of knowledge about Berkshire’s businesses because he purposely limits his selection to companies that are within his area of financial and intellectual understanding. His logic is compelling. If you own a company (either outright or as a shareholder) in an industry you do not fully understand, you cannot possibly interpret developments accurately or make wise decisions.
Investment success is not a matter of how much you know but how realistically you define what you don’t know. “Invest in your circle of competence,” Buffett counsels. “It’s not how big the circle is that counts; it’s how well you define the parameters.”3
Buffett not only avoids the complex, but he also avoids purchasing companies that are either solving difficult business problems or fundamentally changing direction because their previous plans were unsuccessful. It has been his experience that the best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors.
“Severe change and exceptional returns usually don’t mix,” Buffett observes.4 Most people, unfortunately, invest as if the opposite were true. Investors tend to be attracted to fast-changing industries or companies that are in the midst of a corporate reorganization. For some unexplained reason, says Buffett, investors are so infatuated with what tomorrow may bring that they ignore today’s business reality.
Buffett cares very little for stocks that are hot at any given moment. He is far more interested in buying into companies that he believes will be successful and profitable for the long term. And while predicting the future success is certainly not foolproof, a steady track record is a relatively reliable track record. When a company has demonstrated consistent results with the same type of products year after year, it is not unreasonable to assume that those results will continue.
Buffett also tends to avoid businesses that are solving difficult problems. Experience has taught him that turnarounds seldom turn. It can be more profitable to look for good businesses at reasonable prices than difficult businesses at cheaper prices. “Charlie and I have not learned how to solve difficult business problems,” Buffett admits. “What we have learned to do is to avoid them. To the extent that we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”5
Buffett divides the economic world into two unequal parts: a small group of great businesses, which he terms franchises, and a much larger group of bad businesses, of which most are not worth purchasing. He defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. This pricing flexibility is one of the defining characteristics of a great business; it allows the company to earn above-average returns on capital.
“We like stocks that generate high returns on invested capital,” says Buffett, “where there is a strong likelihood that [they] will continue to do so.”6 He added, “I look at the long-term competitive advantage, and [whether] that’s something that is enduring.”7
Individually and collectively, these great businesses create what Buffett calls a moat—something that gives the company a clear advantage over others and protects it against incursion from competition. The bigger the moat, and the more sustainable, the better he likes it. “The key to investing,” he explains, “is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. The most important thing for me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”8
Last, Buffett tells us, in one of his many succinct bits of wisdom, “the definition of a great company is one that will be great for 25 to 30 years.”9
Conversely, a bad business offers a product that is virtually indistinguishable from the products of its competitors—a commodity. Years ago, basic commodities included oil, gas, chemicals, copper, lumber, wheat, and orange juice. Today, computers, automobiles, airline service, banking, and insurance have become commodity-type products. Despite mammoth advertising budgets, they are unable to achieve meaningful product differentiation.
Commodity businesses, generally, are low-returning businesses and “prime candidates for profit trouble.”10 Their product is basically no different from anyone else’s, so they can compete only on the basis of price—which, of course, cuts into profit margins. The most dependable way to make a commodity business profitable is to become the low-cost provider. The only other time commodity businesses turn a healthy profit is during periods of tight supply—a factor that can be extremely difficult to predict. A key to determining the long-term profit of a commodity business, Buffett notes, is the ratio of “supply-tight to supply-ample years.” However, this ratio is often fractional. “What I like,” he confides, “is economic strength in an area where I understand it and where I think it will last.”11
When considering a new investment or a business acquisition, Buffett looks very hard at the quality of management. He tells us that the companies or stocks Berkshire purchases must be operated by honest and competent managers whom he can admire and trust. “We do not wish to join with managers who lack admirable qualities,” he says, “no matter how attractive the prospects of their business. We’ve never succeeded in making good deals with a bad person.”12
When he finds managers he admires, Buffett is generous with his praise. Year after year, readers of the Chairman’s Letter in Berkshire’s annual reports find Buffett’s warm words about those who manage the various Berkshire companies.
He is just as thorough when it comes to the management of companies whose stock he has under consideration. In particular, he looks for three traits:
The highest compliment Buffett can pay a manager is that he or she unfailingly behaves and thinks like an owner of the company. Managers who behave like owners tend not to lose sight of the company’s prime objective—increasing shareholder value—and they tend to make rational decisions that further that goal. Buffett also greatly admires managers who take seriously their responsibility to report candidly and fully to shareholders and who have the courage to resist what he has termed the institutional imperative—blindly following industry peers.
The most important management act is the allocation of the company’s capital. It is the most important because allocation of capital, over time, determines shareholder value. Deciding what to do with the company’s earnings—reinvest in the business or return money to shareholders—is, in Buffett’s mind, an exercise in logic and rationality. “Rationality is the quality that Buffett thinks distinguishes the style with which he runs Berkshire—and the quality he often finds lacking in other corporations,” wrote Carol Loomis of Fortune magazine.13
The question of where to allocate earnings is linked to where that company is in its life cycle. As a company moves through its economic life cycle, its growth rates, sales, earnings, and cash flows change dramatically. In the development stage, a company loses money as it develops products and establishes markets. During the next stage, rapid growth, the company is profitable but growing so fast that it cannot support the growth; often it must not only retain all of its earnings but also borrow money or issue equity to finance growth. In the third stage, maturity, the growth rate slows and the company begins to generate more cash than it needs for development and operating costs. In the last stage, decline, the company suffers declining sales and earnings but continues to generate excess cash. It is in phases three and four, but particularly phase three, that the question arises: How should those earnings be allocated?
If the extra cash, reinvested internally, can produce an above-average return on equity, a return that is higher than the cost of capital, then the company should retain all of its earnings and reinvest them. That is the only logical course. Retaining earnings in order to reinvest in the company at less than the average cost of capital is completely irrational. It is also quite common.
A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below-average rates, (2) it can buy growth, or (3) it can return the money to shareholders. It is at this crossroads that Buffett keenly focuses on management’s decisions, for it is here that management will behave rationally or irrationally.
Generally, managers who continue to reinvest despite below-average returns do so in the belief that the situation is temporary. They are convinced that with managerial prowess, they can improve their company’s profitability. Shareholders become mesmerized with management’s forecast of improvements. If a company continually ignores this problem, cash will become an increasingly idle resource and the stock price will decline.
A company with poor economic returns, excess cash, and a low stock price will attract corporate raiders, which is the beginning of the end of current management tenure. To protect themselves, executives frequently choose the second option instead: purchasing growth by acquiring another company.
Announcing acquisition plans has the effect of exciting shareholders and dissuading corporate raiders. However, Buffett is skeptical of companies that need to buy growth. For one thing, growth often comes at an overvalued price. For another, a company that must integrate and manage a new business is apt to make mistakes that could be costly to shareholders.
In Buffett’s mind, the only reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, two methods are available: (1) initiating or raising a dividend and (2) buying back shares.
With cash in hand from their dividends, shareholders have the opportunity to look elsewhere for higher returns. On the surface, this seems like a good deal, and therefore many people view increased dividends as a sign of companies that are doing well. Buffett believes this is true only if investors can get more for their cash than the company could generate if it retained the earnings and reinvested in the company.
If the real value of dividends is sometimes misunderstood, the second mechanism for returning earnings to the shareholders—stock repurchases—is even more so. That’s because the benefit to the owners is, in many respects, less direct, less tangible, and less immediate.
When management repurchases stock, Buffett feels that the reward is twofold. If the stock is selling below its intrinsic value, then purchasing shares makes good business sense. If a company’s stock price is $50 and its intrinsic value is $100, then each time management buys its stock, it is acquiring $2 of intrinsic value for every $1 spent. Transactions of this nature can be very profitable for the remaining shareholders.
Furthermore, Buffett says, when executives actively buy the company’s stock in the market, they are demonstrating that they have the best interests of their owners at heart, rather than a careless need to expand the corporate structure. That kind of stance sends signals to the market, attracting other investors looking for a well-managed company that increases shareholder wealth. Frequently, shareholders are rewarded twice—once from the initial open market purchase and then subsequently as investor interest has a positive effect on price.
Buffett holds in high regard managers who report their company’s financial performance fully and genuinely, who admit mistakes as well as share successes, and are in all ways candid with shareholders. In particular, he respects managers who are able to communicate the performance of their company without hiding behind generally accepted accounting principles (GAAP).
“What needs to be reported,” argues Buffett, “is data—whether GAAP, non-GAAP, or extra-GAAP—that helps the financially literate readers answer three key questions: (1) Approximately how much is the company worth? (2) What is the likelihood that it can meet its future obligations? (3) How good a job are its managers doing, given the hand they have been dealt?”14
Buffett also admires managers who have the courage to discuss failure openly. Over time, every company makes mistakes, both large and inconsequential. Too many managers, he believes, report with excess optimism rather than honest explanation, serving perhaps their own interests in the short term but no one’s interests in the long run.
Most annual reports, he says bluntly, are a sham. That’s why in his own annual reports to Berkshire Hathaway shareholders, Buffett is very open about Berkshire’s economic and management performance, both good and bad. Throughout the years, he has admitted the difficulties that Berkshire encountered in both the textile and insurance businesses, and his own management failures in regard to these businesses. In the 1989 Berkshire Hathaway annual report, he started a practice of listing his mistakes formally, called “Mistakes of the First Twenty-Five Years (A Condensed Version).” Two years later, the title was changed to “Mistake Du Jour.” Here, Buffett confessed not only mistakes made but opportunities lost because he failed to act appropriately.
Critics have noted that it’s a bit disingenuous for Buffett to publicly admit his mistakes; because of his large personal ownership of Berkshire’s common stock, he never has to worry about being fired. This is true. But by modeling candor, Buffett is quietly creating a new approach to management reporting. It is Buffett’s belief that candor benefits the manager at least as much as the shareholder. “The CEO who misleads others in public,” he says, “may eventually mislead himself in private.”15 Buffett credits Charlie Munger with helping him understand the value of studying one’s mistakes, rather than concentrating only on successes.
If management stands to gain wisdom and credibility by facing mistakes, why do so many annual reports trumpet only success? If allocation of capital is so simple and logical, why is capital so poorly allocated? The answer, Buffett has learned, is an unseen force he calls “the institutional imperative”—the lemming-like tendency of corporate managers to imitate the behavior of others, no matter how silly or irrational it may be.
It was the most surprising discovery of his business career. At school he was taught that experienced managers were honest and intelligent, and automatically made rational business decisions. Once out in the business world, he learned instead that “rationality frequently wilts when the institutional imperative comes into play.”16
Buffett believes that the institutional imperative is responsible for several serious, but distressingly common, conditions: “(1) [The organization] resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”17
Buffett learned this lesson early. Jack Ringwalt, head of National Indemnity, which Berkshire acquired in 1967, made what seemed a stubborn move. While most insurance companies were writing policies on terms guaranteed to produce inadequate returns—or worse, a loss—Ringwalt stepped away from the market and refused to write new policies. Buffett recognized the wisdom of Ringwalt’s decision and followed suit. Today, all of Berkshire’s insurance companies still operate on this principle: Just because everyone else is doing something, that doesn’t make it right.
What is behind the institutional imperative that drives so many businesses? Human nature. Most managers are unwilling to look foolish with, for example, an embarrassing quarterly loss when others in their industry are still producing quarterly gains, even though they assuredly are heading, like lemmings, into the sea.
It is never easy to make unconventional decisions or to shift direction. Still, a manager with strong communication skills should be able to persuade owners to accept a short-term loss in earnings and a change in the company’s direction if that strategy will yield superior results over time. Inability to resist the institutional imperative, Buffett has learned, often has less to do with the owners of the company than with the willingness of its managers to accept fundamental change. And even when managers accept the need for radical change, carrying out this plan is often too difficult for most managers to accomplish. Instead, many succumb to the temptation to buy a new company rather than face the financial facts of the current problem.
Why would they do this? Buffett isolates three factors as being most influential in management’s behavior.
Another common problem, we have learned, is poor allocation skills. CEOs often rise to their position by excelling in other areas of the company, including administrative, engineering, marketing, or production. With little experience in allocating capital, they turn instead to staff members, consultants, or investment bankers, and inevitably the institutional imperative enters the decision-making process. If the CEO craves a potential acquisition that requires a 15 percent return on investment to justify purchase, it’s amazing, Buffett points out, how smoothly the troops report back that the business can actually achieve 15.1 percent.
The final justification for the institutional imperative is mindless imitation. The CEO of Company D says to himself, “If Companies A, B, and C are all doing the same thing, it must be all right for us to behave the same way.”
They are positioned to fail—not, Buffett believes, because of venality or stupidity, but because the institutional dynamics of the imperative make it difficult to resist doomed behavior. Speaking before a group of Notre Dame students, Buffett displayed a list of 37 investment banking firms. Every single one, he explained, had failed, even though the odds for success were in their favor. He ticked off the positives: The volume of the New York Stock Exchange had multiplied 15-fold, and the firms were headed by hardworking people with very high IQs, all of whom had an intense desire to succeed. Yet all failed. Buffett paused. “You think about that,” he said sternly, his eyes scanning the room. “How could they get a result like that? I’ll tell you how—mindless imitation of their peers.”18
Buffett would be the first to admit that evaluating managers along these dimensions—rationality, candor, and independent thinking—is more difficult than measuring financial performance, for the simple reason that human beings are more complex than numbers.
Indeed, many analysts believe that because measuring human activity is vague and imprecise, we simply cannot value management with any degree of confidence, and therefore the exercise is futile. Without a decimal point, they seem to suggest, there is nothing to measure. Others hold the view that the value of management is fully reflected in the company’s performance statistics—including sales, profit margins, and return on equity—and no other measuring stick is necessary.
Both of these opinions have some validity, but neither is, in my view, strong enough to outweigh the original premise. The reason for taking the time to evaluate management is that it yields early warning signs of eventual financial performance. If you look closely at the words and actions of the management team, you will find clues that will help you measure the value of the team’s work long before it shows up in the company’s financial reports or in the stock pages of a daily newspaper. Doing so will take some digging, and that may be enough to discourage the weak of heart or lazy. That is their loss and your gain.
For gathering the necessary information, Buffett offers a few tips. Review annual reports from a few years back, paying special attention to what management said then about the strategies for the future. Then compare those plans to today’s results; how fully were the plans realized? Also compare the strategies of a few years ago to this year’s strategies and ideas; how has the thinking changed? Buffett also suggests it can be very valuable to compare annual reports of the company in which you are interested with reports of similar companies in the same industry. It is not always easy to find exact duplicates, but even relative performance comparisons can yield insights.
It’s worth pointing out that quality of management by itself is not sufficient to attract Buffett’s interest. No matter how impressive management is, he will not invest in people alone, because he knows there is a point where even the brightest and most capable managers cannot rescue a difficult business. Buffett has been fortunate to work with some of the brightest managers in corporate America, including Tom Murphy and Dan Burke at Capital Cities/ABC, Roberto Goizueta and Donald Keough at Coca-Cola, and Carl Reichardt at Wells Fargo. However, he’s quick to point out, “If you put these same guys to work in a buggy whip company, it wouldn’t have made much difference.”19 He adds, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that stays intact.”20
The financial tenets by which Buffett values both managerial excellence and economic performance are all grounded in some typically Buffett-like principles. For one thing, he does not take yearly results too seriously. Instead, he focuses on five-year averages. Profitable returns, he wryly notes, don’t always coincide with the time it takes the planet to circle the sun. He also has little patience with accounting sleight-of-hand that produces impressive year-end numbers but little real value. Instead, he is guided by these four principles:
Customarily, analysts measure annual company performance by looking at earnings per share (EPS). Did EPS increase over the prior year? Did the company beat expectations? Are the earnings high enough to brag about?
Buffett considers earnings per share a smoke screen. Since most companies retain a portion of their previous year’s earnings as a way to increase their equity base, he sees no reason to get excited about record EPS. There is nothing spectacular about a company that increases EPS by 10 percent if, at the same time, it is growing its earning base by 10 percent. That’s no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.
To use this ratio, we need to make several adjustments. First, all marketable securities should be valued at cost and not at market value, because values in the stock market as a whole can greatly influence the returns on shareholders’ equity in a particular company. For example, if the stock market rose dramatically in one year, thereby increasing the net worth of a company, a truly outstanding operating performance would be diminished when compared to a larger denominator. Conversely, falling prices reduce shareholders’ equity, which means that mediocre operating results appear much better than they really are.
Second, we must also control the effects that unusual items may have on the numerator of this ratio. Buffett excludes all capital gains and losses, as well as any extraordinary items that may increase or decrease operating earnings. He is seeking to isolate the specific annual performance of a business. He wants to know how well management accomplishes its task of generating a return on operations of the business given the capital employed. That, he says, is the single best judge of management’s economic performance.
Furthermore, Buffett believes that a business should achieve good returns on equity while employing little or no debt. Buffett knows that companies can increase their return on equity by increasing their debt-to-equity ratio, but he is not impressed. “Good business or investment decisions,” he says, “will produce quite satisfactory results with no aid from leverage.”21 Furthermore, highly leveraged companies are vulnerable during economic slowdowns. Buffett would rather err on the side of financial quality than risk the welfare of Berkshire’s owners by increasing the risk that is associated with high debt levels.
Despite his conservative stance, Buffett does not have a phobia about debt. In fact, he prefers to borrow money in anticipation of using it farther down the road, rather than after a need is announced. It would be ideal, he notes, if the timing of business acquisitions profitably coincided with the availability of funds, but experience has shown that just the opposite occurs. Cheap money has a tendency to force asset prices higher. Tight money and higher interest rates raise liability costs and often force the prices of assets downward. Just when the best prices are available for purchasing businesses, the cost of money (higher interest rates) is likely to diminish the attractiveness of the opportunity. For this reason, Buffett says, companies should manage their assets and liabilities independently of each other.
This philosophy of borrowing now in the hope of finding a good business opportunity later will penalize near-term earnings. However, Buffett acts only when he is reasonably confident the return of the future business will more than offset the expense of the debt. And there’s another consideration: Because the availability of attractive business opportunities is limited, Buffett wants Berkshire to be prepared. “If you want to shoot rare, fast-moving elephants,” he advises, “you should always carry a gun.”22
Buffett does not give any suggestions as to what debt levels are appropriate or inappropriate for a business. This is wholly understandable: Different companies, depending on their cash flows, can manage different levels of debt. What Buffett does say is that a good business should be able to earn a good return on equity without the aid of leverage. Companies that depend on debt for good returns on equity should be viewed suspiciously.
“The first point to understand,” Buffett says, “is that not all earnings are created equal.”23 Companies with high assets compared to profits, he points out, tend to report ersatz earnings. Because inflation exacts a toll on asset-heavy businesses, the earnings of these companies take on a mirage-like quality. Hence, accounting earnings are useful to the analyst only if they approximate the company’s expected cash flow.
But even cash flow, Buffett warns, is not a perfect tool for measuring value; in fact, it often misleads investors. Cash flow is an appropriate way to measure businesses that have large investments in the beginning and smaller outlays later on, such as real estate development, gas fields, and cable companies. Manufacturing companies, on the other hand, which require ongoing capital expenditures, are not accurately valued using only cash flow.
A company’s cash flow is customarily defined as net income after taxes plus depreciation, depletion, amortization, and other noncash charges. The problem with this definition, explains Buffett, is that it leaves out a critical economic fact: capital expenditures. How much of this year’s earnings must the company use for new equipment, plant upgrades, and other improvements needed to maintain its economic position and unit volume? According to Buffett, an overwhelming majority of U.S. businesses require capital expenditures that are roughly equal to their depreciation rates. You can defer capital expenditures for a year or so, he says, but if over the long period you don’t make the necessary capital expenditures, your business will surely decline. These capital expenditures are as much an expense as are labor and utility costs.
Popularity of cash flow numbers heightened during the leveraged buyout period because the exorbitant prices paid for businesses were justified by a company’s cash flow. Buffett believes that cash flow numbers “are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable and thereby sell what should be unsalable. When earnings look inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes to focus on cash flow.”24 But you cannot focus on cash flow, Buffett warns, unless you are willing to subtract the necessary capital expenditures.
Instead of cash flow, Buffett prefers to use what he calls “owner earnings”—a company’s net income plus depreciation, depletion, and amortization, less the amount of capital expenditures and any additional working capital that might be needed. But he admits that owner earnings do not provide the precise calculation that many analysts demand. Calculating future capital expenditures often requires estimates. Still, he says, quoting Keynes, “I would rather be vaguely right than precisely wrong.”
Like Philip Fisher, Buffett is aware that great businesses make lousy investments if management cannot convert sales into profits. There’s no big secret to profitability: It all comes down to controlling costs. In his experience, managers of high-cost operations tend to find ways to continually add to overhead, whereas managers of low-cost operations are always finding ways to cut expenses.
Buffett has little patience with managers who allow costs to escalate. Frequently, these same managers have to initiate a restructuring program to bring costs in line with sales. Each time a company announces a cost-cutting program, he knows its management has not figured out what expenses can do to a company’s owners. “The really good manager,” Buffett says, “does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.”25
Buffett singles out the accomplishments of some of the best management teams he has worked with, including Carl Reichardt and Paul Hazen at Wells Fargo and Tom Murphy and Dan Burke at Cap Cities/ABC, for their relentless attacks on unnecessary expenses. These managers, he says, “abhor having a bigger head count than is needed,” and both managerial teams “attack costs as vigorously when profits are at record levels as when they are under pressure.”26
Buffett himself can be tough when it comes to costs and unnecessary expenses. He understands the right size staff for any business operation and believes that for every dollar of sales, there is an appropriate level of expenses. He is very sensitive about Berkshire’s profit margins.
Berkshire Hathaway is a unique corporation. It does not have a legal department, or a public relations or investor relations department. There are no strategic planning departments staffed with MBA-trained workers plotting mergers and acquisitions. Berkshire’s after-tax corporate expenses run less than 1 percent of operating earnings. Most companies of Berkshire’s size have corporate expenses 10 times higher.
Speaking broadly, the stock market answers the fundamental question: What is this particular company worth? Buffett proceeds in the belief that if he has selected a company with favorable long-term economic prospects, run by able and shareholder-oriented managers, the proof will be reflected in the increased market value of the company. The same, Buffett explains, holds for retained earnings. If a company employs retained earnings nonproductively over an extended period, eventually the market (justifiably) will price the shares of the company lower. Conversely, if a company has been able to achieve above-average returns on augmented capital, that success will be reflected in an increased stock price.
However, we also know that while the stock market will track business values reasonably well over long periods, in any one year prices can gyrate widely for reasons other than value. So Buffett has created a quick test to judge not only the economic attractiveness of a business but how well management has accomplished its goal of creating shareholder value: the one-dollar rule. The increase in value should, at the very least, match the amount of retained earnings dollar for dollar. If the value goes up more than the retained earnings, so much the better. All in all, Buffett explains, “Within this gigantic auction arena, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”27
All the principles embodied in the tenets described thus far lead to one decision point: buying or not buying shares in a company. Anyone at that point must weigh two factors: Is this company a good value, and is this a good time to buy it—that is, is the price favorable?
Price is established by the stock market. Value is determined by the analyst, after weighing all the known information about a company’s business, management, and financial traits. Price and value are not necessarily equal. If the stock market were always efficient, prices would instantaneously adjust to all available information. Of course we know this does not occur—at least not all the time. The prices of securities move above and below company values for numerous reasons, not all of them logical.
Theoretically, the actions of an investor are determined by the differences between price and value. If the price of a business is below its per-share value, a rational investor will purchase shares of the business. Conversely, if the price is higher than value, that investor will pass. As the company moves through its economic value life cycle, the analyst will periodically reassess the company’s value in relation to market price, and buy, sell, or hold shares accordingly.
In sum, then, rational investing has two components.
Through the years, financial analysts have used many formulas for calculating the intrinsic value of a company. Some are fond of various shorthand methods: low price-to-earnings ratios, low price-to-book values, and high dividend yields. But the best system, according to Warren Buffett, was determined more than 70 years ago by John Burr Williams in his book The Theory of Investment Value. Paraphrasing Williams, Buffett tells us that the value of a business is determined by the net cash flow expected to occur over the life of the business discounted at an appropriate interest rate. “So valued,” he says, “all businesses, from manufacturers of buggy whips to operators of cellular telephones, become economic equals.”28
The mathematical exercise, Buffett tells us, is very similar to valuing a bond. A bond has both a coupon and a maturity date that determines its future cash flows. If you add up all the bond’s coupons and divide the sum by the appropriate discount rate (the interest rate of the bond’s maturity), the price of the bond will be revealed. To determine the value of a business, the analyst estimates the coupons (owner earnings’ cash flow) that the business will generate for a period of time into the future, and then discounts all of these coupons back to the present.
For Buffett, determining a company’s value is easy as long as you plug in the right variables: the stream of cash flow and the proper discount rate. In his mind, the predictability of a company’s future cash flow should take on a “coupon-like” certainty like that found in bonds. If the business is simple and understandable, and if it has operated with consistent earnings power, Buffett is able to determine the future cash flows with a high degree of certainty. If he cannot, he will not attempt to value a company. This is the distinction of his approach.
After he has determined the future cash flows of a business, Buffett applies what he considers the appropriate discount rate. Many people will be surprised to learn that the discount rate he uses is simply the rate of the long-term U.S. government bond, nothing else. That is as close as anyone can come to a risk-free rate.
Academics argue that a more appropriate discount rate would be the risk-free rate (the long-term bond rate) plus an equity risk premium, added to reflect the uncertainty of the company’s future cash flows. But as we will learn later, Buffett dismisses the concept of an equity risk premium because it is an artifact of the capital asset pricing model that, in turn, uses price volatility as a measure of risk. In simple terms, the higher the price volatility, the higher the equity risk premium.
But Buffett thinks the whole idea that price volatility is a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty,” he says. “If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.”29 Of course, a company’s future cash flow cannot be predicted with the same certainty as a bond’s contractual coupon payment. Nevertheless, Buffett is more comfortable using the risk-free rate alone than adding several percentage points in risk premium just because a company’s stock price bounces up and down more than the bounciness of the overall market. Still, if you are uncomfortable with ignoring equity risk, you can compensate by demanding a bigger margin of safety in the purchase price.
Last, there are times when long-term interest rates are abnormally low. During these periods, we know that Buffett is more cautious and likely adds a couple of percentage points to the risk-free rate to reflect a more normalized interest rate environment.
Despite Buffett’s claims, critics argue that estimating future cash flow is tricky, and selecting the proper discount rate can leave room for substantial errors in valuation. Instead, these critics have employed various shorthand methods to identify value. Some—those we call “value investors”—use low price-to-earnings ratios, low price-to-book values, and high dividend yields. They have vigorously back-tested these ratios and concluded that success can be had by isolating and purchasing companies with exactly these accounting ratios. Others claim to have identified value by selecting companies with above-average growth in earnings; they are customarily called “growth investors.” Typically, growth companies possess high price-to-earnings ratios and low dividend yields—the exact opposite of what value investors look for.
Investors who seek to purchase value must often choose between the “value” and “growth” approaches. Buffett admits that years ago he participated in this intellectual tug-of-war. Today, he thinks the debate between these two schools of thought is nonsense. Growth and value investing are joined at the hip, he says. Value is the discounted present value of an investment’s future cash flow; growth is simply a calculation to determine value.
Growth in sales, earnings, and assets can either add to or detract from an investment’s value. Growth can add to the value when the return on invested capital is above average, thereby assuming that when a dollar is being invested in the company, at least one dollar of market value is being created. However, growth for a business earning low returns on capital can be detrimental to shareholders. For example, the airline business had been a story of incredible growth, but its inability to earn decent returns on capital has left most owners of these companies in a poor position.
All the shorthand methods—high or low price-to-earnings ratios, price-to-book ratios, and dividend yields, in any number of combinations—fall short. Buffett sums it up for us: Whether “an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investment . . . irrespective of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.”30
Focusing on good businesses—those that are understandable, with enduring economics, run by shareholder-oriented managers—by itself is not enough to guarantee success, Buffett notes. First, he has to buy at sensible prices and then the company has to perform to his business expectations. If we make mistakes, he points out, it is either because of (1) the price we paid, (2) the management we joined, or (3) the future economics of the business. Miscalculations in the third instance are, he notes, the most common.
It is Buffett’s intention not only to identify businesses that earn above-average returns, but to purchase them at prices far below their indicated value. Graham taught the importance of buying a stock only when the difference between its price and its value represented a margin of safety.
The margin-of-safety principle assists Buffett in two ways. First, it protects him from downside price risk. If he calculates the value of a business to be only slightly higher than its per-share price, he will not buy the stock; he reasons that if the company’s intrinsic value were to dip even slightly because he misappraised future cash flow, eventually the stock price would drop, too, perhaps below what he paid for it. But if the margin between purchase price and intrinsic value is large enough, the risk of declining intrinsic value is less. If Buffett purchases a company at a 25 percent discount to intrinsic value and the value subsequently declines by 10 percent, his original purchase price will still yield an adequate return.
The margin of safety also provides opportunities for extraordinary stock returns. If Buffett correctly identifies a company with above-average economic returns, the value of the stock over the long term will steadily march upward as the share price mimics the return of the business. If a company consistently earns 15 percent on equity, its share price will advance more each year than that of a company that earns 10 percent on equity. Additionally, if Buffett, by using the margin of safety, is able to buy this outstanding business at a significant discount to its intrinsic value, Berkshire will earn an extra bonus when the market corrects the price of the business. “The market, like the Lord, helps those who help themselves,” Buffett says. “But unlike the Lord, the market does not forgive those who know not what they do.”31
For readers who more readily process information visually, I created the graphic in Figure 3.1. It shows, in concentrated form, most of the key ingredients of Buffett’s approach.
Figure 3.1 Anatomy of a Long-Term Stock Price
A great business (center column), over time (the x-axis), will produce rising shareholder value (the y-axis) as long as it is bought at a good price (left-hand column), and managerial decisions (right-hand column) avoid extinction in the market, do better than simply matching market rate, and instead lead to increased value in the company.
To witness these tenets in action, refer to the case studies in Chapter 4.
The most distinguishing trait of Buffett’s investment philosophy is the clear understanding that, by owning shares of stock, he owns businesses, not pieces of paper. The idea of buying stock without understanding the company’s operating functions—including its products and services, inventories, working capital needs, capital reinvestment needs (e.g., plant and equipment), raw material expenses, and labor relations—is unconscionable, says Buffett. In the summation of The Intelligent Investor, Benjamin Graham wrote, “Investing is most intelligent when it is most businesslike.” These words are, Buffett often says, “the nine most important words ever written about investing.”
Investors have a choice: They can decide to conduct themselves like the owner of a business, with all that implies, or spend their time trading securities just for the sake of being in the game—or indeed for any reason other than business fundamentals.
Owners of common stocks who perceive they merely own a piece of paper are far removed from the company’s financial statements. They behave as if the market’s ever-changing price is a more accurate reflection of their stock’s value than the business’s balance sheet and income statement. They draw or discard stocks like playing cards. Buffett considers this the height of foolishness. In his view, there’s no difference between owning the company and owning a share of it, and the same mentality should apply to both. “I am a better investor because I am a businessman,” confesses Buffett, “and a better businessman because I am an investor.”32
Buffett is often asked what types of companies he will purchase in the future. First, he says, he will avoid commodity businesses and managers in whom he has little confidence. What he will purchase is the type of company that he understands, one that possesses good economics and is run by trustworthy managers. “A good business is not always a good purchase,” says Buffett, “although it is a good place to look for one.”33
Notes
1. Berkshire Hathaway Annual Report, 1987, 14.
2. Robert Lenzner, “Warren Buffett’s Idea of Heaven: ‘I Don’t Have to Work with People I Don’t Like,’” Forbes, October 18, 1993.
3. Fortune, November 29, 1993, p. 11.
4. Berkshire Hathaway Annual Report, 1987, 7.
5. Berkshire Hathaway Annual Report, 1989, 22.
6. Berkshire Hathaway 1995 annual meeting, as quoted in Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett, rev. ed. (Birmingham, AL: AKPE, 2004), 1356
7. St. Petersburg Times, (December 15, 1999), quoted in Kilpatrick, Of Permanent Value (2004), 1356.
8. Fortune, (November 22, 1999), quoted in Kilpatrick, Of Permanent Value (2004), 1356.
9. Berkshire Hathaway 1996 annual meeting, Kilpatrick (2004), 1344.
10. Berkshire Hathaway Annual Report, 1982, 57.
11. Lenzner, “Warren Buffett’s Idea of Heaven.”
12. Berkshire Hathaway Annual Report, 1989.
13. Carol Loomis, “The Inside Story of Warren Buffett,” Fortune, April 11, 1988.
14. Berkshire Hathaway Annual Report, 1988, 5.
15. Berkshire Hathaway Annual Report, 1986, 5.
16. Kilpatrick, Of Permanent Value (2000), 89.
17. Berkshire Hathaway Annual Report, 1989, 22.
18. Linda Grant, “The $4 Billion Regular Guy,” Los Angeles Times, April 17, 1991 (magazine section), 36.
19. Lenzner, “Warren Buffett’s Idea of Heaven.”
20. Berkshire Hathaway Annual Report, 1985, 9.
21. Berkshire Hathaway Annual Report, 1987, 20.
22. Ibid., 21.
23. Berkshire Hathaway Annual Report, 1984, 15.
24. Berkshire Hathaway Annual Report, 1986, 25.
25. Carol Loomis, Tap Dancing to Work: Warren Buffett on Practically Everything, 1966–2012 (New York: Time Inc., 2012).
26. Berkshire Hathaway Annual Report, 1990, 16.
27. Berkshire Hathaway Letters to Shareholders, 1977–1983, 52.
28. Berkshire Hathaway Annual Report, 1989, 5.
29. Jim Rasmussen, “Buffett Talks Strategy with Students,” Omaha World Herald, January 2, 1994, 26.
30. Berkshire Hathaway Annual Report, 1992, 14.
31. Berkshire Hathaway Letters to Shareholders, 1977–1983, 53.
32. Lowenstein, Buffett: The Making of an American Capitalist (New York: Random House, 1995), 323.
33. Berkshire Hathaway Letters to Shareholders, 1977–1983, 82.