The Warren Buffett Way

by Robert G. Hagstrom

Warren Buffett’s education is, as we shall see, a synthesis of three distinct investment philosophies from the minds of three powerful figures: Benjamin Graham, Philip Fisher, and Charlie Munger.

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

describing analysis as a three-step process: (1) descriptive, (2) critical, and (3) selective. The first phase involves gathering all the facts and presenting them in an intelligent manner. The second involves examining the merits of the standards used to communicate information: Have the facts been represented fairly? The final phase requires the analyst to pass judgment on the attractiveness of the security in question.

Graham insists that for a security to be considered an investment, two conditions must be present: some degree of safety of principal and a satisfactory rate of return.

Someone who conducts a thorough financial analysis based on sound logic and makes a choice for a reasonable rate of return without compromising safety of principal would be, by Graham’s definition, an investor, not a speculator.

Graham proposed a way of selecting stocks that relied on what he called the “margin of safety.”

investors who are optimistic about a company’s future growth have two techniques for adding the stock to their portfolios: (1) purchase shares when the overall market is trading at low prices (generally, this occurs during a bear market or a similar type of correction), or (2) purchase the stock when it trades below its intrinsic value even though the overall market is not substantially cheap. In either technique, said Graham, a margin of safety is present in the purchase price.

Graham suggested that an investor’s energies would be better applied to the second technique: identifying undervalued securities regardless of the overall market price level.

He reasoned that a margin of safety existed for a common stock if its price was below its intrinsic value. And the obvious next question is: How does one determine intrinsic value?

intrinsic value is “that value which is determined by the facts.” These facts include a company’s assets, its earnings and dividends, and any future definite prospects.

Of those, Graham believed the single most important factor is future earnings power. That led him to a simple formula: A company’s intrinsic value can be determined by estimating the future earnings of the company and multiplying those earnings by an appropriate capitalization factor. This capitalization factor, or multiplier, is influenced by the company’s stability of earnings, assets, dividend policy, and financial health. He added a strong caution: The success of this approach is limited by our ability to calculate a company’s economic future, a calculation that is unavoidably imprecise. Future factors such as sales volume, pricing, and expenses are difficult to forecast, which makes applying a multiplier that more complex.

In spite of that, Graham believed that the margin of safety could work successfully in three areas: (1) in stable securities such as bonds and preferred stocks; (2) in comparative analysis; and (3) in selecting stocks, provided the spread between price and intrinsic value is large enough.

Graham proposed that it was not essential to determine a company’s exact intrinsic value; even an approximate value, compared against the selling price, would be sufficient to gauge the margin of safety.

Financial analysis is not an exact science, Graham reminded us. To be sure, certain quantitative factors lend themselves to thorough analysis: balance sheets, income statements, assets and liabilities, earnings, and dividends. We must not, however, overlook certain qualitative factors that are not easily analyzed but are nonetheless essential ingredients in determining a company’s intrinsic value. Two of these are management capability and the nature of the business.

Graham solidified this “don’t lose” philosophy into two specific, tangible guidelines that cemented his margin of safety: (1) buy a company for less than two-thirds of its net asset value, and (2) focus on stocks with low price-to-earnings ratios.

The company have some net asset value

Furthermore, he deducted all of the company’s short- and long-term liabilities. What remained were the current assets. If the stock price was below this per-share value, Graham considered this to be a foolproof method of investing.

Very rare

Philip Fisher

Fisher came to believe that superior profits could be made by (1) investing in companies with above-average potential and (2) aligning oneself with the most capable management.

he believed that two types of companies would, decade by decade, show promise of above-average growth: (1) those that were “fortunate and able” and (2) those that were “fortunate because they are able.”

market potential alone is insufficient. Fisher believed that a company, even one capable of producing above-average sales growth, was an inappropriate investment if it was unable to generate a profit for shareholders.

Fisher sought companies that not only were the lowest-cost producers of products or services but were dedicated to remaining so. A company with a low break-even point, or a correspondingly high profit margin, is better able to withstand depressed economic environments. Ultimately, it can drive out weaker competitors, thereby strengthening its own market position.

A company with high profit margins, explained Fisher, is better able to generate funds internally, and these funds can be used to sustain its growth without diluting shareholders’ ownership. In addition, a company that is able to maintain adequate cost controls over its fixed assets and working capital needs is better able to manage its cash needs and avoid equity financing.

Many companies, Fisher noted, have adequate growth prospects because their lines of products and services will sustain them for several years, but few companies have policies in place to ensure consistent gains for 10 to 20 years. “Management,” he said, “must have a viable policy for attaining these ends with all the willingness to subordinate immediate profits for the greater long-range gains that this concept requires.”

Fisher considered another trait critical: Does the business have a management of unquestionable integrity and honesty? Do the managers behave as if they are trustees for the stockholders, or does it appear they are only concerned with their own well-being?

All businesses, good and bad, will experience a period of unexpected difficulties. Commonly, when business is good, management talks freely, but when business declines, some managers clam up rather than talking openly about the company’s difficulties. How management responds to business difficulties, Fisher noted, tells a lot about the people in charge of the company’s future.

The essential step in prudent investing, he explained, is to uncover as much about the company as possible, from people who are familiar with the company.

The key lesson that Buffett took from Graham was: Successful investing involves purchasing stocks when their market price is at a significant discount to their underlying business value.

If you reach a logical conclusion based on sound judgment, Graham counseled Buffett, do not be dissuaded just because others disagree. “You are neither right or wrong because the crowd disagrees with you,” Graham wrote. “You are right because your data and reasoning are right.”25

From Fisher, Buffett learned the value of scuttlebutt. Throughout the years, Buffett developed an extensive network of contacts who have been helpful in assisting him in evaluating different businesses.

Finally, Fisher taught Buffett not to overstress diversification. He believed that it was a mistake to teach investors that putting their eggs in several different baskets reduces risk. The danger in purchasing too many stocks, he felt, is that it becomes impossible to watch all the eggs in all the baskets.

buying shares in a company without taking time to develop a thorough understanding of the business is far riskier than having a limited diversification.

his investment approach is a combination of a qualitative understanding of the business and its management (as taught by Fisher) and a quantitative understanding of price and value (as taught by Graham).

Buffett’s dedication to Ben Graham, Phil Fisher, and Charlie Munger is understandable. Graham gave Buffett the intellectual basis for investing—the margin of safety—and helped him learn to master his emotions in order to take advantage of market fluctuations. Fisher gave Buffett an updated, workable methodology that enabled him to identify good long-term investments and manage a focused portfolio over time. Charlie helped Buffett appreciate the economic returns that come from buying and owning great businesses.

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.

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.

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.

we see that they naturally group themselves into four categories: 1. Business tenets—three basic characteristics of the business itself. 2. Management tenets—three important qualities that senior managers must display. 3. Financial tenets—four critical financial decisions that the company must maintain. 4. Market tenets—two interrelated cost guidelines. 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.

Tenets of the Warren Buffett Way Business Tenets Is the business simple and understandable? Does the business have a consistent operating history? Does the business have favorable long-term prospects? Management Tenets Is management rational? Is management candid with its shareholders? Does management resist the institutional imperative? Financial Tenets Focus on return on equity, not earnings per share. Calculate “owner earnings.” Look for companies with high profit margins. For every dollar retained, make sure the company has created at least one dollar of market value. Market Tenets What is the value of the business? Can the business be purchased at a significant discount to its value?

Simple and Understandable

He understands the revenues, expenses, cash flows, labor relations, pricing flexibility, and capital allocation needs of every single one of Berkshire’s holdings.

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

Consistent Operating History

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.

“Severe change and exceptional returns usually don’t mix,” Buffett observes.4 Most people, unfortunately, invest as if the opposite were true.

while predicting the future success is certainly not foolproof, a steady track record is a relatively reliable track record.

Buffett also tends to avoid businesses that are solving difficult problems. Experience has taught him that turnarounds seldom turn.

Favorable Long-Term Prospects

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.