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Tuesday 5 May 2009

Investing Like Berkshire Hathaway

Running the Quality Check

So how do we explain The Buffet Munger Paradox? It’s perfectly clear that the gentlemen in question don’t have a problem, but how does Buffett’s demented focus tie in with Munger’s breathtaking scope?

The answer’s simple, of course. Munger’s mental models are the framework upon which Buffett’s ideas are arrayed. Munger’s the quality check on Buffett’s biggest adventures.

Great Businesses at Good Prices

Buffett often says: We prefer to buy great businesses at fair prices than good businesses at low prices. This wasn’t always the case – indeed most of the Buffett Partnership’s investments were often in very poor businesses trading at exceptionally cheap prices – classic Ben Graham type heavy discount to net asset plays. Buffett’s change of focus was coincident with the start of the second phase of his career, as he started to build the web of businesses that led to the Berkshire Hathaway consortium he presides over today.

It seems highly unlikely that Buffett’s investing style changed entirely of its own accord. Warren Buffett is, and always has been, very much his own man but the influence of Munger’s broad based approach can be seen across all of Berkshire’s long term investments both partially and wholly owned.

Earnings not Capital

What Berkshire do is simple to analyse, largely because both Buffett and Munger tell everyone. Yet almost no one can do what they do. They’re contrarians on a grand scale, but their focus is on long term investment because they don’t view companies as pools of capital, to be traded. Berkshire is not, in general, investing for short-term capital gain.

What Berkshire does, and the Buffett Partnership never did, is treat companies as long-term earnings streams. In this model the capital doesn’t matter, because Berkshire never intends to flip its investments. However, to make this model work the companies that Berkshire invests in need to have a bunch of very specific qualities – it’s not enough to buy an average company at a low price because that will never generate the long-term earnings needed to make their model work.

The Four Point Investor’s Checklist

Buffett told us this back in the 2007 Letter to Berkshire Hathaway shareholders:
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases.
Understand that statement and you’ve found the heart of the Buffett Munger paradox. These four qualities are all that Berkshire needs to make its long term earnings stream model work:

a) A business we understand. Don’t confuse this with the nuts and bolts of the businesses they own – this is about understanding the financials and business models. That’s where they add value – they’re managers of capital, not operating companies.

b) Favourable long-term economics. It’s all about the moat. It’s about finding businesses that have a sustainable business advantage that can’t be easily overcome by competitors.

c) Able and trustworthy management. Obvious, one hopes. Not so easy to do for private investors.

d) A sensible price tag. Sensible, not necessarily cheap but one that will provide good returns to shareholders if held over a long enough period.

Buying companies with these characteristics allows Berkshire to invest in companies whose earnings – profits – will reliably increase at an above inflation level over many, many years. Which means that it can ignore short-term issues and focus purely on making sure that the other piece are in place.

Analysing Buffett and Synthesising Munger

It’s easy to see that Buffett’s ruthless pursuit of a financial margin of error ties in beautifully with Munger’s broad based synthesis of ideas to cross-check investment proposals. It’s not just that the businesses need to be good, it’s that they need to offer sustainable long-term business advantages and checking that requires a wide range of mental models, because a single one isn’t going to do the job under all circumstances.

Consider the different types of business and circumstances that Berkshire’s invested in. Wells Fargo was originally bought during the Savings & Loan crisis in the 1990's. Buffett’s analysis was the margin of safety was sufficient to protect Wells against the worst of the downturn (it was, barely). However, it’s the broader analysis that identified the bank’s management and processes as offering long-term competitive advantages. Buffett bought more of Wells Fargo last year, of course. American Express was another crisis investment, Washington Post was bought at a huge discount to net assets and Coca Cola bought opportunistically at moments of peak investment fear.

In their partnership Warren Buffett is very much the senior partner, with effectively a controlling stake in Berkshire. Some of the company’s more risky investments look very much as though Buffett pulled the trigger – Salomon Brothers and GEICO, for instance. Typically the company escaped with a decent return because of Buffett’s relentless focus on margin of safety, but it’s sometimes been a close run thing.

Share Price is Not .. So .. Important

Let’s return to the 2007 shareholder letter:
I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their “moats” – a metaphor for the superiorities they possess that make life difficult for their competitors – have widened during the year.
Share price is not important, sustainable earnings are. In a market environment such as we have today that ought to be writ large through every investor’s heart. Buffet even tells us how to go about looking for the good companies:
To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
By “adding money” here Buffett means that the managers of your company have to keep re-investing your earnings at an increasing rate to stay still, rather having you shovelling new money at the business. Ironically “gruesome” was exactly the type of business that the original textiles based Berkshire Hathaway was. It’s interesting that they kept it going despite its poor return on capital until it could no longer maintain even a pretence of profitability: there’s more to Buffett and Munger than money, there’s humanity too.

Savers or Speculators?

So to be successful ultimately you only need to avoid the last kind of business as long as you don’t let share prices jerk you into buying and selling all the time. The last word, as ever, should go to Buffett himself (from the 1999 shareholder's letter):
If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?"Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall."This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Hallelujah to that.

The Four Filters Invention of Warren Buffett and Charlie Munger ( Large Print Edition )The Rediscovered Benjamin Graham: Selected Writings of the Wall Street LegendThe Snowball: Warren Buffett and the Business of Life

Related Posts: The Buffet-Munger Paradox, Is Intrinsic Value Real?

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