Warren Buffett’s Investment Strategy

Abstract

  • This post is a review of Warren Buffet’s investment strategy based on a handful of books I have read about the Oracle of Omaha. The post addresses 1) which stocks one should add to your portfolio; 2) how much should you allocate to each investment idea; and 3) how to perceive and assess risk.
  • The companies Warren Buffett selects 1) must possess a moat, 2) be predictable, 3) possess pricing power, 4) swim in cash, 5) have shareholder-friendly managers, 6) and it must be offered at an attractive price by Mr. Market.
  • Warren Buffett believes in a focused (rather than diversified) portfolio. In addition, the reader is provided with 6 points that can help guide the investor before a sell decision.
  • Warren is considering 5 factors when he assesses an investment idea’s risk profile.

It was originally my idolatry of Warren Buffett that led me to study the value investing philosophy. Thanks to Warren, I got acquainted with Benjamin Graham’s The Intelligent Investor and Security Analysis – the value investing foundation. I have since read and reviewed 50 books here on dhandho.dk, a lot of them mentions Warren. I thus found it appropriate to dedicate a post to Warren Buffet’s investment strategy; a reflection of what I learned from the Oracle. The post will address three key aspects of portfolio management: 1) which stocks/companies to buy ; 2) how much one should allocate to each idea; and 3) how to assess risk.

Warren Buffett’s Stock-Picking Philosophy
As I reported in my book review of Damn Right!Warren recognized the ‘disadvantage’ of the Graham-styled investing philosophy. Thanks to Charlie Munger, he was transformed from a cigar butt hunter, who was looking for statistically cheap stocks with a single ‘puff’ left in them, to a guy with a business-owner mentality who was on the look-out for “wonderful” franchises with expanding values (companies with such favorable prospects that there is no immediate end to their growth potential, hence ensuring their intrinsic value continues to expand over time). These types of businesses are classic “buy and hold”-picks, which according to Charlie Munger allows the investor to “sit on his ass [and] that’s a good thing.”

But which characteristics underlie “wonderful” businesses? Based on a handful of books on Warren Buffett’s investment philosophy (The Snowball, Warren Buffett Accounting Book, Buffettology, Warren Buffett Speaks and The Essays of Warren Buffett), I believe his stock-picking strategy can be boiled down to this:

  • The business must possess a moat: This aspect is a prerequisite for all the following characteristics. For Warren to find a business appealing, it must be protected by a moat either in terms of its intangible assets such as a strong brand, network efficiency, cost advantages, high replacement costs or high barriers of entry. There must be something that protects the business and ensures some stability.
  • The business must be predictable: As companies that possess a moat are well-protected and own a certain ‘kingdom’ (market share), these businesses are more stable than those that do not have a competitive advantage and thus constantly fight against other ‘unprotected’ businesses. Warren loves simple, stable and predictable companies, evident in a long history of growing revenues, earnings, and high returns on capital. He thus states in The Essays of Warren Buffett: “I would rather be certain of a good result than hopeful of a great one.” (p. 93)
  • The business must have pricing power: It’s alfa-omega for a business’ long-term success that it can increase its prices at a rate that at least matches inflation. It often requires strong brand loyalty, an indispensable product, a well-protected industry or the like. If a company offers a product/service that consumers continue to consume despite annual price increases, that business possesses pricing power – a capability Warren is crazy about: In Warren Buffett Speaks, the following quote is highlighted:“If you own See’s Candy, and you look in the mirror and say “mirror, mirror on the wall, how much do I charge for candy this fall”, and it says “more”, that’s a good business.” (p. 155)
  • The business must be swimming in cash: Warren is looking for companies that are “swimming in cash”. He does not necessarily mean that the balance sheet should be cash-rich. It is rather an expression for a business’ ability to generate a lot of cash from its operations/assets. He craves companies that are able to invest their earnings organically; if earnings can be re-invested back into the business and generate a return that exceeds the return otherwise available to investors (e.g. the return on an index fund), that business generates a market-beating return on incremental capital – and that causes Warren to tap-dance: “The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (The Essays of Warren Buffett, p. 87) In addition, Warren prefers companies with low CAPEX requirements and a conservative capital structure.
  • The business must have a great and shareholder-friendly management team: When Warren acquires a business for Berkshire Hathaway’s portfolio, he gives the management team three guidelines: they should 1) run the business as if they owned the entire enterprise; 2) imagine that it is the family’s only asset; 3) and that they can not sell or merge the business for the next 100 years. In other words, he wants a leadership team that thinks like owners. In continuation, any decision must be taken with the shareholders’ interests at heart. According to Warren, management’s top priority is capital allocation. Capital allocation is the ‘science’ on how to best add shareholder value from the company’s profits. Basically, there are only two options: 1) retain earnings in the company with the purpose of re-investing it back into the business, or 2) return capital to shareholders through dividend or share buybacks. Warren’s guiding principle to determine which of the paths to go down is simple: “Earnings retention is justified only when capital retained produces incremental earnings equal to, or above, those generally available to investors.” (The Essays of Warren Buffett, p. 15)
  • The business must be offered at an attractive price: Even the most amazing business can be a bad investment if you pay too high a price for it. Keep in mind that “the price you pay determines your rate of return.” Therefore, always be sure that you have a wide margin of safety between the purchase price and intrinsic value.

The above characteristics are weaved into Warren’s colorful definiton of a wonderful business: “Wonderful castles, surrounded by deep, dangerous moats where the leader inside is an honest and decent person. Preferably, the castle gets its strength from the genius inside; the moat is permanent and acts as a powerful deterrent to those considering an attack; and inside, the leader makes gold but doesn’t keep it all for himself. Roughly translated, we like great companies with dominant positions, whose franchise is hard to duplicate and has tremendous staying power or some permanence to it.” (The Essays of Warren Buffett, p. 146)

Warren Buffett’s Capital Allocation Strategy
One of the main reasons behind Warren’s financial success is his courage when it comes to capital allocation. In The Snowball, there’s a story of how Warren placed 35% and 40% of the partnership’s funds in Sanborn Maps and American Express, respectively. Forty percent! Warren was so convinced that he was right – and when you know you’re right, you should bet big: “I cannot understand why an investor elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices-the businesses he understands best and that present the least risk, along with the greatest profit potential. […] Too much of a good thing can be wonderful.” (The Essays of Warren Buffett, p. 80)

If you find an attractively priced business with favorable and stable long-term prospects, a competent, honest and shareholder-friendly management team that allocates capital intelligently, one should go all-in. He has always felt that a portfolio of high upside ideas, which he understands, is less risky than a highly diversified portfolio: “Diversification is something people do to protect themselves from their own stupidity. They lack the intelligence and expertise to make large investments in just a few businesses” (Buffettology, p. 173)

Speaking of capital allocation and portfolio construction, this realm includes the most difficult investment decision of them all: selling! According to the Warren Buffett Accounting Bookone should sell a stock if …

  • .. the favorable long-term prospects is fading, i.e. because a competing product/service weakens the market potential.
  • .. the moat seems to weaken.
  • .. the stock has become so expensive that the price significantly exceeds your estimate of its intrinsic value.
  • .. the stock accounts for too large a portion of your portfolio.
  • .. or you simply believe you can get a better return in another investment.

Selling is difficult, and it can often be disconcerting to see a stock appreciate after the sell decision. But one should find comfort in Warren’s comment: “Don’t try to buy at the bottom and sell at the top. This can’t be done – except by liars.”

Warren Buffett’s Perception of Risk
In one of Warren’s shareholder letters, he presents the five factors one should consider when assessing an investment’s risk profile:

  1. The certainty with which the long-term economic characteristics of the business can be evaluated.
  2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows.
  3. The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself.
  4. The purchase price of the business
  5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

These 5 factors also guide Warren in terms of position sizing. If a wonderful company with a competent and shareholder-friendly management is offered at a great price, it is not risky. It’s a bargain, and one you should bet big on.

I hope you enjoyed this review of the world’s most famous investor. Now, I will continue my Warren Wannabe roadshow.

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