Warren Buffett's Secret Investing Checklist | The Warren Buffett Way Summary
The Warren Buffett Way is one of my favorite investing books of all time. It clearly lays out the framework Warren Buffett uses to pick winning stocks. The good news is that you can apply these lessons to your own investing strategy today. This book truly changed the way I think about investing. In fact, the knowledge I gained from reading this book helped me land a job as an investment analyst at a large investment fund. To that point, I owe Warren Buffett and the author of this book, Robert Hagstrom, a huge thank you.
At 320 pages, this book is not a quick read. However, I read this book for you and will spend the rest of this video explaining the key points that you need to know to help improve your own investing skills and knowledge. All I ask for in exchange is for you to like this video; that's it! I just want to help you become a better investor and build wealth for you and your family. Now, let's get into the video.
To understand Warren Buffett, you first have to understand the two men who heavily influenced his investing style. Those men are Ben Graham and Phil Fisher. Let's talk about each of these men and the lessons Warren Buffett learned from each. From Graham, Buffett learned the margin of safety approach: that is, use strict quantitative guidelines to buy shares in companies that are selling for less than their networking capital. Graham also emphasized that following the short-term fluctuations of the stock market is pointless and that stock positions should be long-term.
Author of Common Stocks and Uncommon Profits, Fisher was a stockbroker who set up a business just after the 1929 crash. Fisher focused on companies with an ability to grow sales and profits over the years at rates greater than the industry average. From Fisher, Buffett added an appreciation for the effect that management can have on the value of any business and that diversification increases rather than reduces risk, as it becomes impossible to closely watch all the eggs in too many different baskets.
Warren Buffett decides if he has made a good investment by looking at the performance of the underlying business, not the stock price. By understanding the performance of the business, I mean that Buffett looks to see how profitable the business is, whether it is growing market share, the strength of the company's brand, how the company's management is allocating capital, etc. Buffett's whole approach is to look at a share purchase from the perspective of a business owner rather than as a stock market dabbler.
Even though you will only be able to buy shares in a company representing a very small ownership stake in the business, you should evaluate the business as if you were going to buy 100% of the business and keep the current management of the company running the business. The first question any business person will ask is, "What is the cash-generating potential of this company?" Over time, there will always be a direct correlation between the value of the company and its cash-generating capacity.
The investor would benefit by using the same business purchase criteria as the business person. Change your thinking from buying and selling shares in a company to buying and selling a business you want to own, and you'll have a much-improved perspective. This brings another key lesson in this book that was extremely helpful in making me a better investor. If you have a business-owner mindset and not a stock investor mindset, you should welcome a drop in the stock market, assuming the fundamentals of the business remain the same.
Let me explain by using an example. Let's say you were looking to buy the corner coffee shop. This coffee shop did $100,000 in profits last year and has been growing at around five percent year in and year out. Thinking like a business owner, would you rather pay one million dollars or five hundred thousand dollars for that coffee shop? Of course, you would pick the five hundred thousand dollars. By choosing the lower price, you are spending less to get the same amount of profit from the business. Since stocks are just little pieces of businesses, this same concept should apply in investing.
If there is a stock you like at one hundred dollars a share and it falls to fifty dollars a share, assuming the fundamental earning power of the business remains intact, you should view this as a positive thing. You get to buy into a great business for less money. To sum this point up, remember this: an investor looks at the performance of the business to determine if it was a good investment. A speculator looks at the short-term movement in a stock price to decide if a certain stock was a good purchase. Be an investor, not a speculator.
Now that we have that background, I want to spend the rest of the video talking about what is referred to as the Warren Buffett Way. This is the framework that Buffett uses to evaluate businesses, and the great thing about this is it's not all that complicated. You can apply this same framework to your investing strategy today. These investing principles, which the author refers to as tenets, can be separated into four categories: business tenants, management tenants, financial tenants, and market tenants.
Business tenant one is the business simple and understandable from the perspective of the investor. Do you understand how the company generates sales, incurs expenses, and produces profits? That means you need to understand revenues, expenses, cash flow, labor relations, pricing flexibility, and capital requirements. To understand all these things, you must have a deep understanding of the business. It means that investors should only buy shares in companies within their own circle of financial and intellectual understanding. An investor needs to be realistic about what they do not know. As Buffett says, "When it comes to investing in business, above-average results are most often achieved by doing ordinary things extraordinarily well."
Business tenant two: Does the business have consistent operating history? In general, the best level of profits over the long term are achieved by companies that have been producing the same product or service for a number of years. One-off windfalls generated by unusual events are just too hard to reasonably predict. An investor should never ignore a current business reality because of some vision of future success. Look to buy a business which has shown it can reasonably weather different economic cycles and competitive forces. The best time to buy any business is when profitability has been interrupted for some external short-term reason. This can create a rare one-time opportunity to purchase a sound business at an unusually low price.
Business tenant three: Does the business have favorable long-term prospects? The economic world is divided into a large group of commodity companies and a small group of companies that own the franchise for their product or service. Commodity companies compete solely on price with no differentiation between suppliers. The commodities group now includes computers, automobiles, and airlines. By contrast, companies which own the franchise have a product or service which is needed, has no close substitutes, and for which an unregulated market exists. Ideally, a business purchaser will want to buy a franchise-type company. These companies have an appreciable margin of safety where prices can be raised to offset management mistakes.
The only problem is a strong franchise holder soon attracts competitors and substitute products, which in turn leads to the creation of a commodity market around that product or service. Whenever that happens, the value of management becomes even more critical to the economic performance of the company. If it is not possible to purchase a franchise company, the next best option is to buy the lowest cost supplier in a commodity market. Over the long term, the lowest cost supplier always comes to dominate a commodity market.
Management tenant one is management rational. Does the management act and think like an owner of the company unfailingly? In particular, what does the management team do with the cash the business produces? Are they buying back shares, paying dividends, or growing the business? Rational managers will invest any excess cash generated by the company in projects that produce earnings at rates higher than the cost of capital. Over the long term, allocation of capital determines the value of the company. All companies move through an economic life cycle.
In the development stage, the company loses money while establishing markets and improving its products. During the next stage of rapid growth, the company requires cash to grow and retains earnings and borrows or issues more equity. In the third stage, maturity, the company generates more cash than it needs as sales expand. In the last stage, excess cash tapers off as sales decline. The key question is what managers do with the excess cash in the maturity and decline stages. Irrational management will invest this cash in projects that earn a higher rate of return than the cost of capital on the open market; otherwise, the fund should be returned to shareholders as dividends or by buying back the company's own shares. By contrast, irrational managers are often overcome by their own prowess and continue to reinvest in projects with diminishing returns.
Management tenant two: Is management candid with the shareholders? The ideal business manager reports financial performance openly and genuinely, with an ability to admit mistakes and report the progress of all aspects of the company. The management team should also be able to reaffirm that the company's prime objective is to maximize the return on shareholders' investment. This concept should color every action taken. The tendency to include every piece of information that owners would deem valuable when judging the company's economic performance is a characteristic of a strong management team.
Management tenant three: Does management resist the institutional imperative? The institutional imperative is the tendency of corporate managers to mimic the actions of other companies, even when those actions are destructive or irrational. Most managers are so influenced by what other companies are doing that they are unwilling to do anything which results in short-term pain in exchange for long-term profit. A measure of any company's management skill is how effectively they think for themselves rather than settle for mindless imitation of what everyone else is doing. In essence, successful companies have managers who refuse to follow the herd into mediocrity.
Financial tenant one: Focus on return on equity, not earnings per share. Companies are continually adding to their capital base by retained earnings; therefore, you expect earnings per share to increase year by year. A better measure of a company's performance is its return on equity, the ratio of operating earnings to shareholder equity. This measures the management's ability to generate a return on the operations of the business, given the capital employed. When calculating return on equity, value marketable securities at cost, not market value, as market value is beyond management's control. Exclude all non-recurring extraordinary items which are unrelated to the business. A good management team will consistently achieve good returns on equity while employing little or no debt, or at least employing a manageable debt level for the nature of the business.
Financial tenant two: Calculate owner earnings. The ultimate value of any company is its ability to generate a surplus of cash. However, a company with a high fixed asset-to-profit ratio will require a larger share of retained earnings to stay profitable than a company with a low fixed asset-to-profit ratio. Owner earnings is calculated by adding depreciation, depletion, and amortization charges to net income and subtracting the capital expenditure required to maintain economic position and unit volume. Owner earnings reflects the true cash flow position of a company. Some enterprises, like a real estate development company, for example, require heavy expenditures at the start and very little later on. Others, like manufacturing, require regular expenditures on plant upgrades. Owner earnings is an attempt to provide a cross-industry analysis measure.
Financial tenant three: Search for companies with high profit margins. Buffett warns that managers of high-cost companies tend to find ways to continually add to the expenses needed to run the business, whereas the managers of low-cost operations take pride in lowering their expenses. Any money spent on unnecessary costs is effectively stolen from you as a shareholder. The cutting of unnecessary expenses is a consistent theme of effective managers.
Financial tenant four: For every dollar of retained earnings, has the company created at least one dollar's worth of extra market value? Over the longer term, stock market value will accurately reflect the economic value of the company. The same is true for increased market value created by retained earnings. A well-managed company will add at least one dollar of market value for every dollar of retained earnings. To estimate this factor, subtract all dividends from a company's net income over the last 10 years. This is the total retained earnings. Add that figure to the company's market value at the beginning of the 10-year period to get total A. If the company has used retained earnings effectively, the market value at the end of the 10-year period will exceed total A. If it doesn't, this is a bad sign.
Market tenant one: What is the value of the business? Buffett calculates the value of a business as the net cash flow expected to occur over the life of the business, discounted at an appropriate interest rate. Net cash flows are the company's owner earnings over a long period. Something like the 30-year U.S. Treasury bond rate can be used as a measure of the interest rate for this calculation. By calculating the business value this way, vastly different business enterprises can realistically be compared. If the business is growing rapidly but has unpredictable future revenues, then the company is not classified as simple and understandable, and this formula cannot be applied. The discounted cash flow approach described is very conservative, as long as an appropriate discount rate is applied.
In our view, what makes sense in business also makes sense in stocks. An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all the business.
Market tenant two: Can the business currently be purchased at a significant discount to its intrinsic value? Armed with an accurate calculation of the value of the business, you should now look at the asking price. The rule for market success is to purchase only when the current market price is at a significant discount to value. The intention of any investor is to earn above-average returns. The difference between business value and price is the investor's margin of safety. Most investors have their own margin of safety. Buffett generally aims for a 25% discount as his margin of safety. Additionally, a well-chosen stock will have sound fundamentals, which over the longer term will lead to an above-average growth in the company's share price. This, in effect, becomes an additional reward for the intelligent investor who purchases at a discount.
If you like this video, make sure to check out the video we did on Seth Klarman's book Margin of Safety here. Also, make sure to like this video and subscribe to the Investor Center because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you next time.