“The difference between a good business and a bad business is that good business throw up one easy decision after another. The bad businesses throw up painful decisions time after time.”
We all want to know how to improve our investment decision making. How do we develop a better understanding of a company, its future, and present, its products? Over the years I have read all the Letters to Shareholders of Berkshire Hathaway. I have read most of the books and articles on Warren Buffett, and his mentor Benjamin Graham, and his partner Charlie Munger. I have also listened to hours of audio from interviews via Youtube. All in the effort to gain insights into how Warren Buffett developed their “framework” for investment decisions. And how they arrive at a winning investment decision.
During my research, I came across an interview that Charlie Munger gave to the BBC which discusses his thoughts on how a framework for making better decisions when making investment decisions. You can find the video here. The comments that we will be discussing occur at 5:59 of the video.
The framework is called the Four Filters, and it first appeared in the 1977 Letters to Shareholders in this form.
“We select our marketable securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can easily understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at an attractive price.”
Warren and Charlie have repeated this outline over the years, and they have utilized it to help frame all of their investment decisions.
Warren and Charlie invented an investment formula that is underappreciated by the business community. This formula is a guideline that is followed by arguably the most successful investors of our generation. It deserves to be studied more thoroughly than it has thus far.
The formula is an innovation that uses both quantitative and qualitative properties to help ensure that we find the best investments and avoid making painful mistakes. If you follow the framework, it will help you raise the odds of your investment success.
Here are Charlie’s comments from the BBC interview.
“We have to deal with things that we are capable of understanding, and then, once we are over that filter we need to have a business with some characteristics that give us a durable competitive advantage and then, of course, we would vastly prefer management in place with a lot of integrity and talent and finally, no matter how wonderful it is, it’s not worth an infinite price. We have to have a price that makes sense and gives us a margin of safety considering the normal vicissitudes of life.”
You can find the transcript here.
Filter number one: Develop an understanding of the business.
Warren Buffett said it perfectly. “Seek whatever information will further your understanding of the business.”
Charlie is a huge proponent of developing checklists to help him make better decisions, for each company, he develops a checklist to keep him on track. The reason for a different checklist is that every company is different and have different guidelines to follow.
Charlie developed a system of “latticework of mental models” to help him sort through his thoughts and ideas. He used these models to help him think better.
Munger has come to the conclusion that to make better decisions in business and life you need to find and understand the core principles from all disciplines.
In short, learn all the big ideas and how the interrelate and better, more rational thinking will naturally follow.
That is what he calls Elementary Worldly Wisdom, and using his Mental Models can help you succeed in almost any endeavor. This topic could be a blog post on its own but for our purposes today, let’s consider that Munger uses these models to help him understand a business more fully so that he can make a decision about whether or not to invest in it.
So how does this help us understand a company?
Step one is to read, read, read all that you can about the company. Shareholder letters, letters from the CEO, 10k filings, 10Q filings. Go to the website and read about all of their products. Look at any references to competitors and read about them. Just about every industry has a newsletter or magazine that follows that particular industry, read those publications for knowledge about the different trends, products, and services that other companies offer.
We do this to get a better understanding of how the company operates, what they produce and who they sell it too. Think about anything you buy for your personal use. Do you buy a cell phone you don’t understand how to use? No way. Think about how these types of decisions affect our buying habits.
These are the types of information we need to digest as we learn more about a particular company. I will give you an example; recently I was looking at a company that produces railroad cars. A pretty simple straightforward business but I noticed something in a 10k that I was reading that mentioned that they were solely dependent on steel as their main resource they used in all of their products. That got me to thinking about the price of steel and how it could affect their business, so I researched more about that particular field because I knew nothing about steel. I came to learn that steel is an extremely volatile commodity that has huge price swings, which would obviously affect this company I was researching. And sure enough, as I learned more about steel pricing and tracked the downturns in steel I noticed that coincided with a downturn in the price of the company.
The first step when looking into a company is to look at their website to get a feel for the company and what they do. Look at their product list and see if they are things you understand.
The second step is to read the 10k filings. These are incredibly important documents and very insightful looks into the minds of the people who run the businesses. It is also a great place to learn more about the company and give you a rundown of what they do. If after reading the first part of the 10k outlining the business and you don’t understand it, move on.
If you do understand the business, then continue looking at the financial filings.
When you read the company’s 10k reports you need to go back at least five years; the same goes for the 10q reports as well. Read them from the oldest to the more recent. It gives you a feel for the flow of the business, how the management handles their decisions and following through with their stated agendas. You can also learn a lot from the tenor of the reports as well.
A note about reading these reports, they can be