How Warren Buffett Thinks About Risk Management

Via Base Hit Investing

“Rule #1: Don’t Lose Money….”

The best book I’ve ever read on Warren Buffett is Alice Schroeder’s Snowball. I remember picking up my copy about four years ago and literally not being able to put it down. I read it for hours at a time, all the while marking pages and circling things… and I often reference certain parts of the book when thinking about investments. The book goes much deeper into Buffett’s thought process than most of the other Buffett books.

How Warren Buffett Thinks About Risk Management

Schroeder went through pages of Warren Buffett’s scratch notes on many early investments, some of which were heretofore unknown to the public (one in particular is mentioned below). She does a great job at really capturing what Buffett was thinking behind many of his investments, which makes the book a true gem for reverse engineering Buffett’s ideas.

Below is a video of Schroeder that I recently watched. The video below is a clip of her talk at the University of Virginia, which is a great lecture to listen to. But if you have 9 minutes, I strongly recommend watching the clip below.

The First Step in Warren Buffett’s Investment Process

One of the most fascinating things about Warren Buffett is his ability to quickly and efficiently filter through many investment ideas. In the video, Schroeder discusses a key question that Buffett asks immdediately before doing any work on a prospective investment. The question is basically: What are the odds that this investment could fail because of catastrophe risk? In other words, what are the major things that could go wrong?

Schroeder goes on to explain that this question was the first step in Warren Buffett’s investment process. He was not interested in putting capital at risk if there was any chance of cat risk. He didn’t care about the potential upside if he perceived there to be a major reason that the business could fail. This is much different than how most investors think. Some investors are willing to take positions in stocks that have significant risk, but even greater upside. Buffett was not. He simply wanted to invest in high probability and low risk situations. This simplified his process.

He missed out on many investments because he wasn’t willing to take the risk. Some members of his family got rich investing in Control Data in the 1960?s, even as Buffett urged them not to. He didn’t care about missing opportunity in situations that had catastrophe risk. He wanted high returns, and significant upside–just not at the expense of major risk.

Mid-Continent Tab Card Company

This brings us to an example that Schroeder discusses in this video clip. The Mid-Continent Tab Card Company is a fascinating case study on Warren Buffett’s investment process.

I’ll let Schroeder share the specifics of the investment, but the summary is that Buffett passed on an early stage start-up business that his friends were working on because he thought the business could (not necessarily would) fail due to stiff competition from IBM. So he passed on the idea. However, his friends got the business off the ground, and a year later were hugely profitable, and successfully competing with IBM. They approached Buffett again needing to raise more money. This time he said he would consider it. The cat risk was off the table, and he began doing research on the business.

The case study is also interesting because Schroeder discusses Buffett’s process for evaluating the business, which is also significantly different from how most investors research ideas. He didn’t use DCF’s, he didn’t do detailed projections… he used basic analysis with simple common sense logic. And he only did his analysis after first identifying that cat risk was off the table.

The result of the investment is less important than studying his process, but nevertheless, it was fantastic. Warren Buffett ended up making millions from an initial $60,000 investment, compounding his capital in this investment at 33% per year for almost 2 decades.

Think of Stocks as Businesses

By the way–one more interesting point from the video. Warren Buffett was only 29 when his friends brought him this deal. He had yet to prove himself as a successful investor. His friends knew he was a businessman, and a good investor, but had no idea of how good he really was. I thought this illustrated an interesting point that Buffett was a business owner first and foremost. He truly thought of stocks as businesses, and that’s likely one of the most significant factors in his phenomenal successes as a capital allocator.

Here are some other useful pieces on the Mid-Continent Tab Card Company and Warren Buffett’s filtering process:

Here is the video clip of Schroeder at the Darden School. It’s a great clip to watch:

Via Base Hit Investing