Chapter five of A Fistful Of Valuations In The Style Of Warren Buffett & Charlie Munger by Bud Labitan
A Fistful Of Valuations - Chapter 7: The Four Filters
I believe that Warren Buffett and Charlie Munger invented an investing formula that is underappreciated by the business and academic communities. The Four Filters process functions as an effective time-tested focusing formula for investing success. They serve as a very useful guide for assessing intrinsic value and sensible price.
Behavioral Finance and Common Sense have shown us that we all have human tendencies to frame ideas that are affected by our emotions. Ideally, we would use the best of our emotional and intellectual energies in the right way.
Charlie Munger has spoken about the merits of having a “pilot’s checklist.” Warren Buffett mentioned the Filters in the 2007 annual report this way: “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.” These Four Filters can enhance the probability of our investment success. They will help you in your search for intrinsic value and sensible investment.
Warren Buffett learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Along the way, he and Charlie Munger got better at picking stocks and whole companies for investment.
Note that growth is only one component in assessing value. Through the conscientious process of Elaboration and Elimination, the Filters illuminate the most important factors for business and investing success. The Filters highlight and reveal the good prospects and eliminate the bad prospects for investment. They encompass four clusters that are vitally important to investing success: 1. Products 2. Customers 3. Management 4. Margin of Safety.
If Buffett and Munger had focused solely on the fourth filter, “Margin of Safety” from bargain prices, they would have still done well. However, used as a sequential set of filters, the Four Filters are remarkably effective in preventing loss. It is an elegant algorithm that combines the use of important qualitative and quantitative decision steps. And, practicing these steps will make you a better investment thinker.
From a practical point of view, business is about taking good care of your customer and arriving at an agreeable trade. Finding the company that has enduring competitive advantage means that you are finding a business that has been tested by time and its customers. Products, Customers, Good Management, and Financial Safety given by a bargain purchase are always important. However, Charlie Munger has said that “people calculate too much and think too little.” Here, the filters guide our thinking on a sequential path to understanding. Within that Fourth Filter, Bargain Price, we see Ben Graham’s three most important words in investing, “Margin of Safety.” Investing safety is practically insured by purchasing at a bargain price.
This process can help us impose a greater prudence upon our investment decision making. Writing about speculation, Ben Graham believed that the value of analysis diminishes as the element of chance increases. However, if we decrease the element of chance, imagine what this does for our predictive probabilities.
By studying business situations more rationally, we can improve our decision making skills. Using the Filters, we can decrease the element of chance and increase our probability of focusing and finding a higher quality bargain.