THE FOUR WARREN BUFFETT STOCK INVESTING PRINCIPLES

A lot of people assume that Warren Buffett’s investment strategy is a big secret – but it’s really not a secret at all.

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In fact, Buffett’s investment criteria has been included in the beginning pages of every singleBerkshire Hathaway Annual Report since 1982:

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BERKSHIRE HATHAWAY INC. ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

  1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
  2. Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
  3. Businesses earning good returns on equity while employing little or no debt,
  4. Management in place (we can’t supply it),
  5. Simple businesses (if there’s lots of technology, we won’t understand it),
  6. An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.

[drizzle]

Of course… Buffett is talking about private acquisitions of entire companies here. So unless you have $5-20 billion sitting around, the above criteria probably isn’t very useful to you.

But don’t worry.

As you’ll see down below, Warren Buffett and Charlie Munger say that they’re “also happy to simply buy small portions of great businesses by way of stock-market purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.”

[As an aside, don’t be upset if you think you’re missing out on big returns because you can’t buy entire companies like Berkshire Hathaway. Buffett: “Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership.”]

In the 1977 Berkshire Hathaway Shareholder Letter, Buffett gives us one of our first glimpses into what he looks at when he evaluates a stock:

WARREN BUFFETT STOCK INVESTMENT CRITERIA
We select our marketable equity 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 understand,
  2. With favorable long-term prospects,
  3. Operated by honest and competent people, and
  4. Available at a very attractive price.

We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.

Apart from the first and last criteria of “large purchases” and “an offering price”, this is really just the same list as Berkshire’s Acquisition Criteria for purchases of private companies that I presented first.

WARREN BUFFETT’S 4 PRINCIPLES

Indeed, these “4 Principles” as I call them are pure Buffett, and succinctly summarize some of his core beliefs that are inherent in many of his most popular quotes:

A business we understand: Invest within your circle of competence

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

With favorable long-term prospects: Our favorite holding period is forever

Time is the friend of the wonderful company, the enemy of the mediocre.

Operated by able and trustworthy management: Reputation is your most important asset

It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.

Available at a very attractive price: Intrinsic value and a margin of safety

Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

Principles #1, #3, and #4 are very simple to understand: Stick with what you know, find good & honest managers (but not ones that are solely responsible to the success of the business), pay less than the value you’re receiving.

But what about Principle #2? What does Buffett mean by “favorable long-term prospects” and how can we determine if a company meets this criterion?

The answer to this question comes down to whether or not the company has an enduring “moat”that will protect its “castle.” In other words, does the company have some sort of long-term competitive advantage that will allow it to continue to earn high returns on its capital?

Buffett revisits these 4 Principles in the 2007 Berkshire Hathaway Shareholder’s Letter. You can see that even after 40 years his principles are virtually the same (with the sole difference being in Principle #4: a “very attractive price” becomes a “sensible price”).

In the following excerpt from that 2007 Shareholder’s Letter, Buffett expands on how his 4 Principles can combine to create a truly wonderful business:

WHAT KIND OF BUSINESSES TURN WARREN BUFFETT ON?

Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

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. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

HOW CAN YOU APPLY BUFFETT’S 4 PRINCIPLES TO YOUR OWN INVESTING?

  1. Stay within your circle of competence: What industries and companies do you understand? For example, Apple, Kellogg, and John Deere have easy business models to understand and operate in relatively straightforward industries. Think you want to invest in that hot tech start-up that facilitates the creation of backward overflow synergies? Unless you have specialized industry expertise and know what that means, or you take the time to carefully study the company and industry first, you better stay away.
  2. Look for companies with favorable long-term prospects: What is your company’s long-term competitive advantage? Does your company have a very wide and very sustainable “moat” that will protect its “castle” for years to come? Or will the company constantly have to re-dig its moat every year?
  3. Evaluate top management for honesty and competence: Has the company or any of its executives been involved in fraud at any point in time? Is there “key man” (or key woman) risk? What would happen if the CEO or founder of the company left?
  4. Is the stock of the company at least reasonably priced: What is the price of the company on the stock market and what do you think the intrinsic value of the company actually is? Is there a margin of safety, i.e. is the stock trading at a discount?

[/drizzle]

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