A Unique Behind-The-Scenes Look Into Warren Buffett’s Investment Process by Vintage Value Investing
In 2009, the U.S. government established the Financial Crisis Inquiry Commission, a ten-member commission that was assigned the task of investigating the causes of the 2007-2008 financial crisis. The Commission had the power to subpoena documents and witnesses (businessmen and women, academicians, government officials, etc.) for testimony.
One person the Commission questioned was Warren Buffett.
The interview covered Warren Buffett’s investment in Moody’s, his thoughts on the causes of the financial crisis, his views on financial policies and regulations, and a whole host of other topics. Although the interview took place in 2010 and the Commission reported its findings in 2011, the transcript was not released until last week.
You can read all 103 pages of the interview right here (it’s really fascinating).
But in just the first few pages of the transcript, Warren Buffett gives a unique behind-the-scenes look into his investment process.
Here’s a little background to set up this situation:
Buffett invested in Dun & Bradstreet in 1999 and 2000. Founded in 1841, Dun & Bradstreet provides commercial data (e.g. business credit reports, sales & marketing lists, business research reports through its Hoover’s subsidiary) and was one of the first companies to be publicly traded on the New York Stock Exchange. In 2000, Dun & Bradstreet spun off Moody’s (one of the major credit rating agencies, which D&B bought in 1962) as a separately traded public company – which gave Buffett shares in both Dun & Bradstreet and Moody’s.
The major credit rating agencies (Moody’s, Standard & Poor’s, and Fitch) were very heavily criticized during the 2007-2008 financial crisis for giving perfect credit ratings (e.g. AAA) to bad subprime mortgage-backed CDOs – which ended up being a big contributing factor to the financial crisis.
So, the interviewer from the Financial Crisis Inquiry Commission begins his interview with Buffett by asking how he decided to invest in Moody’s and what his involvement with the company has been. I’ve lightly edited the transcript below to make it more readable. Enjoy!
Warren Buffett and How He Decided to Invest in Moody’s
BONDI: I understand, sir, that in 1999 and in February 2000, you invested in Dun and Bradstreet.
BUFFETT: That’s correct. I don’t have the dates, but that sounds right. Yes, sir.
BONDI: And am I correct, sir, in saying you made no purchases after Moody’s spun off from Dun and Bradstreet?
BUFFETT: I believe that’s correct.
BONDI: Okay. What kind of due diligence did you and your staff do when you first purchased Dun and Bradstreet in 1999 and then again in 2000?
BUFFETT: Yes. There is no staff. I make all the investment decisions, and I do all my own analysis. And basically it was an evaluation of both Dun and Bradstreet and Moody’s, but of the economics of their business. And I never met with anybody.
Dun and Bradstreet had a very good business, and Moody’s had an even better business. And basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.
BONDI: Now, you’ve described the importance of quality management in your investing decisions and I know your mentor, Benjamin Graham – I happen to have read his book as well – has described the importance of management.
What attracted you to the management of Moody’s when you made your initial investments?
BUFFETT: I knew nothing about the management of Moody’s. I’ve also said many times in reports and elsewhere that when a management with reputation for brilliance gets hooked up with a business with a reputation for bad economics, it’s the reputation of the business that remains intact. If you’ve got a good enough business, if you have a monopoly newspaper, if you have a network television station (I’m talking of the past) you know, your idiot nephew could run it. And if you’ve got a really good business, it doesn’t make any difference.
I mean, it makes some difference maybe in capital allocation or something of the sort, but the extraordinary business does not require good management.
I’m not making any reference to Moody’s management, I don’t really know them. But if you own the only newspaper in town, up until the last five years or so, you have pricing power and you didn’t have to go to the office.
BONDI: And I’ve seen in many places where you’ve been referred to as a passive investor in Moody’s. Is that a fair characterization, and what sort of interactions and communications have you had with the board and with management at Moody’s?
BUFFETT: At the very start, there was a fellow named Cliff Alexander who was the chairman of Dun and Bradstreet while they were breaking it up.
I met him in connection with something else, years earlier; and so we had a lunch at one time. But he wasn’t really an operating manager. He was there sort of to oversee the breakup of the situation.
Since we really own stock in both Dun and Bradstreet and Moody’s when they got split up, I’ve never been in Moody’s office, I don’t think I’ve ever initiated a call to them. I would say that three or four times as part of a general road show, their CEO and the investor relations person would stop by and – and they think they have to do that. I have no interest in it basically, and I never requested a meeting. It just – it was part of what they thought investor relations were all about. And we don’t believe much in that.
BONDI: What about any board members? Have you pressed for the election of any board member to Moody’s –
BUFFETT: No, no –
BONDI: – board?
BUFFETT: – I have no interest in it.
BONDI: And we’ve talked about just verbal communications. Have you sent any letters or submitted any memos or ideas for strategy decisions at Moody’s?
BONDI: In –
BUFFETT: If I thought they needed me, I wouldn’t have bought the stock.
BONDI: In 2006, Moody’s began to repurchase its shares, buying back its shares that were outstanding, and they did so from 2006 to 2008, according to our records.
Why didn’t you sell back your shares to Moody’s at that time? I know subsequent in 2009 you sold some shares, but from ‘06 to ‘09, during the buyback, did you consider selling your shares back, and if so, why didn’t you?
BUFFETT: No, I thought they had an extraordinary business, and – you know, they still have an extraordinary business. It’s now subject to a different threat, which we’ll get into later, I’m sure.
But I made a mistake in that it got to very lofty heights and we didn’t sell – it didn’t make any difference if we were selling to them or selling in the market. But there are very few businesses that had the competitive position that Moody’s and Standard and Poor’s had. They both have the same position, essentially. There are very few businesses like that in the world. It’s a natural duopoly to some extent. Now, that may get changed, but it has historically been a natural duopoly, where anybody coming in and offering to cut their price in half had no chance of success. And there’s not many businesses where someone can come in and offer to cut the price in half and somebody doesn’t think about shifting. But that’s the nature of the ratings business. And it’s a naturally obtained one.
It’s assisted by the fact that the two of them became a standard for regulators and all of that, so it’s been assisted by the governmental actions over time. But it’s a natural duopoly.
Warren Buffett and Investment Models
BUFFETT: The rating agencies, they have models, and we all have models in our mind, you know, when we’re investing. But they’ve got them all worked out, with a lot of checklists and all of that sort of thing.
I don’t believe in those, myself.
All I can say is, I’ve got a model in my mind. Everybody has a model in their mind when they’re making investments. But reliance on models, you know, work 98 percent of the time, but they never work 100 percent of the time. And everybody ought to realize that, that’s using them.
So what conclusions can we draw from this behind-the-scenes look?
Well, first I still think Buffett’s investment process is incredible. Every other investment firm in the world has research analysts, market strategists, complex financial models, fully staffed deal teams, and intense investment committees. Warren Buffett, on the other hand, does all of his own analysis and uses the model in his own head. Just amazing.
Second, Warren Buffett tells us that “the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” Moody’s has pricing power because it has a duopoly of the credit ratings market with Standard & Poor’s (and to a lesser extent Fitch). If you want a credit rating, you basically have to go to Moody’s or S&P, because they are the industry standard and often are the only credit ratings that are accepted by investors and others. In fact, Moody’s, S&P, and Fitch are the only nationally recognized statistical rating organizations (NRSRO) designated by the SEC. So someone new could come in and set up a ratings agency and charge 50% what Moody’s and S&P charge, but they just wouldn’t get any business.
As a kid, Buffett used to sit on the porch of his friend’s house and watch the cars and the street trolley pass on the street in front of the house during rush hour. One day he said to his friend’s mom, “All that traffic. What a shame you aren’t making money from the people going by. What a shame, Mrs. Russell.” Even little 9 year old Warren was thinking about businesses, and he wanted his friend’s mom to set up a toll booth. And that’s how he’s always thought about businesses and investing. Warren Buffett’s always sought out businesses with large economic moats – businesses that have a large, unique, and sustainable competitive advantage that ultimate results in pricing power and high returns on invested capital.
If you’d like to read the rest of the interview then click here or read on below. Thanks for your continued support of Vintage Value and be sure to share this article with a friend or on social media!