What Warren Buffett Understands

What Warren Buffett Understands

Warren Buffett frequently repeats that he only invests in businesses that he “understands.”  That is why he avoids technology companies.  What I have always found frustrating about Mr. Buffett’s statement is that he never clearly explains what it is he does not understand.  Surely he knows that the value of any company is determined by its expected future cash flows.  Technology companies are no different that way.

I think the last post on my blog contains the key.  What Mr. Buffett does not understand are growth options.  In this, he has a lot of company.  Growth options are by their nature vague and uncertain.  They depend on unknown future innovations.  This is in sharp distinction to the value generated by asset in place that is determined largely by the current earnings and the “moat,” to use Mr. Buffett’s term, that protects those earnings from competition.  These are things Mr. Buffett can see and “understand.”  However, for companies like Facebook, Amazon and Tesla such assets in place account for only a fraction of their value.  The rest comes from the markets expectations regarding the value of future innovations – the company’s growth options.

Viewed in this light, it is not surprising that the two technology companies that Berkshire owns are Apple and IBM.  The value of both companies is based almost exclusive (in the case of Apple more than exclusively) on assets in place.

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Bradford Cornell is an emeritus Professor of Financial Economics at the Anderson School of Management at UCLA. Prof. Cornell has taught courses on Applied Corporate Finance, Investment Banking, and Corporate Valuation. He is currently developing a new course on Climate Change, Energy and Finance. Professor Cornell has published more than 125 articles and four books on a wide variety of topics in applied finance. Professor Cornell is also a managing director at BRG where he heads the practice on Climate Change, Energy and Finance. In addition, he is a senior advisor to the Cornell Capital Group and to Rayliant Global Advisors. In both capacities, he provides advice on fundamental investment valuation.

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