Unpacking Buffett’s Investment Philosophy: A Personal Perspective

How does our investment approach stack up against Warren Buffett’s? 

This was a question I received from a reader. Answering this question gives me a chance to dissect Buffett’s famous investment principles and compare them to our own strategy. It is a fun little exercise which I really enjoyed, and I hope you do too.

The reader continued:

Buffett summarizes his investment philosophy as follows:

• Find wonderful businesses
• With highly capable management
• Which trade at fair valuation levels

How about you?

Let’s start with “wonderful businesses.” Going to Berkshire Hathaway annual meetings every year has probably had an impact on me. It is nirvana to own a truly wonderful business. It makes one’s life so much easier, and the return per unit of brain damage is so much higher. I wish we had a whole portfolio of them.

What is a wonderful business?

It is a high-quality business with a long runway of growth. Let me unwrap this a bit more. What is high quality? A company will have a significant competitive advantage, which will be accompanied by, or result in a high return on capital and pricing power, and the business will be so strong a monkey could run it. Now, you combine high return on capital and a long runway for growth, and this means the company can self-finance its growth and thus create a lot of value for shareholders. It also has a great balance sheet with a reasonable amount of debt and is run by great management (I’ll come back to this later).

So far, I have described a great business, which may or may not be a good investment (or a good stock). A wonderful business purchased at a high price may turn into a miserable investment (think of Nifty Fifty stocks in the late 70s or Wal-Mart-like, high-quality stocks in the late 1990s).

In reality, very few wonderful businesses fit into the category of good investments, and, as important, stay in that category.

Buffett says he’d like to own a business that can be run by a monkey, because at some point it will be. I always thought of Starbucks as a wonderful business. Just think about its brand and goodwill with consumers. But this business could not be run by a monkey, and so far has proven that it cannot even be run by a good executive unless his last name is Schultz and his first name is Howard. Howard Schultz, its founder, has had to come back twice to “save it.”

I would argue that today, very few businesses are high-quality enough that they can be run by mediocre management and not suffer the consequences. The world is more competitive now than ever before.

Coke, when Buffett bought it in the 80s, had a long runway of growth ahead of it. Today, it has not grown revenues in more than a decade. Runways end. A monkey could still probably run this company, but I am not sure anyone can grow this very mature business.

Apple is another example. It took the company a long time to get to this point. It built several super-long runways, first with the iPod and iPhone and then the iPad.

Unless it builds a brand new (iPhone market sized) runway, the company is destined for single-digit revenue growth. In fact, today, Apple is a great example of a great, most likely ex-wonderful business, trading at a valuation that has turned it into a mediocre (at best) stock. It will likely have a decade or two of no, or negative, returns. I wrote about it here. 

Let’s take a look at Berkshire Hathaway’s other holdings.

Reinsurance can be a good business, especially if Buffett is the one who invests the float, but it is not wonderful. Allow a monkey to do the underwriting at General RE, and it would not be long for this world.

Burlington Northern (a railroad) has a good moat but not a great return on capital. It has very-high-maintenance capital expenditures, far in excess of its depreciation. Thus, return on capital and accounting profits overstate its true profitability – how much free cash flows it generates.

Another example is Occidental Petroleum – a business Buffett has been buying lately. It extracts oil out of the ground, and its profitability is at the whim of the commodity, which it has little control over. Not a wonderful business.

I am highlighting these examples to make several important points.

First, there are very few truly wonderful businesses.

Second, they don’t always stay wonderful. Aside from running out of growth runways, which is virtually a guarantee, competition over time will shrink their moats.

Third, it is very difficult if not impossible to assemble a portfolio of truly wonderful businesses while not paying through the nose for them. In other words, finding wonderful businesses is easy, buying them at the right price is hard.

And finally, if we are lucky, we (including the Oracle himself) own some wonderful businesses, but most of our portfolio is good, above-average businesses.

What we try to do is find a good business with special characteristics.

For instance, we own an oil company that is a low-cost producer – which is important when selling a volatile commodity. It has almost no debt, a necessity for getting through tough times. Most of its oil is in oil sands with a low production decline rate (requiring less maintenance-capital expenditure).

It has incredible management that has both skin and soul in the game, and is also great at allocating capital, creating a lot of value in this highly volatile (cyclical) industry. And most importantly, we bought it very cheap; so even if oil prices decline and remain low, this investment is unlikely to lose money.

Is this a wonderful business? No, it is an oil company with special characteristics that make it a good investment.

There are two additional points I want to stress. Investing is nuanced – quality rarely arrives in primary colors but in a mixture of many more subtle shades. And second, we aim for great companies, accept (special) good ones, and, most importantly, try very hard to avoid bad ones.

The last but very important stop is management. 

As I matured as an investor, I became more uncompromising on management and transparency. I arrived at this conclusion through the pain and losses of past decisions.

There is an inherent conflict in the time horizons of management and the business. A tenure of a typical CEO is maybe five years or so – even though a business theoretically has an indefinite time horizon. Realistically, a business should be looking at least five to fifteen years out. Management that truly cares about the business is prioritizing the long-term success of the business, rather than their own tenure. As a result, decisions may appear suboptimal in the short run but will ultimately benefit the business.

Why?

When you make decisions that are going to bear fruit in five years or longer, they usually require investments today – an outflow of capital which punishes your near-year earnings. You, as a CEO, may not be the one collecting the fruits of your investment.

We never compromise on management quality. But we make mistakes, and if we realize we made a mistake on management, we usually sell the stock. If we come to question management’s character, we immediately run for the exits. You cannot make a good deal with bad people.

Even good management can make mistakes. Management making a mistake is not a reason to sell. Everyone makes mistakes; it is what makes us human. It is when we lose trust in management’s soul in the game that we start putting their decisions under the microscope.

Transparency is also very important, and it is one of the metrics we use to evaluate management. Great management teams are usually transparent. Look at GE under Jack Welch or Jeff Immelt: It was impossible to model this company. Under Welch, GE played accounting tricks with its financial arm – the company was managed to “beat the numbers.” Under Immelt, acquisitions made the company impossible to analyze.

When I was younger, I saw complex financials as a mountain I had to climb. However, I learned my lesson in a painful way. When I see complex financials that lack transparency, it means that management doesn’t want to communicate with their shareholders and may have something to hide. 

Today I have enough self-confidence to walk away and move on to the next stock. In investing you don’t get extra points for difficulty.

Management never comes out and says, we are going to cheat and destroy capital. Though sometimes, signs are there right in the open – you just need to pay attention.

We recently looked at a company in the defense industry that seemed very attractive until we saw that the management had made it an officially stated goal to grow revenues from $1.5 billion to $3 billion in five years. Only a small part of that growth was going to be organic (from current business). Most of it was going to come through acquisitions. 

This management is basically saying, we are going to pay whatever price we need to have an empire with $3 billion of revenues. If they “succeed” at growing revenues to $3 billion, I can almost guarantee that shareholder capital will be destroyed in the process. It was very easy for us to walk away from this investment.

Regarding the final part of Buffett’s investment philosophy, to buy wonderful businesses at “fair” valuations, Buffett, with his multi-hundred-billion-dollar portfolio, is at a significant competitive disadvantage against anyone who manages hundreds of millions in assets, or even a few billion. He is a victim of his own success – the size of Berkshire Hathaway.

The only exception to this is when the economy goes into severe distress, and he becomes the lender (investor) of last resort – his cash and his reputation buy a lot more then. This would have happened during the pandemic, but the Fed stepped in and bailed out the economy.

Thus, in the plain-vanilla environment where Buffett operates, he has to settle for fair valuations, as his opportunity set is tiny. IMA is a bit smaller (I am being generous to IMA), and as a result, we are looking for “unfair” valuations.

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Key takeaways

• Buffett’s investment philosophy of finding wonderful businesses with capable management at fair valuations is ideal but difficult to implement consistently in today’s market.
• Truly wonderful businesses are rare, and even those that qualify may not remain wonderful indefinitely due to changing market conditions, competition, or limited growth runways.
• Your approach focuses on finding good businesses with special characteristics rather than exclusively pursuing wonderful businesses, acknowledging the nuances and subtleties in business quality.
• Management quality and transparency are non-negotiable in your investment strategy, a principle that aligns with Buffett’s philosophy but is applied more stringently in your approach.
• Unlike Buffett’s acceptance of “fair” valuations due to Berkshire Hathaway’s size constraints, your strategy aims for “unfair” valuations, leveraging the advantage of managing a smaller portfolio.