Chapter 55 - The Snowball: Warren Buffett and the Business of Life
Today’s Chapter is based on the book “The Snowball: Warren Buffett and the Business of Life” by Alice Schroeder
Heres’ what I have learned from the book:
Value Investing
"There's only one intelligent form of investing: figuring out what something's worth and see if you can buy it at or below that price. It's all about value."
— Howard Marks
Warren Buffett is well-known for being the greatest investor of all-time. In the book “The Snowball: Warren Buffett and the Business of Life”, Alice Schroeder gives us a glimpse on what made Buffett a successful investor. A big reason for Buffett’s success in investing is due to the fact that he had a great teacher and role model in Benjamin Graham, who is often named as the father of value investing.
According to Buffett, he took three main principles from Benjamin Graham’s investment philosophy:
A stock is the right to own a little piece of a business. A stock is worth a certain fraction of what you would be willing to pay for the whole business.
Use a margin of safety . Investing is built on estimates and uncertainty. A wide margin of safety ensures that the effects of good decisions are not wiped out by errors. The way to advance, above all, is by not retreating.
Mr. Market is your servant, not your master . Graham postulated a moody character called Mr. Market, who offers to buy and sell stocks every day, often at prices that don’t make sense. Mr. Market’s moods should not influence your view of price. However, from time to time he does offer the chance to buy low and sell high.
Firstly, Buffett recognises that stocks should be seen as a piece of business rather than a bunch of numbers on a screen. While the majority of people are speculators who are trading stocks as if they were chips in a casino, value investors such as Buffett try to identify the total value of the chips.
There are many ways to value the worth of a business, but in Benjamin Graham’s case, he would often seek companies that were trading below their net assets’ value. Similarly, Buffett, in his early career as an investor, “went through the Moody’s Manuals page by page. Ten thousand pages in the Moody’s Industrial, Transportation, Banks and Finance Manuals—twice.” in the hope of finding companies trading under their intrinsic value.
Another one of his favourite sources to find new investment ideas was the Pink Sheets. On this, Buffett says “I would pore through volumes of businesses and I’d find one or two that I could put ten or fifteen thousand dollars into that were just ridiculously cheap.” His goal? To invest as much as $100,000 to get a significant position in companies trading below net assets value with a market value of one to ten million dollars.
Secondly, Benjamin Graham mentions that value investors must have a margin of safety when investing, meaning that they must leave plenty of room for error. Buffett illustrates this concept of margin of safety with the following saying: “Buy one dollar for fifty cents.”
“You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety.You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin.”
— Warren Buffett
The reason why having a margin of safety is important is due to the fact that mistakes can be costly. In the case of investing, you must avoid losing money at all cost. As a matter of fact, “If someone has a dollar and she loses fifty cents, she has to double her money to make back what she’s lost. That’s difficult to do.”
On this subject, Buffett is known for this following saying: “Rule number one, don’t lose money. Rule number two, don’t forget rule number one. Rule number three, don’t go into debt.”
Finally, on the concept of “Mr. Market”, I’ll allow Buffett to explain it in his own words. In his 1987 Berkshire Hathaway letter to shareholders, he wrote the following:
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions, he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic: He doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”
Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?
The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind.
Following Ben’s teachings, Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.”
— Warren Buffett
Circle of Competence
“I’m no genius. I’m smart in spots—but I stay around those spots.”
— Tom Watson Sr.
While Warren Buffett started his investment career by following Benjamin Graham’s teaching. His investment philosophy changed after meeting his Berkshire Hathaway’s partner in Charlie Munger. Munger convinced Buffett that “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Buffett also believed that Munger’s method would be the better approach considering he was now managing a much larger sum of money. As a matter of fact, the number of statistical bargains such as cigar butts tended to be small companies and gains earned this way wouldn’t move the needle. As such, Buffett decided to take a more qualitative approach instead of his quantitative method. He once said that the “really big money tends to be made by investors who are right on qualitative decisions.”
In one of his shareholders meeting, he defined the ideal business as the following:
“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine. So if you had your choice, if you could put a hundred million dollars into a business that earns twenty percent on that capital—twenty million—ideally, it would be able to earn twenty percent on a hundred twenty million the following year and on a hundred forty-four million the following year and so on. You could keep redeploying capital at [those] same returns over time. But there are very, very, very few businesses like that … we can move that money around from those businesses to buy more businesses.”
— Warren Buffett
Furthermore, it is primordial to make sure that the companies have great competitive advantages to maintain the ability to earn very high returns on capital for a long period of time. This is what Buffett calls a moat. He once posed the Desert Island Challenge to explain this concept: If you were stranded on a desert island for ten years, in what stock would you invest in? The answer is to find the company least subject to the corroding forces of competition and time.
An example of a wonderful company with a great brand power is See’s Candies. Munger mentioned to Buffett that “See’s has a name that nobody can get near in California. We can get it at a reasonable price. It’s impossible to compete with that brand without spending all kinds of money.”
While paying $25 million for a company earning $4 million in pretax earning may seems expensive, Munger and Buffett were confident that See’s pricing power could add an additional $2 to $3 million of pretax earning by increasing prices due to their pricing power. With that included, the return on their capital would be fourteen percent — a decent return, and that is without considering the fact that earnings would continue to grow.
However, you will notice that to be able to make smart investment decisions, it is important to understand each companies’ competitive advantages. To do so, one must rely and invest in their own circle of competence. As Charlie once said, “I want to think about things where I have an advantage over other people. I don’t want to play a game where people have an advantage over me. I don’t play in a game where other people are wise and I am stupid. I look for a game where I am wise and they are stupid. And believe me it works better. God bless our stupid competitors. They make us rich.”
“I don't try to jump over 7-foot hurdles; I look for 1-foot hurdles I can step over.”
— Warren Buffett
Similarly, one must be able to draw a line around himself and stay within the subjects he is an absolute expert in. By doing so, in the long run, one is bound to have unpopular opinions among the crowd. In Buffett’s case, near the end of 1999, while technology stocks were providing extraordinary returns to their shareholders, he refused to invest in technology companies. Why? Buffett understood that he knew “about as much about semiconductors or integrated circuits as I do of the mating habits of the chrzaszcz.”
In order to maintain his temperance while others were profiting from technology stocks, Buffett has what he calls an “Inner Scorecard”. He explains this concept as follow:
“The big question about how people behave is whether they’ve got an Inner Scorecard or an Outer Scorecard. It helps if you can be satisfied with an Inner Scorecard. I always pose it this way. I say: ‘Would you rather be the world’s greatest lover, but have everyone think you’re the world’s worst lover? Or would you rather be the world’s worst lover but have everyone think you’re the world’s greatest lover?’ Now, that’s an interesting question.”
— Warren Buffett
Another way to avoid missing out is to enlarge your circle of competence. This can be done by spending time learning on the new subject at hand. In Buffett’s case, a big reason for his success in investing is due to the fact that he is a learning compounding machine. Like many others, Buffett reads a lot. His bookcase is filled with biographies. He studied the lives of men like Jay Cooke, Daniel Drew, Jim Frisk, Cornelius Vanderbilt, Jay Gould, John D. Rockefeller and Andrew Carnegie.
But more importantly, the things you learn through reading must be put into action to become lessons well learned. As Kenneth Blanchard once said, “Learning is defined as a change in behavior. You haven't learned a thing until you take action and use it.” For example, in Buffett’s case, after reading “How to Win Friends and Influence People” by Dale Carnegie at the age of eight or nine, he started implementing and testing the rules:
“He decided to do a statistical analysis of what happened if he did follow Dale Carnegie’s rules, and what happened if he didn’t. He tried giving attention and appreciation, and he tried doing nothing or being disagreeable. People around him did not know he was performing experiments on them in the silence of his own head, but he watched how they responded. He kept track of his results. Filled with a rising joy, he saw what the numbers proved: The rules worked.”
— Alice Schroeder
Power of Compounding
“The elementary mathematics of compound interest is one of the most important models there is on earth.”
— Charlie Munger
Right from a young age, Warren Buffett had a talent for arithmetic. While he was great at memorising numbers and at basic arithmetic, Buffett, more importantly, understood compound interest. He understood that due to compound interest, a small sum could turn into an exponential number if it grew at a constant rate over time.
As we have learned from Edward Thorp, “over a sufficiently long time, compound growth at a small rate will vastly exceed any rate of arithmetic growth, no matter how large!”
From a young age, by understanding compounding, Buffett understood that a dollar he spent today could be worth ten some years from now. As such, he “wasn’t going to hand over a dollar more than he needed to spend. Every penny was another snowflake for his snowball.” With his knowledge of this powerful knowledge, he announced to his friend Stu Erickson that he would be a millionaire by the time he would be thirty-five.
One of Buffett’s first business endeavours that shows the power of compounding was to buy a pinball machine and to place them in barbershops around time. He would then use profits he earned from his pinball machine to buy other pinball machines. He also did something similar with weighting machines:
“The weighing machine was easy to understand. I’d buy a weighing machine and use the profits to buy more weighing machines. Pretty soon I’d have twenty weighing machines, and everybody would weigh themselves fifty times a day. I thought—that’s where the money is. The compounding of it—what could be better than that?”
— Warren Buffett
As we have learned previously, the power of compounding is a mental model that shouldn’t be only used in investing. Compounding also works in terms of seeking wisdom or obtaining good habits. As a matter of fact, a one percent improvement every day leads to 37x improvement in a year.
Alternatively, Buffett also uses it to think about his mind and body’s health. As a matter of fact, bad habits can also compound negatively. Even more concerning is the fact that you only get one mind and one body to last a lifetime. As Buffett once said, “It’s what you do right now, today, that determines how your mind and body will operate ten, twenty, and thirty years from now.”
Buffett often mentions snowball as an analogy to understand compounding. Here’s a few of his quotes:
“I packed my little snowball very early, and if I had packed it ten years later, it would have been way different than where it stands on the hill right now. So I recommend to students that if you start out a little ahead of the game—it doesn’t have to be a lot, but it’s so much better than starting out behind the game. And credit cards really get you behind the game.”
— Warren Buffett
“The snowball just happens if you’re in the right kind of snow, and that’s what happened with me. I don’t just mean compounding money either. It’s in terms of understanding the world and what kind of friends you accumulate. You get to select over time, and you’ve got to be the kind of person that the snow wants to attach itself to. You’ve got to be your own wet snow, in effect. You’d better be picking up snow as you go along, because you’re not going to be getting back up to the top of the hill again. That’s the way life works.”
— Warren Buffett
Beyond the Book
Read "Lesson #17: Margin of Safety" by Safal Niveshak
Read "The Timeless Parable of Mr. Market" by Farnam Street
Read "Mastering Success: Navigating Within Your Circle of Competence" by Farnam Street
Read "Why Small Habits Make a Big Difference" by Farnam Street
Read "Compounding Knowledge" by Farnam Street