Chapter 89 - A Few Lessons for Investors and Managers From Warren Buffett
Today’s Chapter is based on the book “A Few Lessons for Investors and Managers From Warren Buffett” by Peter Bevelin.
The book is a compilation of passages from Berkshire Hathaways’s Letters to Shareholders. It holds a lot of valuable insights for both investors and business managers. As Warren Buffett once said, "I am a better investor because I am a businessman and a better businessman because I am an investor.”
Previously on Warren Buffett:
Here’s what I have learned:
Valuating A Company
“Unfortunately, the greater fool theory only works until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.”
— Howard Marks
At the heart of Warren Buffett’s investment philosophy is the concept of valuation. As we have learned previously, Buffett has been greatly inspired by his mentor, Benjamin Graham, who once said, “Price is what you pay; value is what you get.” As such, in essence, an investor must understand that the market price of an asset does not always reflects its true worth. He or she must look beyond short-term market fluctuations and focus on finding the intrinsic value of the businesses they are considering acquiring shares in. Buffett once said, "We will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly."
For Buffett, the intrinsic value of a company is the discounted present value of its future cash flows. However, in order to identify a company’s intrinsic value, investors are required to conduct thorough due diligence before making any investment, as each company’s future cash flows may vary depending on the business model, growth and competitive landscape.
This reminds me of how Warren Buffett changed his valuation process of companies after meeting Charlie Munger. Initially, Buffett used to purchase companies trading below net asset value, or what he used to call “cigar butt” investing. However, after meeting Charlie Munger, he quickly realized that “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” This method allowed Munger and Buffett to “sit back and collect money” from cash generating businesses rather than to be always on the lookout for cheap companies which takes more effort and requires one to make more decisions. This is what Munger calls the “Sit on Your Ass” investing approach.
What is even more interesting is the fact that if you are acquiring wonderful companies, the price that you purchased the companies at may not matter in the long run. As Buffett once said, "Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions.”
Furthermore, Buffett also warn us that when valuating a company, it is important to not put too much emphasis on past financial results or short-term metrics. As he explains, "if merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians." Instead, one must truly try to predict the future cash flows.
Luckily for us, Buffett mentions that due to the inherent uncertainty in predicting a company’s future cash flows, one does not need to pinpoint a company’s intrinsic value precisely in order to succeed. As he once said, "Our inability to pinpoint a number doesn't bother us: We would rather be approximately right than precisely wrong."
"Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach."
— Warren Buffett
Finally, Buffett reminds us that figuring a company’s intrinsic value is a great way of identifying the best investment opportunity available to us. As he once said, "the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase." As a matter of fact, in investing, the biggest mistake usually isn’t what you choose to invest in, but what you did not invest in as a trade-off. As Munger once said, “Opportunity cost is a superpower, to be used by all people who have any hope of getting the right answer.”
The principle of “opportunity cost” is well explained in Gregory Mankiw’s textbook “Principles of Economics”. Here’s what he said:
“Making decisions requires trading off one goal against another.
Consider a student who must decide how to allocate her most valuable resource—her time. She can spend all of her time studying economics, spend all of it studying psychology, or divide it between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money.
Or consider parents deciding how to spend their family income. They can buy food, clothing, or a family vacation. Or they can save some of the family income for retirement or for children’s college education. When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good.”
— Gregory Mankiw
Quality of Business
“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”
— Warren Buffett
Buffett categorizes businesses into three distinct groups based on their economic characteristics: great businesses, good businesses, and gruesome businesses. Understanding these classifications can help investors identify which companies are worth their time and money. For Buffett, a hallmark of a truly great business is its ability to maintain an enduring competitive advantage or “moat”. As he once said, "A truly great business must have an enduring 'moat' that protects excellent returns on invested capital."
This moat can take various forms—be it brand loyalty, cost advantages, or unique products—that allow a company to fend off competition effectively. For instance, companies like Coca-Cola possess powerful brands that create significant barriers to entry for competitors. Buffett also emphasizes the importance of sustainable growth without requiring excessive capital expenditures. He explains that "The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow."
In contrast, he warns against investing in gruesome businesses—those with low returns on capital that struggle to generate sufficient profits without large cash investments. As Buffett explains, "Asset-heavy businesses generally earn low rates of return—rates that often barely provide enough capital to fund the inflationary needs of the existing business." These companies often lead to disappointing long-term performance.
“Our acquisition preferences run toward businesses that generate cash, not those that consume it.”
— Warren Buffett
As a matter of fact, Buffett is well known for coining the term “economic moat” in business. For him, the holy grail of investing, is to invest in companies that are able to widen their moat. As he explains that "the dynamics of capitalism guarantee that competitors will repeatedly assault any business 'castle' that is earning high returns." Therefore, a formidable moat is essential for sustained success. As Buffett once said, “The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle.”
One example of great company with a large moat is See’s Candies, a company acquired by Berkshire Hathaway in 1972. When Buffett and Munger purchased See’s, they quickly learned how they could earn great returns from a great business even if they purchased it at a higher valuation. In a recent Podcast, Mohnish Pabrai explains how See’s Candies’ brand and pricing power made them change their investment strategy to focus on acquiring companies with an economic moat:
“See's is a wonderful business. It taught them a lot. It taught them more than they ever thought they'd learn from a stupid candy business.
But one of the things Warren did when he first bought See's is he told the CEO, listen, you got free rein, run the business like you've been running and so on and so forth. But on December 26th, I'm going to set the prices for the next year. So he would sit down with the entire See's price list and he would bump all the prices by 10 or 15%.
And inflation might have been 3%, right? And so he would raise prices significantly above inflation. And what he would observe is volumes went up.
So, and then the year after that, he'd again bump it by another 10, 12% and volume still went up. And so both him and Charlie were amazed that you could have a business where you're continuously raising prices significantly above the rate of inflation. And there's no resistance on the customer base to accepting those prices.
And that's what gave them a huge lesson in brands.”
— Mohnish Pabrai
Finally, on the importance of moat, Warren Buffett once explained that when evaluating a business’ performance on a year-to-year basis, the number one question he asks himself is if the competitive advantage have been made stronger and more durable than before, and that’s even more important than the Profit & Loss for a given year.
"So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way - it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses-or virtually all of our businesses-have pretty darned good moats.”
— Warren Buffett
This concept of “moat” reminds me of what we have learned from Bernard Arnault from LVMH. Before others, he understood that luxury could be a truly profitable industry. As he once said, “it is the only area which it is possible to make luxury profit margins.” In my opinion, Arnault’s tenure with Dior and at LVMH proved how brand name can be a terrific economic moat. Here’s what Arnault said concerning his objective at the helm of LVMH following his purchase of LVMH which truly highlights his understanding of the power of brand name.
“My ten-year objective is that LVMH’s leading position in the world be further strengthened in the luxury goods sector. I believe that there will be fewer and fewer brand names capable of retaining a worldwide presence and that those of our group will be among them as we will provide them with the means for growth [...] My plan for the next six months is to see all the group managers and increase their motivation by sharing my highly ambitious objectives with them.”
— Bernard Arnault
As such, it is fair to say that a luxury brand name is a strong enduring moat. In fact, customers are more willing to pay more for the products due to the brand name’s recognition and exclusivity. As a matter of fact, LVMH is known to destroy unsold bags to increase the scarcity. Here’s how Pat Dorsey explains the power of brand name:
“But the key thing to look at is — and this gets back to your initial point about mindshare — does the brand change customer behavior? Does it make the customer act differently? It can do that in one or two ways. It can either increase the customer’s willingness to pay. You pay more for Coke than you do for President’s Choice Cola. You pay more for Hershey’s [HSY] than you do for lower-end chocolate. Or does it reduce search costs? You become familiar with a product. You don’t want to compare prices all the time on a stick of gum; so you just buy Wrigley [owned by privately held Mars]. You buy Wrigley because it’s what you want, and it’s a $0.50 pack of gum. I’m not going to sit here comparing 50 cents. You’ve reduced my search costs.”
— Pat Dorsey
Quality of Management
“The greatest leader is not necessarily the one who does the greatest things. He is the one that gets the people to do the greatest things.”
— Ronald Reagan
Buffett believes that management quality is paramount when evaluating potential investments. A skilled and trustworthy management team can significantly influence a company’s success or failure. He once said, "After some other mistakes, I learned to go into business only with people whom I like, trust, and admire."
As a matter of fact, for Buffett, integrity is the most important trait he’s looking for in a manager. He explains, “You’re looking for three things, generally, in a person, intelligence, energy and integrity. And if they don’t have the last one, don’t even bother with the first two. I tell them, ‘Everyone here has the intelligence and energy—you wouldn’t be here otherwise. But the integrity is up to you. You weren’t born with it, you can’t learn it in school.’”
Furthermore, Buffett explains that talented managers aren’t necessarily those that are highly qualified in terms of education or those that have an MBA degree. As a matter of fact, Alan Greenberg once said, “If somebody with an MBA degree applies for a job, we will certainly not hold it against them, but we are really looking for people with PSD degrees (PSD stands for poor, smart and a deep desire to become rich.)”*
"Berkshire's CEOs come in many forms. Some have MBAs; others never finished college... Our team resembles a baseball squad composed of all-stars having vastly different batting styles."
— Warren Buffett
Finally, Buffett explains that once you have identified a superb manager, you have to make sure that you do everything in your power to retain them even if they are getting old. As he once said, "We do not remove superstars from our line-up merely because they have attained a specified age... Superb managers are too scarce a resource to be discarded simply because a cake gets crowded with candles."
And as we have previously seen, Warren Buffett is well-known for his decentralised management system at Berkshire Hathaway. Charlie Munger, the ex-Vice Chairman of Berkshire Hathaway once described the system as “delegation just short of abdication.” While the capital allocation decisions are taken care of by Munger and Buffett, all operation decisions are left to managers in the company who are left alone to run their businesses.
As Buffett mentions, “At Berkshire, managers can focus on running their businesses: They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment... Our trust is in people rather than process. A "hire well, manage little" code suits both them and me.”
“Our managers are totally in charge of their personal schedules. Second, we give each a simple mission: Just run your business as if:
You own 100% of it;
It is the only asset in the world that you and your family have or will ever have; and
You can't sell or merge it for at least a century. As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations. We want our managers to think about what counts, not how it will be counted.”
— Warren Buffett
Beyond the Book
Read "Warren Buffett — The Best Book On Investing And What It Can Teach You" by Farnam Street
Read "Tradeoffs: The Currency of Decision Making" by Farnam Street
Read "How (Supposedly) Rational People Make Decisions" by Farnam Street
Read "Warren Buffett: The Three Things I Look For in a Person" by Farnam Street