The Enduring Investment Principles Of Warren Buffett
I have recently been reading the 5th edition of The Essays of Warren Buffett edited by Lawrence Cunningham. Reading these excerpts from Buffett’s Berkshire Annual Letters over the years has been an extremely calming experience for me, almost a form of meditation. Because Buffett, building on his mentor Ben Graham, has devised a perennial system of investment excellence that will survive the test of time. In this blog, I’m going to outline four principles central to Buffett’s approach.
1- Buy Excellent Companies: The first principle is the most important. The long term performance of a stock is a function of its economic performance. Therefore, you want to own great companies that compound earnings over long periods of time as this kind of performance will be reflected in the stock price over time. Perhaps the most important quote Buffett ever wrote is: “It is better to buy a wonderful business at a fair price than a fair company at a wonderful price” (1989 Letter To Shareholders).
It is essential to note that this represents an evolution from the ideas of Ben Graham. Ben Graham, the original value investor, recommended buying quantitative cheap stocks. Stocks with cheap P/Es, stocks trading cheaply relative to their Book Values, etc… This is in fact the strategy Buffett followed for the first 25 or so years of his career but he ultimately discovered its limitations. When you buy cheap stocks, you tend to get what you pay for. That is, you get low quality businesses. Buffett came to call these stocks “cigar butts”. Even though the businesses are bad, they frequently have one good puff left in them, like a cigar butt, that will allow you to make a profit on your investment. But they must be sold quickly before the bad economic characteristics of the business destroy value.
For many years, I too followed the Ben Graham strategy of hunting for quantitatively cheap stocks. The one that finally awoke me from my dogmatic slumber was Tailored Brands which owned Men’s Warehouse and Joseph A. Abboud suits which I bought in 2019. I rode the stock down, adding as its price decreased, until I finally bailed at a big loss. The company eventually went bankrupt.
Buffett wrote of his experience with this strategy in his 1987 Letter To Shareholders: “It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for “bargains” – and had the misfortune to find some. My punishment was an education in the economics of short-line farm implement manufacturers, third-place department stores, and New England textile manufacturers.”
2 – Margin Of Safety: A second important Buffett principle is to buy stocks at a discount to their intrinsic value. While you want to buy great companies, you can’t buy them at any price. Consider the Nifty Fifty of the early 1970s or The Magnificent 7 of today. These were and are great companies but the price paid means that price is greater than intrinsic value which results in poor investment performance.
The value of a company is its future cash flows discounted back to the present by a discount rate. It is important to note that calculating intrinsic value is an art, not a science, that depends on your assumptions about future earnings and the discount rate you use. The important point is to be conscious of the relationship between intrinsic value and the price you are paying when purchasing a stock.
3 – Circle Of Competence: You can’t know everything. You have your own personal and educational history that inclines you to understand certain businesses and not others. Some people have a technical background that allows them to evaluate technology companies, but many like Buffett and myself do not. That’s why Buffett didn’t buy any technology companies until Apple in 2017, which is in many ways a consumer products company anyways. You cannot analyze stocks whose business you don’t understand. Fortunately, there are enough companies within your circle of competence to pick from. When asked about a company he didn’t understand, a former friend of mine used to say “too hard”. It took me many years to understand the wisdom of that answer.
4 – Mr. Market: One of the things that makes following Buffett’s principles so difficult is the daily fluctuations in market prices and all the noise and opinions. One day the market is up 2% on a dovish CPI report while another day it’s down 2% on a weak Jobs Report. A company frequently drops 10% or even 20% on one quarter of earnings. Many of us tend to react like the market is some sort of barometer of value like a temperature gauge, but it isn’t. It’s a herd of people trading and takes on all of the emotional and irrational characteristics of a crowd.
Instead of worrying about what Mr. Market is doing on any given day, focus on whether he is offering to sell you businesses below their intrinsic value or offering you prices for your holdings above their intrinsic value. Use him to your advantage rather than being absorbed in his frenetic activity.
On this note, it’s worth mentioning Buffett’s sale of much of his Apple (AAPL) position. Buffett has often said that his preferred holding period is forever but he appears to be getting out. The only reason he would do this is if he believed the stock had become substantially overvalued.
Reading Buffett’s essays (edited by Cunningham) has focused my mind. What Buffett does is simple, though not easy. It requires extensive business research, humility, patience and discipline. In other words, in addition to his intelligence one of the key reasons for Buffett’s success is his character.
Most people are not cut out to do what Buffett does. They get caught up in the daily movement of the market, they need action and overtrade, etc… But Buffett has created a perennial investment philosophy that anybody can follow and will lead to for superior returns as long as human nature remains what it is.
For more on Buffett see:
“Munger: The Man Behind Warren Buffett’s Rise To Greatness”, Top Gun Financial, November 29, 2023
“An Open Letter To Warren Buffett Re: AAPL”, Top Gun Financial, August 3, 2023