Warren Buffett’s Investment Philosophy

Warren Buffett’s investment philosophy

This chapter is split in two subchapters. First, Warren Buffett’s principles of stock picking are explained. Subsequently, his portfolio strategy is outlined. Together, this serves as a brief overview to better understand the origin of his investment decisions.

Picking companies

When looking at a company, Warren Buffett inspects four key areas. Ideally, a company satisfies the criteria in each tenant and hence, Warren Buffett would invest in the company. However, historically he also invested in companies that did not meet all the criteria comprehensively. But this was the exception rather than the rule and needed strong justification for him. In the following, the criteria in each tenant are explored in detail.

• Business tenants
• Management tenants
• Financial tenants
• Market tenants

The business tenants encompass three fundamental elements. First, the business needs to be simple. This implies a clear, laid-out value creation. Warren Buffett would never invest in a business he does not understand and thus, always stayed away from the high-tech industry for example. Second, the business has to have a consistent history. It needs to have rather stable numbers and operating schemes over the last five years. This is further strengthened by the fact that Warren Buffett usually uses five-year averages as opposed to yearly numbers. However, this criterion was for example not met in his famous Capital Cities ABC investment.  Although generally speaking, it holds for most of his investments. Third, the business needs to have favorable long-term prospects. Warren Buffett calls such a business that has a positive outlook for the future a franchise. Franchises are characterized by three main characteristics. They are needed, there are no substitutes and they are not heavily regulated. Given the three characteristics, a franchise has pricing flexibility and that is important to Warren Buffett.

The management tenants originate from Warren Buffett’s idea that there is not a big difference between buying shares of a company or owning the whole company. He emphasized the importance of having a strong and consistent management. This entailed three traits. First, the management needs to be rational and especially rational in the allocation decision of capital. Second, candor is a very important quality to him. As Warren Buffett showed in his letter to the shareholders of Berkshire Hathaway in 1989, he wants his management to be open about the situation of the business and the mistakes they made. In his 1989 letter, Warren Buffett wrote a whole chapter on the mistakes of the first 25 years of Berkshire Hathaway. He expects the same self-criticism and candor from his management teams. Third, the management needs to overcome institutional imperative. By institutional imperative, he describes the phenomena of managers imitating the actions of competitors and other managers. The trait he searches for in his management team is to stand above such influences and to have the ability to make rather unpopular decisions if they are good for the long run. He wants his managers to act with the mind of an owner and hence, think long-term.

The financial tenants include four main elements. First, Warren Buffett focuses on Return on Equity and not on Earnings per Share. This originates from his perspective as an owner even though he sometimes would only hold shares. Hence, the overall Return on Equity is what interests him. To calculate the Return on Equity, he uses operating earnings divided by shareholders’ equity. When calculating, he uses the cost principle as opposed to the market value principle because of his inherent mistrust of price fluctuations. Hence, the cost principle provides a more stabile and trustworthy account. Additionally, unusual items need to be taken out. In the end, the essence of his approach is to find a company with a high Return on Equity even though it has little to no leverage. Second, Warren Buffett concentrates on owner earnings as opposed to accounting earning numbers. Owner earnings can be understood as free cash flow as he uses Net Income, adds Depreciation & Amortization and subtracts Capital Expenditures. He puts great emphasis on the adjustment of Capital Expenditures and the analysis of the company’s Capital Expenditures going forward. Ideally, the Capital Expenditure needs in the future are manageable in terms of funding them through retained earnings so that no further capital needs to be invested. Third, the company needs to have high and sustainable profit margins. This is closely linked to his fundamental belief in always cutting costs. High profit margins are a key source for the high returns he is seeking. Fourth, the companies need to pass the one-dollar premise. This indicates that one-dollar of retained earnings need to yield more than one-dollar of market value. In essence, this means that the company can create additional value by the capital allocation decision of reinvesting in the company.