The Warren Buffett Way

Learning from the Oracle of Omaha

Warren Buffett is one of the most celebrated and studied value investors in financial history. It’s no surprise that people have written countless books about him. One of the more popular books is Robert Hagstrom’s The Warren Buffett Way, which gives readers an accessible introduction into the methods and philosophy of Warren Buffett. For the seasoned investor, it serves also as a quick refresher on value investing. In this post, we will review some of the key themes from Hagstrom’s book. This includes the business, management and value tenets that characterise Buffett’s investment philosophy.

Put simply, Warren Buffett likes to buy high quality companies, run by comptent and honest managers, at a reasonable price. There are a few elements to this. Firstly, he focuses on companies that he believes are easy to understand and judge. That is, he stays within his circle of competence. Secondly, he thinks carefully about the economics of a business, their competitive advantages and disadvantages, and the durability of it.

Thirdly, he watches for how managers operate. This includes their alignment with shareholders, discipline with capital allocation and overall integrity. Finally, to purchase companies at a reasonable price, Buffett looks for a large margin of safety. This is the diffrence between the company’s stock price and his estimate of intrinsic volume. The larger this margin the better.

Hagstrom’s four tenets

While there is much more to the Warren Buffett Way, the points above characterise much of his value-investing philosophy. Robert Hagstrom divides Buffett’s philosophy into four tenets: business, management, financial and value. Under each tenet, he outlines several questions which we know Buffett to think about when investing. They serve as a simple checklist to help us identify companies with potentially attractive long-term investment prospects. We outline a few of them as follows.

Business

Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favourable long-term prospects?

Financial

What are the company’s owner earnings?
What are the return on equity and profit margins?
Does the company create at-least one dollar of market value for every dollar retained?

Management

Is management rational?
Is management candid with shareholders?
Does management resist the institutional imperative?

Value

What is the value of the company?
Can it be purchased at an attractive discount to its value?

Durable businesses

Buffett believes great businesses should generate consistently high returns on invested capital. For companies to achieve this, they must have a durable competitive advantage. This is what Buffett famously refers to as the company’s economic moat. These companies tend to be durable franchises with products or service that customers need or desire; have few direct and indirect substitutes; and exhibit strong pricing power over time.

In Competition Demystified, Professor Bruce Greenwald describes how durable competitive advantages tend to come from one or more supply, demand or scale advantages that reinforce one another in tandem. Likewise, Pat Dorsey talks about intangible assets, switching costs, network effects and cost advantages as potential sources of economic moats in his book The Little Book That Builds Wealth.

But recognising a durable competitive advantage that others have not yet seen is a challenge. Finding these companies while they’re small, with a runway for growth and at affordable prices, is an even bigger ask.

Financial position

In his later years, Buffett gravitated from cheap ‘cigar-butt’ stocks towards companies that earn high returns on equity, high profit magins, and with little to no debt employed. There is nothing impressive about companies that achieve high earnings growth via an ever expanding debt and/or equity base. This view shares ground with investors like Peter Lynch, who liked companies with strong net cash positions (difference between cash and long-term debt). Lynch highlights how these companies are better placed to navigate unexpected downturns.

Competent managers

Warren Buffett looked for managers that operates with integrity, intelligence and energy. Managers that lack one or more of these qualities are more likely to destroy company value. Buffett also liked to see managers operate with an owner mentality, and treat their shareholders as long-term partners. Managerial stock ownership and remuneration schemes may provide one indication of this. The way they communicate might be another. In Investing Between the Lines, LJ Rittenhouse recommends we evaluate executive communications on the basis of their vision, strategy, accountability, relationships, capital stewardship and candour.

One dollar test

Warren Buffett also looked for rational managers and effective capital allocators. Companies with good prospects and shareholder alignment should see their results reflected in its market value over time. That is, Warren Buffett wanted every dollar of retained earnings to create at least one dollar in market value. He called this the one dollar test.

Capital discipline

Furthermore, Hagstrom notes that management’s choice between reinvestment and return of capital is another test of their capital discipline.For example, managers that earn consistently poor returns on capital on acquisitions (as opposed to simply returning excess cash) are destroying shareholder value.

The outsiders

Hagstrom also highlights Buffett’s preference for managers that operate with candour and independence. This tenet is similarly explored in William Thorndike’s book The Outsiders. Thorndike observed that chief executives with outstanding value-creation track records, such as The Washington Post’s Katharine Graham, are rational, independent, long-term thinkers. They combine patience with occasional boldness, and spend more time on capital allocation than on investor relations.

Red flags

Another red flag for management is unintelligible footnotes in financial reporting. Annual reports will sometimes include inflated achievements, half-truths and intentional obfuscations. Buffett did not hesistate to put stocks in the ‘too-hard’ basket. Similarly, excessive stock option plans that transfer value to management at the shareholder’s expense is another red flag. Again, managerial alignment with shareholders is important.

Warren Buffett also observed how bad managers have difficulties with resisting the institutional imperative. These managers are typically resistant to change, and like to employ consultants and bankers in legions to justify their projects. Behaviours are also reflected in a tendency to imitate their peers in expansions, acquisitions and compensation schemes.

Margin of safety

Investors need to buy high quality companies at prices below their estimates of intrinsic value to generate satisfactory investment returns. This value is the expected net cash flow over the investment’s lifespan, discounted at an appropriate cost of capital. Warren Buffett himself focused on owner earnings. In his 1986 letter, he described this as the available cash flows after expenditures the company needs to maintain its competitive position and unit volume.

Owner earnings = Net income + (Depreciation & Amortisation) – (Capital Expenditures + Additional Working Capital)

It is easier for us to assess intrinsic value when owner earnings are stable and predictable. Hagstrom notes that Warren Buffett used a discount rate of around 10%, or the yield for long-term bonds. Perhaps this was for ease of calculation and for a margin of safety when bond yields are lower.

Purchasing stocks at prices below underlying value provides investors with a margin of safety and some room for error. It allows investors to absorb some downside risk if the company’s intrinsic value were to deteriorate. Similarly, it acts as a hurdle rate to select investments with higher expected upside relative to its prevailing market price.

Diversification and risk

Warren Buffett and his partner, Charlie Munger, have had numerous bugbears with academic finance. One major contention relates to risk and diversification. Academic finance typically measures risk on the basis of stock price volatility and co-variances. They promote the benefits of diversification and highlight challenges of outperforming efficient markets. While markets are usually efficient, they are not always efficient (as history often shows). This creates opportunities for disciplined investors like Buffett.

Furthermore, risk is the likelihood of loss of capital, not the volatility in stock prices. In reality, portfolio concentration might reduce risk if they allow us to find higher quality stocks. Likewise, a fall in stock prices might decrease risk by increasing your margin of safety (assuming intrinsic valueu is unchanged). Finally, diversification, as with index funds, reduce the likelihood of both abnormal losses and gains.

The outperformers

Hagstrom describes the Warren Buffett Way as a rational approach to investing. Such an approach can help investors to avoid the emotional and intellectual traps that one might otherwise face by relying on intuition. Similarly, such focused investors turn off the stock market. Markets are not soothsayers to them. Rather, they are simple albeit volatile mechanisms to buy and sell shares of stock. You are neither right or wrong because the crowd disagrees with you.

Additionally, Hagstrom notes that outperformers also worry less about the economy. They look for investments that can thrive across multiple scenarios, including downturns. These investors focus on buying outstanding companies with a margin of safety. While patient, they place big bets when the probabilities are in their favour. They hold their portfolios for the long term and avoid panics during temporary price swings.

Interestingly, Hagstrom’s empirical analysis found market beating fund managers to exhibit four attributes. Firstly, they have a lower portfolio turnover at an average of ~30% (compared to the all equity fund average of 110%). Secondly, they employ greater portfolio concentration, where 37% of assets are concentrated in their top 10 picks. Thirdly, they adopt intrinsic-value approaches. Finally, they are geographically underrepresented in key financial centers such as New York. This might also present evidence for greater independence and lower hyperactivity.

References

Hagstrom, R. (1994). The Warren Buffet Way.
Lynch, P. (2000). One Up On Wall Street: How To Use What You Already Know To Make Money In The Market.
Greenwald, B., Kahn, J. (2007). Competition Demystified: A Radically Simplified Approach to Business Strategy.
Buffett, W. (2019). Berkshire Hathaway’s Annual Letter to Shareholders. Available at <https://www.berkshirehathaway.com/letters/letters.html>
Buffett, W. (1999). Berkshire Hathaway, An Owner’s Manual. Available at <https://www.berkshirehathaway.com/owners.html>

The Warren Buffett Way – Robert Hagstrom on investing

Learning from the Oracle of Omaha

Jump ahead