Buffett believes that when one invests one must buy a business, not a stock. This means that the investment must be viewed from the long term perspective of a business man. How should one think about an investment? Buffett applies the following tenets.
Business Tenets: Buffett is interested in businesses which satisfy the following criteria:
Simplicity and Understandability: The business must be simple and understandable. Otherwise you may not be able to figure out how it generates profits.
Consistent History: In order to bet on the future of the company you should know how it has fared in the past. A good track record provides an assurance about the ability of the company to earn profits.
Franchise: A franchise offers the best long term prospects. A franchise is a business that sells a desired product or service which has no close substitute. Further, its profits are not subject to regulation. As against a franchise, a commodity business offers poor prospects.
Coca-Cola, Gillette, See’s Candy and the Washington Post are excellent examples of franchise businesses in which Berkshire Hathaway, a Buffett controlled company has huge investments. Buffett’s edge seems to be in his ability to invest in and, if required shape the franchise businesses.
Management Tenets: For assessing the quality of management, Buffett employs the following criteria:
Management Rationality: Rational managers invest cash in projects that earn returns in excess of the cost of capital. If such projects are not available, they will return the money to shareholders. Irrational managers, on the other hand, look for ways to invest surplus funds, somewhat unmindful of their profitability. As a consequence, they tend to earn returns less than the cost of capital.
Managerial honesty: The openness with which the management communicates with shareholders is important. Does the management explain how various operating divisions are performing? Does the management forthrightly claim that its primary objective is to maximize the returns to shareholders?
Resistance to Institutional Imperative: Most managements succumb to the institutional imperative. They mindlessly imitate the behavior of others and tend to build a big empire, often hurting the shareholders in the process. An important measure of managerial competence is its ability to resist the institutional imperative and its unwavering commitment to the welfare of shareholders.
Financial Tenets: The following financial yardsticks are considered important by Buffett:
Return on Equity: Investors often judge a company’s annual performance by its earnings per share. A better measure of a company’s annual performance is its return on equity – this measure takes into account the company’s growing equity base.
Profit Margin: High profit margins reflect a strong business as well as a firm managerial determination to control costs.
Market Tenets: Naturally, Buffett is interested in buying businesses which are available at a significant discount over their value. He focuses on the following.
Value of the Business: A strong advocate of the discounted cash flow method, Buffett values a business by discounting its estimated cash flow at a suitable discount rate.
Purchase at a Significant Discount: Buffett believes in purchasing the business when its price is substantially lower than its value. Note that Buffett looks at the stock market price only at this juncture. To deal with the potential efforts in valuation, Buffett (1) adheres to businesses which are simple and stable in character, and (2) insists on a margin of safety which acts as a cushion.
Manage a Portfolio of businesses:
Since Buffett manages a portfolio of businesses and not stocks, he does not believe in wide diversification. He thinks that wide diversification makes sense only for the know nothing investors who would do well to buy an index fund. Paradoxically he says, when dumb money acknowledges its limitations, it ceases to be dumb.
On the other hand, Bufett argues, if you are a know something investor able to understand business economics and to find five to ten sensibly priced companies that possess important long term competitive advantages, conventional diversification makes no sense to you. In our view, Buffett says, what makes sense in business also makes sense in stocks: an investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.