Warren Buffett has covered every aspect of investing over the years. Whether in one of his letters to shareholders, an interview, or an essay, a laundry list of investment tips drawn from the content can help get anyone started from covering how to consider risk against reward, or how to consider portfolio concentration, for example.
Learning to invest remains challenging, but Buffett is a great place to start learning from the best. Buffett presents many different investment ideas, but we can narrow those down.
We can become better investors by following the advice and guidance he provides. Studying his investment choices provides us with a guidepost to develop.
These lessons are subjective, and you will build your perspectives as you learn more.
In today’s post, we will learn:
- Warren Buffett’s Four Pillars of Investing
- Quality of Information
- Consistency of Earnings Growth
- Finding Opportunities To Drive Your Investment Style
- The Importance of Great Management and How to Find
- Investor Takeaway
Warren Buffett’s Four Pillars of Investing
Warren Buffett started his investing journey in 1941 with his first buy. He bought six shares of Cities Service preferred stock for $38 per share. He was eleven, and three shares were for his sister, Doris.
He was always interested in making money and had an entrepreneurial bent from an early age. Over time, he became more interested in investing. At one point, he read every finance book in his local library.
But he cut his teeth at Columbia Business School studying with the great Benjamin Graham. Yes, that Benjamin Graham, the author of The Intelligent Investor. The book launched a million value investors, myself included.
Buffett learned many lessons during those early days, many of which have stayed with him — ideas such as margin of safety, the price you pay matters, and fundamentals.
But over the years, Buffett has morphed from buying cheap “cigar butts” to more quality-focused companies, while still retaining the foundation he built with Graham.
If we study his writings and investments, we can see a core of four pillars. These four pillars contain elements of the value investing philosophy. But they also contain other ideas and elements he picked up from Charlie Munger.
The four pillars are:
- Quality of information
- Consistency of earnings growth
- Finding opportunities around your investment style
- The importance of management and how to find
These pillars contain a mix of hard and soft skills. Or better, quantitative or qualitative skills we can use to find great investments.
Quality of Information
Buffett believes investing should be like having a punch card with only twenty holes. Each hole corresponds to a potential investment a person could make throughout their lifetime. He believes in sound research and how the information could give him an edge.
He gives us the roadmap for finding certain information for each investment. When I looked at Buffett’s investments, one thing that stuck out was how much excellent data he had on the businesses he bought.
Consider Burlington Northern Santa Fe as an illustration. Buffett had access to a wealth of knowledge when he decided to invest in the business.
Along with financial data, BNSF includes its rail company’s most important operational KPIs in its yearly reports. The KPIs include metrics like:
- Freight revenue per thousand tons
- Revenue per ton of revenue
- Customer satisfaction ratings
Since BNSF has provided these metrics over many years, prospective investors have access to the pertinent, unbiased data they need to comprehend how BNSF performs from year to year.
Even more important, the annual report discusses each business sector and the main factors influencing them. The 10-K explains that the distribution of automotive items makes up 10% of the consumer products sector, while 90% of domestic and international commodities transit are involved.
BNSF continues by outlining the capital requirements of the company over time. And explaining why rail is a more effective mode of transportation for certain product categories than the alternatives (most notably, trucking).
Thus, enough verifiable and objective evidence supports the qualitative insight required for a wise investment.
Buffett’s insight was that future returns on marginal capital employed would continue to increase with higher network density in BNSF’s rail business, resulting in a decrease in future capital intensity and an increase in future returns on capital employed that would likely last for many more decades.
Buffett’s investing was consistently characterized by relevant enough, objective facts for the companies in question across various circ*mstances. Concerning his investment in American Express, Buffett had data to back up his observations about the long-term potential of credit cards and travelers’ checks, as well as the localized and immediate harm caused by the Salad Oil Scandal.
The takeaway from studying these two investments we use?
Look at primary sources of information. We can start with financial statements, annual reports, and quarterly earnings calls. But, we can also read industry reports revealing all kinds of data. For example, you can find publications sharing relevant data in the rail industry.
You can also read reports and documents related to the same field from experts in the field. In today’s age, we have access to podcasts, blogs, news sites, and much more.
Consistency of Earnings Growth
Buffett took into account the information quality. But what I want to draw attention to and what remains even more crucial is the consistency of sales performance and profitability.
Most value investors seek companies with long-lasting competitive advantages or “moats.” Many people will have to spend time looking for:
- Network effects
- Switching costs
- Scale benefits
- Other qualitative advantages
On the quantitative side, we can analyze current earnings and returns in depth.
Cash earnings after maintenance costs remain the preferable statistic, which is also roughly what Buffett looked at (CAPEX for maintenance). Return on capital, which we can determine by dividing the earnings by the total capital (or by some other form of marginal capital utilized), is another common quantitative emphasis for value investors.
The lesson learned from studying Buffett’s investments is that while all these elements are important and deserving of close examination, being able to estimate a company’s prospects comes first.
The bulk of the companies Buffett has bought has grown their sales and profitability in previous years. Given how few businesses operate at this level, the fact that these companies have grown revenues or earnings nine out of the preceding ten years is extraordinary.
Buffett placed high importance on reliable historical financial data to comprehend the qualitative factors underlying a company’s steady development (in sales or earnings). He then used this information to predict the future performance of the company. For instance, he saw that as more people traveled, there would be a growing demand for traveler’s checks from American Express.
For Buffett, much of the analysis came down to a few factors.
- What kind of competitive advantage did the company own?
- How does that impact the company’s ability to grow?
One of his superpowers, among the many, remains the ability to determine a company’s moat and how the strength of the moat corresponds to the company’s financials. For example, he refers to returns on capital many times. He feels a company generating high returns on capital for a long time gives the company a competitive advantage.
But returns on capital are not the end all, be all. For example, when compared to a company with lower returns, a business with a fantastic 50% return on capital but grows its revenues or earnings by 0% reaps no benefits from its high return on capital. Companies not reinvesting well cannot continue to expand.
Given this, I now think that one should spend more time looking for businesses with great consistency in earnings growth and finding quality data that supports a clear idea of why this growth occurs rather than spending 80% of one’s research time establishing with extreme accuracy the current earnings in the last year or establishing a precise return on capital for a business.
We should remember to focus more on “being approximately correct than precisely wrong.”
Finding Opportunities Around Your Investment Style
Many investors characterize their investment strategy in today’s investing environment by a particular approach, such as “value,” “growth,” or “event-driven.”
Buffett went beyond these sorts; he didn’t invest only in low-cost net-nets, top-notch companies, or preferred shares. Instead, he adjusted his investment plan to the state of the market and his unique investing configuration.
One might examine how Buffett accomplished this in more detail. Buffett outlines three categories that form the basis of his investing strategy in his 1961 partnership letter.
Generals: Securities that, in his opinion, remain below fair value or their inherent worth. Most of what one may consider traditional value investments are long-only investments in cheap companies compared to assets or values.There was no general timeline for how long they stayed undervalued. But, he expected these companies to have a large “margin of safety.”
Workouts: These were businesses where actions, such as mergers, liquidations, reorganizations, spin-offs, and so on, determined the financial returns. Buffett believed this class of assets should be less reliant on the market and predicted an average return of between 10% and 20%.
Control situations: The partnership can control a corporation in certain circ*mstances or own enough stake to affect operations. While one of the two types of investments could lead to these circ*mstances, Buffett’s goal here is to persuade a business to discover hidden value in assets, cash on hand, or (later in his career) functional upgrades.
His overarching goal was to outperform the market over the long run by combining all three investing styles. He stated that his goal was to have smaller losses than the market in sinking markets, while equaling or overperforming markets in advancing markets.
The ideal investment strategy fluctuates based on the state of the market. But Buffett is responsive to the market by building a pipeline of opportunities. He can react when the situation permits by having a ready list of attractive prospects.
Buffett was open to many investment styles yet steadfast about his hurdle rates.
The Importance of Great Management and How to Find
One element of Warren Buffett’s strategy has stayed consistent over the years: his top priority was effective management.
Other world-class value investors, such as Walter Schloss and Benjamin Graham, focused little on assessing management. Buffett spent a lot of time comprehending and assessing a company’s management.
A track record of operational performance is one factor Buffett looks for when evaluating management.
For example, in 1940, Jack Ringwalt (from National Indemnity) and his brother Arthur cofounded the company and started it from scratch. By the time Buffett made his investment in National Indemnity in 1967, Jack had managed it for over 25 years while balancing its risks and development opportunities.
The CEOs of the major public firms that Buffett invested in had a similar record of achievement:
- Howard Clark, the CEO of American Express
- Roberto Goizueta, the CEO of Coca-Cola
Both were successful executives who had held their positions for many years.
These managers shared another trait: they produced thorough, truthful annual reports that provided uncommon insight into their companies. Buffett’s decision to invest in a business without first researching the manager’s track record of success was exceptional.
Buffett appeared to place a premium on owner-managers or CEOs who are either stockholders or otherwise involved with the company.
Some situations were quite obvious; for example, Jack Ringwalt and Rose Blumkin of Nebraska Furniture Mart were the founders and owner-managers of their respective companies. Because she was the granddaughter of the Washington Post’s founder, Katharine Graham was as well.
Buffett made investments in businesses where the managers had a very long and clear history with the company; for example, Tom Murphy at Capital Cities, Carl Reichardt at Wells Fargo, Ronald Ferguson at General Re, and Matthew Rose at BNSF had all worked for their respective companies for more than ten years, and in some cases, over twenty-five.
Because they had the same interests as he would have as a long-term owner of the company, Buffett favored owner-managers.
Buffett also has many other standards for managers. A manager, in his opinion, should have the highest level of honesty because, in that case, they may endanger investors more by being intelligent than by being foolish.
However, he was also ready to teach management the conservative strategy he advocated rather than insisting that they be masters of it to begin with. He also respected managers who could deploy capital well.
Buffett had little doubt that management was one of the most crucial factors, if not the most crucial factor, in determining a sound investment.
He devoted a great deal of time to getting to know, assessing, and advising managers, looking for sincere individuals with successful track records who also had a genuine concern for the organizations they headed.
Investor Takeaway
Decoding Warren Buffett is a difficult task. However, there are many valuable lessons to be learned from examining the actions and tactics employed by Buffett.
A common question from investors is, “How can I replicate Warren Buffett’s investments?”
And the answer, we need to remain true to our strengths, but we can follow his example and learn from his investments in GEICO, American Express, co*ke, and BNSF.
We see his investment process follows some familiar patterns; he looks for companies with:
- Strong historical earnings/revenue growth, with prospects for continuing the growth
- The ability to reinvest capital at high rates over a long period (i.e. co*ke)
- Strong management teams with a long history with the company or owner/operators with a big stake in the success of the company
- And finally, stay in your lane, and invest in companies which you understand both the business model and financials
If you follow those simple but not easy rules, you will do well over a long horizon.
If you are interested in learning more about Warren Buffett and his investment ideas, you are lucky because information about Buffett is endless.
The best place to start is his Letters to Shareholders, then you can graduate to wonderful books:
And with that, we will wrap up our discussion concerning what we can learn from Warren Buffett.
Thank you for reading, and I hope you find something of value. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Dave
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