Revisiting The Warren Buffet Way
I first read The Warren Buffett Way
A decade later I’m trying to position my portfolios for the next ten years. It is a good time to revisit the principles distilled in The Warren Buffett Way. I’ve re-read the book recently, and it seems to make much more sense now after gaining more experience investing and going through the depths of the financial market collapse.
Robert Hagstrom does a very good job simplifying the process of evaluating an investment. He examines twelve investment tenets with a focus on the business, management, financials, and valuation.
Business Tenets
1. Is the business simple and understandable?
2. Does the business have a consistent operating history?
3. Does the business have favorable long-term prospects?
In my own investing, I always tend to focus on #3. I’m always drawn to the next big thing. This interest is often to the detriment of #1 and #2. Too many times I’ve been drawn to investments that show tremendous promise, but fail to demonstrate consistent, long-term profitability. The requirement that a business be simple and understandable has also been a weakness.
I would say that the recent financial crisis has demonstrated that many investors did not understand the risks inherent with many companies in the financial sector. My own investment in First Marblehead was very costly early on in the meltdown. My recent look at CapitalSource is an example of a company with a good deal of complexity. Even after close examination and a careful read of their annual report and conference call transcript, I’m not sure I fully understand the risks. The value appears compelling, but the business is certainly not simple and understandable.
Simple and understandable also requires that an investor stay within their circle of competence. Having worked in commercial real estate for over 11 years, understanding the risks and business of REITs may come more easily to me than comprehending a mining company or a company in the energy sector.
Management Tenets
4. Is management rational?
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?
One of the most difficult aspects of investing is evaluating management. There are, of course, extreme examples of management behaving badly, but it is not always so easy to see. Quarterly calls and annual reports are a great place for management to communicate their strategy and decisions to shareholders. As an investor, I want to see that the decisions of management make sense.
There is nothing more frustrating than a management team trying to gloss over bad decisions and poor performance. In quarterly reports, investors will often see a headline touting one or two metrics where performance was acceptable during a horrid quarter. During the recent financial meltdown, how many financial institutions have admitted that the sought too much leverage and invested in poor assets. Candor can certainly be difficult to come by.
The institutional imperative is the degree to which a management team follows the crowd. Buffet himself is a great example of this. During the years before the financial crisis, he went to great efforts to reduce exposure to derivatives, while companies like AIG were absorbing ever more exposure to these instruments.
Financial Tenets
7. What is the return on equity?
8. What are the company’s owner earnings?
9. What are the profit margins?
10. Has the company created at least $1 of market value for every dollar retained?
I think investors often make investing more complicated than it needs to be. Companies with light business models and high profit margins will produce better returns. If retained earnings can be invested in more growth, the company will likely produce strong returns over a long period of time.
Value Tenets
11. What is the value of the company?
12. Can it be purchased at a significant discount to its value?
Hagstrom effectively explains how to value a company in The Warren Buffet Way. The book provides many good examples of how Buffet views value. For new investors, this is a great place to start. For more experienced investors, this book will serve as a reminder of how simple investing should be.
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