The Warren Buffett Investing Frame Of Mind

( A summarized document based upon Buffett's talks and writings. )

If I were looking at a company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I worried about? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones. Our formula is the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people. We believe that our formula is certain to produce reasonable success. We expect to keep on doing well. When buying companies or common stocks, we look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements. We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong. The majority of our companies have important competitive advantages that will endure over time. It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved.

Our advantage, is attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. When you invest, focus on your circle of competence. Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times. Focus is one thing that Coke, Gillette & GEICO have in common. And I love focused management. Read the old Coca-Cola annual reports. You won't get the idea that Roberto Goizueta was thinking about a whole lot of things other than Coca-Cola. I've seen that work time after time. And when you lose that focus as did both Coke and Gillette, at one point 20-30 years ago, it shows.

Think for yourself. I read annual reports of the company I’m looking at and I read the annual reports of the competitors—that is the main source of the material. Never mind what the professors say about Efficient Market Theories. For me, it’s what’s available at the time. Charlie Munger and I are not interested in categories per se., we are interested in value. For some reason, people take their cues from price action rather than from values. In investing, I went the whole gamut. I collected charts and I read all the technical stuff. I listened to tips. and then in 1949, I picked up Ben Graham’s The Intelligent Investor, and that was like seeing the light. Prior to that, I had been investing with my glands instead of my head. If Graham's three basic ideas are really ground into your intellectual framework, you can do reasonably well in stocks. His three basic ideas - and none of them are complicated or require any mathematical talent or anything of the sort - are:

1. that you should look at stocks as part ownership of a business,

2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,

3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it. I think those three ideas 100 years from now will still be regarded as the three cornerstones of sound investment.

Keep it simple. Value Investing ideas seem so simple and commonplace. It seems like a waste of time to go to school and get at PhD, and having someone tell you the ten commandments are all that matter. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He or she can earn them only by carefully evaluating facts and continuously exercising discipline. The common intellectual theme of the disciplined investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market.

Over time, we learned that it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie Munger understood this early; I was a slow learner. My pal and partner Charlie Munger is a Harvard Law graduate, who set up a major law firm. I ran into him in about 1960 and told him that law was fine as a hobby but he could do better. He set up a partnership quite the opposite of investors from Graham-and-Doddsville. His portfolio was concentrated in very few securities and therefore his record was much more volatile but it was based on the same discount-from-value approach. He was willing to accept greater peaks and valleys of performance, and he happens to be a fellow whose whole psyche goes toward concentration. When he ran his partnership, however, his portfolio holdings were almost completely different from mine and the other fellows, but he followed the Graham and Dodd approach of seeking a bargain. Charlie said, lets go for the wonderful business. We both realized that time is the friend of the wonderful business and the enemy of the mediocre. You might think this principle is obvious, but I had to learn it the hard way. In fact, I had to learn it several times over.

I met Phil Fisher in the early Sixties, after reading his first book. His ideas, like those of Ben Graham, were simple but powerful, and I wanted to meet the man whose teachings had such an influence on me. I dropped in without an appointment. Phil, of course, had no idea who I was but couldn't have been more gracious. A born teacher, he couldn't resist an eager student. It's been over 40 years since I integrated Phil's thinking into my investment philosophy. As a consequence, Berkshire Hathaway shareholders are far wealthier than they otherwise would have been. Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn't count. Keep it simple. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by constantly shifting and complex variables. We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality.

I made a study back when I ran an investment partnership that showed me that my larger investments always did better than my smaller investments. There is a threshold of examination and criticism and knowledge that has be overcome or reached in making a big decision that you can get sloppy about on small decisions. Keep it simple. If you need a calculator or a computer, you've got no business playing the game. Tom Murphy didn't use a computer to figure out what to pay for A.B.C. It's not difficult enough. So instead, in business schools something is taught that is difficult but not useful. The business schools reward complex behavior more than simple behavior, but simple behavior is often more effective.

I put heavy weight on certainty. Use probability in your favor and avoid risk. It’s not risky to buy securities at a fraction of what they are worth. Don’t gamble. You’re dealing with a lot of silly people in the marketplace; it’s like a great big casino, and everyone else is boozing. Watch for unusual circumstances. Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misapraised. In apraising the odds, Ted Williams explained how he increased his probability of hitting: "My argument is, to be a good hitter, you've got to get a good ball to hit. It's the first rule in the book. If I have to bite at stuff that is out of my happy zone, I'm not a .344 hitter. I might only be a .250 hitter." Charlie and I agree and will try to wait for valuable opportunities that are well within our own circle of competence.

In The Theory of Investment Value, John Burr Williams described the equation for value. The value of any stock, bond, or business today is determined by the cash inflows and outflows, discounted at an appropriate interest rate, that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as it is for bonds. Even so, there is an important, and difficult to deal with, difference between the two. A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the "future coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the "equity coupons." The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase. Irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value, the cheapest investment shown by the discounted-flows-of-cash is the one that the investor should purchase.

Investing in bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He or she can earn them only by carefully evaluating facts and continuously exercising discipline. In 2002, we were able to make sensible investments in a few "junk" bonds and loans. When we are unable to invest in equity securities or to acquire entire businesses, our management may alternatively invest in bonds, loans or other interest rate sensitive instruments. Our approach to bond investment is treating it as an unusual sort of “business” with special advantages and disadvantages. This may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. Despite important negatives, Charlie and I judged the risks at the time we purchased Washington Public Power Supply System bonds to be considerably more than compensated for by prospects of profit. As you may know, we buy marketable stocks for our insurance companies based upon the criteria we would apply in the purchase of an entire business. This business-valuation approach is not widespread among professional money managers and is scorned by many academics. Nevertheless, it has served its followers well. Simply put, we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen to us - particularly if we own a group of such securities. We extended this business-valuation approach even to bond purchases such as the WPPSS bonds.

We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price. Before looking at new investments, we consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process. We would love to increase our economic interest in See's or Scott Fetzer, but we haven't found a way to add to a 100% holding. In the stock market, however, an investor frequently gets the chance to increase his economic interest in businesses he knows and likes. In 1994, we went that direction by enlarging our holdings in Coca-Cola and American Express. How does one decide what price is "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking. In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

Berkshire’s arbitrage activities differ from those of many arbitrageurs. First, we participate in only a few, and usually very large, transactions each year. Most practitioners buy into a great many deals. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie nor I wish to spend our lives. To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.? Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation. So far, Berkshire has not had a really bad experience. But we will, and when it happens, we’ll report the gory details. The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.

Obviously, every investor will make mistakes. By confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy. It is no sin to miss a great opportunity outside one's area of competence. But I have passed on a couple of big purchases that were served up to me on a platter and that I was fully capable of understanding. Charlie and I think we understand Gillette's economics and therefore believe we can make a reasonably intelligent guess about its future. However, we have no ability to forecast the economics of the investment banking business (in which we had a position through our 1987 purchase of Salomon convertible preferred), the airline industry, or the paper industry. This does not mean that we predict a negative future for these industries. Our lack of strong convictions about these businesses, however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics.

We love owning stocks if they can be purchased at attractive prices. However, unless we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.