I recently completed reading “The Warren Buffett Way” which was written by Robert Hagstrom and published by Wiley Finance. The book was written to provide insight into the financial and investment philosophies of one of the most successful investors of our time. It is largely successful in this task, explaining what qualities Buffett looks for in companies in which he invests.
Robert Hagstrom describes Warren Buffett’s investment principles in the terms of four tenets. Buffett seeks out companies that meet his quality criteria in these four categories:
- Business Tenets. These are the basic characteristics of the business itself.
- Management Tenets. These are qualities that senior managers of the company must possess.
- Financial Tenets. The company must satisfy certain financial criteria.
- Value Tenets. The purchase price of the company must be fairly or undervalued.
This seems confusing at first but Hagstrom dedicates four chapters in the book to explaining these tenets. Overall, these tenets are simply a way of categorizing the various things that Buffett looks for in an investment.
Warren Buffett evaluates companies, he does not pick stocks. This is a relatively well-known fact. Buffett uses the same criteria to buy a stock that he uses to buy a whole business. Shares of stock represent shares of ownership in a business so Buffett’s attitude towards stock analysis makes a lot of sense. Hagstrom sums up Buffett’s requirements for a company to meet this tenet in the form of three questions. All three questions must be answerable in the affirmative for Buffett to consider the company as a potential investment:
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favorable long-term prospects?
If Buffett can answer ‘yes’ to all three of these questions then he will continue with his analysis. If he cannot then he will discard the company as an investment possibility.
Hagstrom goes on to explain how Buffett conducts his analysis to determine the answer to these questions. This is where Buffett’s famous concept of the “circle of competence” comes into play. Simply put, Buffett has no faith in his evaluation of a company if he does not understand it. He also believes that sticking with companies that he can understand can help him avoid making big mistakes. His record proves him right.
Most people who are at least casual followers of Buffett know that he spends a great deal of time investigating the management of any company that he is considering investing in. Hagstrom points out that this is a technique that Buffett learned from investing legend Philip Fisher. Buffett needs to be able to answer yes to these core questions about a company’s management or he will not invest in it:
- Is management rational?
- Is management candid with the shareholders?
- Does management resist the institutional imperative?
According to the author, Buffett requires managers to behave and think like an owner of the company. He then spends the rest of the chapter explaining how Buffett evaluates managers to determine the answer to these three critical questions. In particular, Buffett requires managers to be good allocators of capital, to be open and honest about their company’s performance and prospects, and management’s willingness to go against the herd when necessary. His experience has taught him that most managers do not do this; most managers only trumpet successes and blindly follow and imitate their peers. In Buffett’s view, that cannot lead to outperformance. This makes a lot of intuitive sense.
Warren Buffett has particular criteria when evaluating a business’s finances, some of which differ from that which analysts on Wall Street typically look at. For example, Buffett does not particularly care about a company’s earnings per share (EPS). He instead focuses on return on equity and “owner earnings.” He especially likes when a company manages to consistently increase its return on equity without using high amounts of leverage or accounting gimmickry. He does not think that steady EPS gains are anything to get excited about if the company is also steadily increasing its shareholders’ equity (unless ROE is also increasing). Buffett’s way of calculating ROE involves a few adjustments which Hagstrom goes on to explain. These mostly involve adjusting the numbers to remove non-cash gains, losses, or extraordinary items.
The concept of “owner earnings” is especially important to Buffett. This is because GAAP requires a number of things to be included in net income that cause it to paint an inaccurate picture of a company’s ability to generate cash. Buffett defines owner earnings as cash flow from operations minus CapEx and any additional working capital. This metric gives Buffett (and any other investors) a more accurate way to measure the cash that the business earns for its owners.
Buffett is most likely the best known value investor in the world. While he is not opposed to paying a fair price for a good company (a trait he acquired from Charlie Munger), he also will not overpay for a stock or for a whole business. If all of the other tenets have come back positive then Buffett will buy the company if the price delivers adequate value. Buffett will only buy when the company is selling for a significant discount to its intrinsic value that Buffett calculated through his analysis. The author presents a few examples to show how Buffett calculates this value with a discounted cash flow model.
Warren Buffett does not only invest in stocks or businesses. He has also been known to buy bonds and other fixed income securities. Buffett’s analytical techniques when evaluating fixed income securities are very similar to the ones that he uses when analyzing equities. He primarily looks for securities that are selling at a significant discount to their intrinsic value.
I found the book to be a surprisingly easy read and it includes a huge number of case studies that illustrate the author’s points and are quite interesting in and of themselves. Hagstrom includes no suggestions on how to actually find companies that could fit Buffett’s criteria nor does he include any detail on how Buffett finds the companies that he investigates. I suppose that a stock screener could be constructed by someone that understands the concepts here but he gives no specifics on this. The Warren Buffett Way is not a how-to book but it does give excellent insight into the mind of one of the greatest investors in history.