Warren Buffett is considered by many the best stock market investor in history. Figures don’t lie – he is surely the richest stock market investor. But is he really? Is Warren Buffett a stock market investor? Virtually everyone thinks that he is – and this is where they actually make a mistake. Warren Buffett is not a stock market investor. Warren Buffett is an entrepreneur.

But he does not owe it to himself only. His views and way of investing was a result of knowledge and skills, which he learnt from his teachers, two biggest teachers Buffett owes the most are:

  • Benjamin Graham – a lecturer of economics at the Columbia University, considered the father of financial analysis – he emphasized treatment of shares as enterprises, the concept of the margin of safety and knowledge of psychological mechanisms when investing.
  • Philip Fisher – a prominent investment adviser, who worked in the 20th century for more than 50 years – he emphasized the importance of the quality of management staff and having a concentrated portfolio.

The basis for Buffett’s philosophy was the conviction that there is no fundamental difference between purchasing the whole company and only its part through shares. He is an analyst of an enterprise, whose co-owner he may become. Therefore, contrary to the entire mass of the so-called stock market analysts, he does not waste his time on things such as:

  • Trends on the stock exchange
  • Historical price graphs
  • Support and resistance levels
  • Index ratios
  • Interest rates

Before acquisition Buffett asks himself just one question – ‘do I want to become the owner of this company?’. This question makes him conduct an analysis of a different type. It can be divided into 4 areas:

  1. Principles regarding the company
    • Does the company operate a business activity which is understandable to you?
    • Did the company operate the same type of activity in the past?
    • Does the company have any favorable future perspective?
  2. Principles regarding the company’s management
    • Does the management act rationally?
    • Is the management open to the shareholders?
    • Does the management oppose the institutional imperative?
  3. Principles regarding the company’s finances
    • What is the owners’ income?
    • Does the company have a high profit margin?
    • Did the company create the market value of at least $1 per each $1 of indivisible profit?
  4. Principles regarding the market
    • What is the company value?
    • Can the company be bought for a price much lower than its value?

I don’t have enough place to discuss in detail each of those issues, therefore I will only present a general description of them. Detailed information can be found in literature in libraries or bookshops.

1. Principles regarding the company

The key point of this section is the idea that an investor’s luck is directly proportional to the knowledge of the subject of investment. Buffett would often even say: ‘Invest within your circle of competences. It’s not how big the circle is that counts, it’s how well you define the parameters.’ If you don’t understand the company’s business, what it makes profit on, what costs it bears and what prospects it has for the future – how should you know if it is worth to become the owner? What is also important is the same or very similar type of business in the past or better yet, avoiding companies which are or have just been in the phase of complete reorganization and restructuring. Buffett says – ‘sudden changes and exceptionally high profits do not go hand in hand.’ It pays off more to allocate your energy to buying good companies at reasonable prices than poor companies at low prices. Buffett even often admits that he can’t solve difficult corporate problems – so he has learnt to avoid them.

2. Principles regarding the company’s management

The essence of this section are people managing your potential company. Are they honest? Can they, in their announcements and reports, openly admit to their mistakes and failures? (every company makes mistakes – the small ones and the serious ones – but can it admit that?) What is also important is the ability to go against the trend and not blindly follow others. This is the so-called ‘institutional imperative’ – lemming-like tendency of company managers to assume the herding behavior, i.e. imitating one another, regardless of whether it is smart or not. It is an imperative based on the principle ‘one has to err in a conventional way, or else they will look like an idiot.’ But the fact that others act in a certain way does not mean that we also have to. Perhaps, after an analysis, it may prove true, but it doesn’t have to.

3. Principles regarding the company’s finances

To analyze company finances Buffet uses a modified version of cash flows, which are defined in a traditional way as net profit after tax, increased with depreciation and various types of impairment allowances and write-offs. Buffett additionally reduces this amount by the increase in capital expenditure and the required increase in current assets, since it should be assumed that a certain part of a company’s profit must be spent on new equipment, modernization of the plant or other improvements required for maintaining the current economic status.

4. Principles regarding the market

We should here define the company value and whether it is worth to purchase it. The very choice of a good enterprise is not the reason for its acquisition – we should only do it when we can buy it at a much lower price than its actual value. In order to define a company’s value, Buffett uses the already mentioned income of the owners, which are discounted to today’s value. Valuation is performed assuming continuation of a given company’s operation, therefore there is no point taking e.g. the liquidation value for today, we should calculate what revenue the company will be able to generate in the future and convert it into the current value using the discount rate. Note – it is not always necessary to calculate the exact amount, sometimes a range may be enough. Buffett says – ‘I would rather be vaguely right than precisely wrong.’ This may be slightly counterintuitive that a range is enough, but it makes sense. After all, the final criterion of a purchase is the so-called safety margin. It is a difference between the real and nominal value, divided by the real value. For example, if according to the analysis and further calculations, the company is worth $100 million and its nominal (stock market) price is $50 million, the margin of safety at the acquisition of the company is (100-50)/100 = 50%. In the case of business acquisition it does not matter whether this margin is 45%, 48% or 50% – it is important that it exists and is high. According to Benjamin Graham – it should be at least 33% to take the acquisition into account.

Let me tell you a bit more about a few ideas of Buffett’s philosophy, which are very crucial and have not been described in detail in this article yet:

  • basic rule
  • Mr. Market
  • concentrated portfolio

The basic rule – ‘Price is what you pay, value is what you get.’

The company’s price and the company’s value are not the same. Many people may think that since a given company’s shares are listed at ‘X’ price, the company’s value is ‘the number of shares’ times ‘X’. But in fact, this is only stock market valuation of this company, the value may be, and usually is, different. It can be much lower, but it can also be 2.5 or 10 times higher. Buffett is not a stock market investor, he does not invest on the stock market, he does not chase any indices or benchmarks. He only uses the stock market as an intermediary to acquire good companies at a price much lower than their values. Remember – money is made not on the stock market, but on a company, the stock market is only an intermediary.

Mr. Market – an allegory created by Benjamin Graham

Mr. Market is a guy who comes to you every day and tells you the price it is ready to offer to buy your company shares. The problem is, he is paranoid and he can give random figures. On Monday he might tell you +10%, on Tuesday -20%, on Wednesday -5%, on Thursday +7% and on Friday 0%, which means that he is ready to pay the same price as on Thursday. Mr. Market has one more characteristics – it doesn’t get offended. Even if you don’t use his offer on a given day, he will come to you the next day, anyway, and offer his price. But it is its portfolio that is useful to us, not the wisdom. According to Graham, the right reaction of an investor to a downward trend (regarding your company) on the market should be the same as the company owner’s reaction to an unattractive price offer for acquisition of their company – turning it down. There is no point in selling a good business for pittance only because somebody puts forward such offers. On the other hand, Mr. Market’s irrationality can be used to our advantage. When others will be selling their shares in excellent enterprises for little money, because the downward trend in the market has become unbearable to them – we can find excellent opportunities for investment.

A concentrated portfolio – a concept by Philip Fisher

We are living in the times of diversification paradigm dictate, i.e. not putting all our eggs into one basket. Moreover – many people believe that the more diversified their portfolio is (per different countries, regions, economy sectors, etc.), the safer their investments. Nothing could be further from the truth. Buffett says – ‘If you are an investor who can understand business economics and search for a few companies with competitors advantage in the long run, the conventional diversification is not for you.’ The defect of such conventional diversification is, first of all, that you can very often buy something you don’t know enough about. The idea that by breaking down into many companies, we in fact know little about, we can reduce risk is a fallacy. Acquisition of a company without sufficient knowledge is in most cases more dangerous than insufficient diversification.
The main benefit of diversification is the psychological factor, which involves reduction of volatility of the entire portfolio. However, if we have selected proper companies, bought them at a price much lower than their real value and we are able to believe that if Mr. Market offers us pittance for a very good company, we can simply reject his offer – then diversification is something we don’t need at all. In fact, it would even be harmful to us. If we know that there is still an excellent company to acquire at a reduced price, why would we, instead of buying a higher number of shares in an excellent company, break it down to e.g. 10 companies, with 9 of them being worse than the best one? The right measure for our new investments should be the best of what we already have. If the novelty you are thinking of buying is not better than what you know is available, it does not meet the prerequisite – it eliminates 99% of what you see.

What is also important is the psychological mechanism standing behind Buffett’s philosophy. Buffett says: ‘One of the hardest things is to realize that your intelligence is not extraordinary.’ If you ask a majority of people what they are like compared to others, e.g. in terms of driving skills, morality of choices, etc. – majority of them will say that they are better than the majority :-)
But where is all the rest then? … Even Gaussian normal distribution suggests that majority must be and is average. And perhaps the hardest task for us is to realize that we probably belong to the majority ourselves. Buffett is, contrary to what is believed, an average person. Only he realized that. Therefore, he decided that it was practically impossible for him to make hundreds of investment decisions himself and never make a mistake, be right and make profit. He prefers to remain inactive until he is convinced that what he has in front of him is a real pearl, which can be bought at a price of a regular shell. There is no bonus for hyperactivity in investing, one should not mistake activity for productivity and effectiveness. Very often less means better. Maximization of profits is of secondary nature, the priority is to avoid losses.

You should certainly remember – this all applies only if you have chosen a company in a reliable and competent way. That you know its financial standing, you know what it generates profit from, what costs it has, how it is going to develop, where it is going to sell its products, what makes it better than its competitors, what are its prospects, who manages it and whether those people are honest, whether the company can well manage its property and most of all – whether one can become its co-owner (through shares) at a price much lower than the company’s worth? As Benjamin Graham put it:

Investment is most intelligent when it’s most businesslike. An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.