Warren Buffett's 'Secret' Investment Formula

Includes: BRK.A, BRK.B
by: Todd Kenyon, CFA

As one of the most successful investors ever, Warren Buffett's methods are widely studied and many attempt to replicate them. Mr. Buffett has frequently discussed his investing criteria and the influence Ben Graham had on him in the early days. And he has repeatedly said over the decades that value investing is simple, but not easy.

So just how simple is Buffett's investing methodology? There are many stories out there that Buffett does not use a computer (other than to play bridge online), hence he does not use the ubiquitous Wall Street crutch, the spreadsheet financial model. Buffett also doesn't use a calculator. Maybe it's that Buffett is just so darn sharp that his brain is the only calculator he needs.

There is no doubt Buffett is super sharp, and able to see what matters and quickly and efficiently evaluate it. But, I think that is just a bonus for Buffett - not a requirement to practice his investing style. He would agree, I think, since he has frequently stated that investing success only requires an average IQ. Certainly we are now very familiar with the damage done by those who supposedly have superior IQ's.

Alice Schroeder recently released "The Snowball", the most complete account of The Man to date (and next on my reading list - if I only had any time to read books). Ms. Schroeder had unprecedented access, spending years in Buffett's office going through his old files. How did she gain Buffett's approval? Through her work as an insurance analyst a decade ago for Paine Webber and Morgan Stanley. Her reports from that era on Berkshire (NYSE:BRK.A) are the only coherent analyst reports on Buffett's empire that I have ever read. And her valuation model for Berkshire was the best I've seen. I still use my own version of it. I think she won the Buffett lottery because she was the only one who "got" Berkshire on Wall Street.

Schroeder recently gave a keynote at the Darden Value Investing Conference. In it she clearly laid out Buffett's "secret" investment methodology. But first she also made it clear that Buffett is a unique animal. At age 7 he asked for a book titled "Bond Salesmanship" for Xmas and read it cover to cover. She describes him as someone who is always thinking "what more can I do", especially to get an edge on the other guy. And, he is a learning machine with a cumulative mental file cabinet. And he always thinks like a horse handicapper, he's always thinking about probabilities.

So what is Buffett's secret method? Here it is step by step:

  1. Look at the risk of loss. What is the probabilty that I will permanently lose money here, and what could happen that would result in total loss? If there is ANYTHING that could reasonably result in a total loss, stop right there. Buffett never tries to talk himself into any investment. He says that much of his success is from immediately passing on things due to realistic appraisal of catastrophic risk.
  2. Look at historical financial data. Look at the historical quarterly sales, expenses and profits (and cash flow of course) for each line of business or operating unit. DO NOT build a model or try to predict the future. Schroeder says there was not one model of any kind in Buffett's files - just simple hand-written tables with historical financial data.
  3. Once he's happy with the first two critieria, he sets his price. He "only" requires that he receive a day one return of 15%, with a good likelihood that his return will compound from there. Although Schroeder is not clear on this, I assume he looks at cash earnings or the so-called "owner's earnings" for his 15% return. Essentially this is cash from operation, less one-time and options benefits, minus maintenance or essential capital expenditures. So you could say he is looking to buy in at 6.67 (or less) x today's cash flow - something that's been nearly impossible up until September.

There you have it, Buffett's secret. Extreme simplicity that requires extreme discipline to execute. Buffett has the advantage of not having to answer to anyone. He says he gets up and looks in the mirror, then everyone has had their say for the day. Furthermore, he believes that 90% of being successful in business is guts: you must only answer to yourself. He can wait indefinitely for a good opportunity. This is in direct contrast to the typical money manager, who has to answer to clients, employers, media, and on and on. Hence Buffett's is largely an IMPOSSIBLE strategy to execute on Wall Street. However, as an individual investor you only have to wrestle with your own psyche, and that will be the hardest part of investing like Buffett.

What about future predictions?? Everyone knows the stock market is always looking 6 months ahead, always anticipating the future. Buffett says that the whole purpose of investing with Graham's infamous "margin of safety" is to render forecasting unnecessary. And margin of safety is ALWAYS a function of price paid - hence Buffet's 15% day one return requirement. Imagine if everyone invested this way. Even more Wall Streeters would be out of jobs: analysts, strategists, economists - worthless (not that they have any value now - they're just paid as if they do).

I plan on presenting a series of stock ideas over time in the premium blog that I think fit Buffett's "secret" method. There has been no better time in my 12 year investing career to look for such bargains. Sure it's tough out there, and anything you buy today will likely go down tomorrow. Buffett was recently interviewed by Tom Brokaw, and had this to say about how to deal with today's market, and how investors can steel themselves against the rampant fear and panic:

If you own a farm nobody tells you when it's gone down 50 percent 'cause you don't get a quote every day. But you really look to the farm and what it produces to determine whether you made a good investment. Now if people look to the newspaper every day at the price of a stock to determine whether they made a good investment they're making a mistake.

They have to look to the business, the asset itself. If you own an apartment house you wouldn't get a quote on it every day. You'd just look at-- what the rent rolls were, and your taxes were and expenses were. And if they all came in with--in line with what you expected when you bought it, you'd feel you'd made a satisfactory investment, and you'd never get a quote on it. So I don't look at quotes. I can't tell you what Berkshire Hathaway is selling for today."