So you want to know the secrets of Buffett’s investing success? Who doesn’t.
Most of the books out there are great for picking up on the important stuff regarding the financial qualities Buffett seeks in a company - profit margins, high return on equity, low debt, hefty cash flow, etc. But there’s a problem with just about all of the information out there: It tries to distill Buffett’s investing prowess into a formula that anyone can use by plugging in numbers. But it’s far from that simple.
When I had the great fortune of meeting Mr. Buffett, he said he does not place nearly as much emphasis on the financial elements of a company as he does on the qualitative factors. And for all the stress everyone places on precise DCF analysis, Charlie Munger quipped at a Berkshire Hathaway meeting that he has never seen Buffett run one.
Beyond the Financials
Obviously, the financials matter. They ultimately drive the value of the business. But there are more important considerations that must be taken into account before they mean anything. That is, a company which looks good from a numbers perspective may be of little interest to Buffett. Thus, the logicians might say that strong finances are a necessary, but not sufficient, condition for investment.
So what are the important considerations, and how does Buffett evaluate them? If we can answer this question, I contend, we get “the secret.”
Well, it’s no surprise that Buffett is seeking companies with “durable competitive advantages” and which are run by honest and capable management. He’s gone on record countless times saying this. And to this end, Berkshire’s acquisitions and stock purchases seem to verify the truth of Mr. Buffett’s not-so-secret claims. He isn’t hiding anything here.
Evaluating Competitive Advantages
But how does one find and evaluate these competitive advantages? And how does one evaluate management?
As for the latter, I’ve already written on evaluating management here. So no need to reinvent the wheel. On to competitive advantages…
Many companies that are household names have competitive advantages that are obvious and which we’re all aware of. Coca-Cola (NYSE:KO) has an indestructible brand name and high customer loyalty. Microsoft (NASDAQ:MSFT) has a huge market share with its Windows operating system. Google (NASDAQ:GOOG) is the king of internet search and its Google Adwords a virtual necessity for online advertisers. Wal-Mart (NYSE:WMT) can undercut any competitor with absurdly low costs. The Altria Group (NYSE:MO) sells an addictive product, sporting the ultimate form of customer retention, with a strong brand in Marlboro and Parliament to boot.
But not all competitive advantages are as obvious. What kinds of advantages does Buffett look for, and how does he spot them? There are several prospects we can consider:
1) Brand name – a company with a recognizable and trusted brand can count on important benefits. Products with brand names can be placed right next to generic competitors, command higher prices, and STILL sell in higher volumes. Just ask Advil (produced by Wyeth (WYE)). Normally priced at a premium to the generic Ibuprofen bottles that flank it, it sells a lot more at nearly any drug store.
2) High switching costs – This is sometimes, but not always, closely related to a strong brand name. When a company or its product has some unique quality that leads to intense consumer loyalty or makes it difficult for consumers to switch to another company’s product, they benefit from “switching costs.” Trying to get Windows users to switch to a new operating system when they are so intimately familiar and used to Windows is no easy task.
3) Superior product – Some companies just know how to provide a better product or service than others. Google’s search is simply superior to others’. Internet users have quickly come to realize that.
4) Intellectual property – Patents can bestow temporary, legal monopolies upon a company. Pharmaceutical companies can rely heavily on this advantage, which enables them exclusive rights to sell a product for a period when no others can.
5) Economies of scale – This refers to the advantage a company can get when it leverages size to obtain lower costs for itself. Wal-Mart is a classic example. By buying in HUGE amounts from suppliers, it can obtain tremendous volume discounts, passing these on to customers in the form of low prices.
6) Unmatched human capital – The people behind a business are absolutely crucial to the business’ success. In some cases, the people running and/or staffing a business are so incredibly good at what they do that they bestow a competitive advantage upon their companies. Berkshire Hathaway (NYSE:BRK.A), with legendary investor Warren Buffett at the helm, is one such example. Goldman Sachs (NYSE:GS), with its ability to attract the top minds in the world, is another.
7) Government granted monopolies – Sometimes, the government regulates an industry and one or two companies obtain monopolies that prevent others from entering the business. Utilities are a common example. And Buffett has invested in them before (think MidAmerican (MDPWK.PK)).
8) Huge fixed costs – A company may get itself a “natural” monopoly if it has very large startup costs, which would prove prohibitive for any competitor to try to duplicate. For instance, network television used to have such an advantage. After a huge initial investment in the infrastructure, the company would profit as it had little ongoing (marginal) costs.
Now, anyone who knows anything about Buffett knows that he would not invest in Google or a pharmaceutical company. This is partly because he does not understand them and partly because he wouldn’t rely on something like patents as a durable competitive advantage (after all, they’re not durable). Our next questions, then, are 1) what does it mean for him to “understand” something (after all, Buffett’s not a dumb man) and 2) what makes the competitive advantage durable and, hence, appealing to him?
Well the first question is often misconstrued but has an easy answer. When Buffett claims to understand something, he means he understands it almost 100% and can say with virtual certainty what the company will look like in ten or twenty years. It’s not that Buffett is out of touch and doesn’t know what a computer or a prescription drug is. He may have you think that in jest, but, as Bill Gates has said, he knows their businesses, opportunities, and challenges quite well. Yet, and here’s the key, he does not have any advantage or insight into how the companies will perform in ten years due to the fickleness of their industries.
The second question is a bit tougher to answer. What makes a competitive advantage durable? How does Buffett know? Again, some of these are obvious. For instance, Wal-Mart won’t have many competitors able to duplicate its success anytime soon.
Here the discourse gets a bit fuzzier, Buffett’s analysis (at least my claim of what it is) becomes a bit less concrete, and, heroically, Charlie Munger enters the scene.
The Influence of Charlie Munger
I personally believe Munger’s influence at Berkshire and on Buffett’s thinking goes, regrettably, unsung. Very unsung. If Munger hadn’t been around, Buffett arguably would not have gained an appreciation of buying great businesses rather than cigar butts. Munger helped make Berkshire’s returns phenomenal, while allowing for scalability that could not have otherwise been achieved. In other words, Berkshire could never have been scaled to its huge size by purchasing cigar butts — there aren’t enough of them, and the returns are not “continuing” (i.e. when they reach fair value, there’s no further upside. You must sell it and move on). Berkshire, therefore, needed to invest in great businesses that it could hold on to.
But I digress. Back to Munger and durable competitive advantages.
Charlie Munger is a staunch proponent of a type of interdisciplinary model of thinking in which one draws on the accumulated wisdom of many different disciplines (including, but certainly not limited to, psychology, physics, biology, economics, etc.) and understands how they interact. This “latticework” of mental models ultimately becomes worldly wisdom. And it is a structure for thinking, solving problems, and, yes, finding investments.
Why is this important for Buffett? Because he runs Berkshire this way. He manages people this way. He finds investments this way. And it is a tool for determining what is a durable competitive advantage. An example would probably help.
Coke, for Example
In Poor Charlie’s Almanack, a great read that I highly recommend to anyone, Munger gives a talk in which he poses the hypothetical problem of how to turn $2 million into $2 trillion in less than 150 years. Thus he begins the “fictional” proposition that he and his partner, Glotz, create a non-alcoholic beverage. But to make this worth $2 trillion, generic won’t do. So they create a trademark and brand: Coca-Cola.
The story continues as Munger and Glotz figure out how to make this work. Key, they know, is human psychology. For instance, they must get customers “classically” and “operantly” conditioned to drink this beverage. That is, customers must associate the brand with positive things so as to create positive Pavlovian mental associations. They must also be “trained” so to speak, to reach for the beverage when they see the brand and the beverage must maximize rewards while minimizing the possibility that reflexes are extinguished.
And, since they need a huge market share, the brand must be ubiquitous and lots of people must be conditioned in this way. But for this to work, of course, and so as not to risk competition with others, the drink must be available anywhere and at anytime. This all starts to create what Munger calls a “lollapalooza effect” — an outsized result coming from a combination of factors working together.
So they create an exotic-sounding, good-tasting, stimulating drink and advertise it heavily. But that’s not enough. They think in reverse (an important skill, says Munger) and avoid the things they shouldn’t do. They know every drink must taste the same and that they must avoid changing the flavor, because they cannot afford to lose or extinguish the conditioning they have achieved. So they guard their secret recipe, protecting their creation and adding to the allure of the product. Of course, if all goes according to plan, they will create a durable competitive advantage.
Even if, say, some crazy competitor (Pepsi (NYSE:PEP), anyone?) comes along and takes some market share, Coke will still be so ingrained in culture and human psyches that it can remain dominant and valuable as ever. And even if the flavor can be duplicated to perfection by someone else and priced lower, no one would overcome the powerful psychological effects and the indestructible brand of Coca-Cola. So the advantage is durable.
This is all how the plan played out in real life and Coke, no doubt, has done pretty well and should continue to do so. Naturally, it doesn’t take a genius to realize that Coke has competitive advantages. And clearly, not every opportunity can be analyzed exactly like Coke. Each durable competitive advantage is different. So understanding why something (like Coke) has advantages can shed light on how to think about less obvious opportunities. Learning how Buffett and Munger think is far more important than learning what they think.
To truly understand a durable competitive advantage like Buffett and Munger, I believe, requires a thought process uncommon amongst investors, or, for that matter, anyone. And most importantly, Buffettologists, if you will, should stop trying to turn Berkshire’s investment strategy into a quantitative formula, because that misses the whole point. So what does one need to do to start thinking like Buffett and Munger? Here’s my top five list. Be forewarned, it requires work and it cannot be turned into a formula (sorry!)…
1) Read. A lot. Draw from different disciplines. See and appreciate how they interact and what they can learn from one another. One who pigeonholes disciplines goes through life, as Munger has said, as a one-legged man in an ass-kicking contest.
2) Know about human psychology. Understand what motivates people, why and how they misjudge things, and start to change your own biases (and yes, you do have them).
3) Think in reverse. Working through a problem forwards is usually not enough. One must think backwards (not to be confused with backward thinking). For instance, always ask “what should I not do here?”
4) Question everything. Know the “why” and “why not.”
5) Know what you know. That’s not a tautology. It means to define clearly your circle of competence. Humans typically have trouble knowing when they do and do not truly understand something. Be sure you truly understand something before investing in it. Don’t be afraid to say “I don’t know.”
Hopefully, I’ve given you some insight into my own thoughts on the methods of Mr. Buffett and Mr. Munger. Unfortunately, talking the Warren Buffett talk is easier than walking the Warren Buffett walk. And it simply cannot be turned into some quantitative screen or simple checklist. After all, why should it be that easy?