The Warren Buffett Way: Investment Strategies of the Wo… (2024)

A sort of guide/educational related book, explaning how Warren Buffet tackles the world of investing, the book is easy to read, and the information that it is providing is easy for the reader to absorb, I found this book increased my knowledge and very useful, decent book cover, no editorial issues, suitable for the self-investor, professional investor, economic students, this book will appeal to all age groups, and if you have an interest in the world of investing, this book should be one that you read. it is a strong platform/base from which to obtain further knowledge. I always believe that if you read a book for educational reasons, that you should only read the book of a person and take advice from a person (or people) that have walked the path that you wish to walk, which makes it easier to respect their education and advice. Good book, wish I had read it years earlier.

I divide the book into four parts. The first part of the book (chapter 2) describes Buffett’s intellectual influences. The second part (chapter 3) is a series of miscellaneous reflections on inflation, portfolio management, macro forecasts, long-termism, etc. The third part (chapter 4) describes the principles of his investing philosophy. And the final part (chapters 5 and 7) describes his positions and evaluates them in light of the investing principles previously described. I skimmed chapters 1 and 8, and I skipped chapter 8 (on bonds). The essence of the book, I thought, was contained in chapter 5. If you have a background in accounting and finance, I would recommend only reading chapter 5; you’d still derive 80% of the benefit.

Investing Influences: Graham and Fisher

Buffett’s influences were Ben Graham and Phil Fisher. Graham is best known for systematizing value investing in his textbooks The Intelligent Investor and Security Analysis. In essence, Graham’s approach is to buy a business at a discount to its underlying value, which value investors call ‘intrinsic value,’ as opposed to its market price. (I will discuss valuation more below). There were several screening tools he used; here are three: Graham would screen for companies that (a) trade at﹤2/3 net asset value, (b) trade at a low P/E ratio, and (c) could earn 5x fixed charges. We see that Graham is a highly cautious investor, dealing in companies that trade at a discount to their liquidation value, which is a function of his family’s experience during the Great Depression. (The Einstein of Money is a good biography of Graham.)

Phil Fisher’s investing philosophy (encapsulated in his Common Stocks and Uncommon Profits), part of which Buffett began to emulate at the urging of Munger, places more emphasis on the qualitative analysis of a company, not just how cheap its stock trades: e.g., its R&D, industry dynamics, growth prospects, the acumen of management, merchandising expertise, etc. This is in contradistinction to Graham, who often referred to his companies as cigar butts, i.e., those only promising one last puff. Thus, we say that Fisher considered growth, whereas Graham was only concerned with value. I found Fisher’s emphasis on non-dilutive growth to be noteworthy. Growth is considered dilutive when the company resorts to issuing more equity to finance its operations, which dilutes EPS. Fisher looks for companies that can internally finance their growth; we’ll see that Buffett, too, looks for companies that use retained earnings to fund growth, pay dividends, repurchase shares, etc.

In sum, we see a focus on a company’s fundamentals; there is no weight given to technical analysis or macro forecasts, which diverges from Wall Street’s MO. Indeed, Buffett’s investing style is often described as contrarian. We also see consideration given to a company’s growth prospects, but that growth is purchased with a concern for value. We should also note that actively managing a portfolio—buying and selling stocks because they are mispriced—is highly at odds with the notion of market efficiency, which is treated as dogma in academia (except at Yale, apparently). The efficient market hypothesis (EMH) maintains that all value-relevant information is priced in, thus any future price movements are random, (i.e., they cannot be predicted by an analyst), so Buffett’s success is attributed to luck. (That’s all I will say here regarding the EMH; I plan to review a book on it in the future.)

Investing: Theory and Application

In this section, I will describe key aspects of Buffett’s company analysis. Hagstrom provides the following taxonomy (ch. 4), which I will use to frame this section. There are four dimensions to Buffett’s investing style: business, management, market, and financial.

Business

Buffett invests in companies that he understands—companies that fall within his circle of competence. They have favorable long-term economics, consistent operating history, and competitive advantage (or “moat”). To illustrate the last of these, Buffett distinguishes between two types of businesses: franchises and commodity businesses. A franchise offers a product that is differentiated from its competitors, thus it has pricing power and higher margins. Conversely, a commodity business offers a product that is non-differentiated, thus it must compete by lowering costs, which means lower margins. (Note that this is standard Porter analysis.) A franchise can increase prices without losing market share, which is advantageous during an inflationary environment. Commodity businesses’ profits are largely dependent on tight supply. Demand constant, an increase in supply reduces industry profits (see Capital Returns by Edward Chancellor). Whether a business is a franchise or a commodity business has implications for management. For instance, commodity businesses have lower margins, which reduces the margin of error for incompetent management.

Management

Management is evaluated on the basis of their behavior. Buffett looks for management that is rational, and candid, and seeks to maximize shareholder value. The following behavior aims to improve shareholder value: cost discipline (no extravagant corporate offices or jets—one CEO even made his execs share a secretary!); share buybacks (appropriately priced) and dividend increases; wise capital allocation decisions, such as sensibly priced M&As; willingness to divest from unprofitable segments, cut a bloated workforce; ability to identify profitable investment opportunities, increase margins, and deleverage. Of the aforesaid, the two that recur the most often through the case studies are economizing costs and share buybacks. (Note that share buybacks are more tax-efficient than returning earnings to shareholders via dividends, though management should not retire shares if they are overpriced.)

Market (or Valuation)

Buffett determines the intrinsic value of a business by discounting cash flow. To be precise, Buffett discounts owner’s earnings (earnings plus depreciation and amortization, less capex). This requires that one determine the appropriate discount rate and estimate future earnings growth. Hagstrom notes that though most academics advise adding a equity risk premium to the risk-free rate, Buffett simply uses the interest rate on a 30-year treasury bond for the discount rate. Estimating future cash flows is more difficult—as Yogi Berra said, or is said to have said, “It’s tough making predictions, especially about the future.” Nonetheless, Buffett uses his business acumen to project future earnings growth. This step is dependent on many company-specific variables, e.g., capital intensity, management, industry dynamics, macro factors, company life cycle, etc. For instance, Hagstrom notes that a two-stage discount model was appropriate to value co*ke since there were two phases of compounding annual growth: 17.8% from 1981-88, 7.6% from 1988-92. In my view, forecasting future growth is the most difficult part of stock analysis, and it’s where Buffett’s genius is most conspicuous.

Financial

There are certain financial characteristics that Buffett screens for in a company. In no particular order: little to no debt, low capital intensity, high return on equity, and economic goodwill. Buffett distinguishes between accounting goodwill, which is amortized, and economic goodwill, which is not amortized. Examples of the latter include brand name, location, business connections, distribution systems, etc.—all of those intangibles that account for why the company trades above its book value. According to Hagstrom, Buffett is deterred by companies with a high ratio of fixed assets to sales, such companies are capital intensive and characterized by low margins; they can seldom afford to repurchase shares or increase dividends, and they underperform during inflationary periods due to rising capex.

Final Reflections

I’ve read biographies of Buffett, Munger, and Graham before; and I’ve read Fisher and a few books on value investing, but this book was the first time that I thoroughly studied Buffett’s investing philosophy. Hagstrom reinforced a few things from prior reads, namely, the importance of cost discipline and share buybacks—these demonstrate management’s commitment to shareholder value. In discussing Buffett’s Freddie Mac position, Hagstrom argued that the concern about the deterioration of underwriting standards in the mortgage industry was without foundation—a claim that didn't age well. But Buffett's suspicion that Freddie Mac was backed by government guarantee was correct. Indeed, the regulatory environment and the implicit guarantee constituted part of its competitive advantage.

Overall, I’m sympathetic to value investing—I have almost a puritanical disdain for speculative frenzies—but I’m less disposed to Buffett’s macro agnosticism. I’m cognizant of the hubris implied by the latter statement, and I know that hubris courts Nemesis, especially in the context of investing. But there are certain macro events that are too obvious to ignore, e.g., the 2020 monetary and fiscal stimulus → market mania → inflation → rate hikes → market crash. Someone will object that there was similar monetary and fiscal stimulus in 2008, but there was no inflation. But there were important differences that even I (three months into my grad program) noticed: (a) the fiscal stimulus went directly into the hands of consumers in 2020, whereas in 2008 it stayed in the banking system, which was reflected in Divisa aggregates; (b) in 2022, rent and debt moratoria improved consumers’ financial position, increasing inflationary pressure; (c) in 2022, supply shocks contributed to inflationary pressure; (d) in 2022, overgenerous unemployment resulted in a negative supply shock to the labor market, increasing inflationary pressure. None of this is to say, my God, that macro forecasting is easy. Only the obvious is easy; the rest is difficult! ;-)