This article is not investment advice. It is for educational purposes only.
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Investing is making financial bets on future states of the world. You either make or lose money depending on what you had at stake, and how the state of the world turned out to be vs. what you had predicted.
If investing is betting, investing successfully over the long term requires an edge. Without some sort of advantange on your side, your bets will, almost inevitably, end with ruin.
Strategies for finding and exploiting edges abound. I am most familiar with Warren Buffett’s approach, which I call the Buffett-Munger system — to recognize the fact that Charlie Munger contributed significantly to shape it.
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First and foremost, whenever buying a financial asset, Buffett seeks to make money from cash flows “produced” by the assets themselves — and not from a future sale of those assets at higher-than-initially-bought prices.
Because Buffett claims no insight about where stock prices are going to be in the near future. Having no insight on future movements of the market, he makes a conscious and deliberate effort to be “independent” from future prices.
This attitude is in stark contrast to how most people approach investing. Most people are trying to “buy low” and — crucially — “sell high”. What Buffett does is different. He also tries to “buy low”, but he wants the asset to pay itself. Selling is, therefore, much less important to his system.
There is a clear benefit in not relying on future prices. It greatly reduces the chances of being in the position of having to sell an asset at a potentially unfavorable price.
The idea seems interesting, but of course risk is not completely gone. Buffett only “shifts” it. He avoids the risk of relying on future buyers to sell at a higher price. But the risk of not earning a return because of underwhelming cash flows is still very much present.
Buffett is very aware of such a risk, and here is how he tries to minimize it:
For businesses in some specific circumstances, Buffett is extremely confident that he can predict, with a rough precision, the business owner’s earnings 10+ years out in the future
In other words, because Buffett doesn’t know much about where the market is going, he aims to make money independently of future prices of assets he owns. And the way he does that is by buying specific businesses whenever their prices seem attractive vs. their expected ability of generating future cash flows.
In many ways, this is just being conservative and applying common sense. Again, if one wants to make money while not depending on the capricious stock market, then the investment itself must pay you back in form of profits.
From the 2003 Berkshire Hathaway Annual Meeting:
If somebody gave me all 500 stocks in the S&P and I had to make some prediction about how they would behave relative to the market over the next couple years, I don’t know how I would do.
But maybe I can find one in there where I think I’m 90% in being right. This is an enormous advantage in stocks. You only have to be right on the very, very few things in your lifetime as long as you never make any big mistakes.
In the same 2003 Annual Meeting, he also said:
As a practical matter, there’s just some businesses that possess economic characteristics that make their future prospects far out far more predictable than others. There are all kinds of businesses that you just can’t remotely predict what they’ll earn, and you just have to forget about them.
But can he really predict the future cash flows of the kinds of businesses he buys?
The world is ever changing. How on earth can anyone predict decades ahead? And do that consistently — even if for just a few stocks?
Well, if we take Buffett’s astonishing track record as evidence, it does seem he is doing something quite correctly.
It turns out there are several tricks that Buffett employs to make such a daunting task possible. Chiefly, he is very picky about the specific circumstances surrounding the businesses he considers investing in.
What does Buffett have in mind when selecting investment candidates? An asset must pass several filters. The key ones1 are:
A businesses. Buffett strongly prefers to invest in businesses. He buys either a portion (via the stock market) or 100%. He shies away from gold because it is not a cash generating asset (same for other commodities). He finds real estate too hard to find mispriced opportunities and avoid it as well. The exception to business is bonds. Eventually, he takes advantage of large price dislocations in bonds, but most of the time he is out of fixed income market.
Businesses that he deeply understands. He invests only in businesses he thinks he is an expert on. He famously says that the subset of businesses that he understands well are within his circle of competence.
Businesses with deep and wide moats. Moats are durable competitive advantages. Buffett looks for them because they make forecasting easier. It is a trick to be more confident in extrapolating the present into the future with less chance of being too optimistic. In other words, if a business has a enduring moat, Buffett is more confident this business’ competitive dynamics are going to stay largely the same and earnings over decades will be less affected by competition.
Businesses ran by competent and honest people. Buffett is admittedly hands-off, in Berkshire he does capital allocation and that’s pretty much it. So, when buying an entire businesses, Buffett seeks to keep the current management in place. And when investing in the public markets, he says he looks for candid and capable management. In either case, he needs to trust the management because, again, predicting the future is hard enough. Dealing with incompetent or mischievous people would make it nearly impossible. Ideally, Buffett looks for managers who are independently wealthy (and therefore didn’t need to be there) but who deliberately chose to continue running the business because there is nothing else they would rather do (they love it).
From the 1999 Annual Letter:
As I mentioned earlier, several of the companies in which we have large investments had disappointing business results last year. Nevertheless, we believe these companies have important competitive advantages that will endure over time. This attribute, which makes for good long-term investment results, is one Charlie and I occasionally believe we can identify.
More often, however, we can’t — not at least with a high degree of conviction. This explains, by the way, why we don’t own stocks of tech companies, even though we share the general view that our society will be transformed by their products and services. Our problem — which we can’t solve by studying up — is that we have no insights into which participants in the tech field possess a truly durable competitive advantage.
Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie and I have no special capital-allocation expertise. For instance, we bring nothing to the table when itcomes to evaluating patents, manufacturing processes or geological prospects. So we simply don’t get into judgments in those fields.
Buffett’s advantages in investing stem not only from being able to predict the future of businesses in specific circumstances.
He thinks deeply about risks and seeks to protect himself from all sorts of adverse situations. For example, we have just learned that because he does not need to sell higher, he effectively avoids to be at the mercy of the market.
Over the years, he has also worked to mitigate several other risks that negatively affect any investor. As a matter of fact, in Berkshire Hathaway, Buffett has devised an ingenious “machine” that provides him an upper hand on several facets of investing.
Here is a set of structural advantages he holds when dealing with the “market”:
Avoid debt, prefer float. To avoid having to deal with obligations (either roll over debt or service it) in unknown market conditions (which could snowball against him), Buffett avoids debt altogether and instead gets “leverage” from insurance float (under the terms that Berkshire itself underwrites, and therefore “controls”)
Avoid “timed” offerings. To avoid transactions deliberately timed by executives and investment bankers, Buffett tends to steer clear from new offerrings, and focus instead on buying stocks at open market (where he can choose the moment to act)
When purchasing entire businesses, buy only from sellers who want to sell. To avoid getting into auctions (and bidding wars) when buying private companies, Buffett never makes the open move, he instead asks for every seller to state their offering price
Positive selection of sellers, stemming from their stellar reputation. To attract the right kind of sellers (and avoid adverse selection), he does not engage in unsolicited transactions. Instead, he has built Berkshire’s reputation as a safe harbor for private businesses (i.e., they are a buyer that “never” sells, that doesn’t touch on debt, etc)
The excerpts below has Buffett explaining in more detail Berkshire’s thoughtful approach to leverage — via insurance float and deferred income taxes:
From his 2020 Annual Letter:
Berkshire now enjoys $138 billion of insurance “float” — funds that do not belong to us, but are nevertheless ours to deploy, whether in bonds, stocks or cash equivalents such as U.S. Treasury bills.
Float has some similarities to bank deposits: cash flows in and out daily to insurers, with the total they hold changing very little.
The massive sum held by Berkshire is likely to remain near its present level for many years and, on a cumulative basis, has been costless to us. That happy result, of course, could change — but, over time, I like our odds.
And from the 2018 Annual Letter:
This collect-now, pay-later model leaves P/C [property and casualty insurance] companies holding large sums — money we call “float” — that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float.
We may in time experience a decline in float. If so, the decline will be very gradual — at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. That structure is by design and is a key component in the unequaled financial strength of our insurance companies. That strength will never be compromised.
If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money — and, better yet, get paid for holding it.
From the 2018 Annual Letter:
We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time.
At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian-roulette equation — usually win, occasionally die — may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don’t risk what they have and need for what they don’t have and don’t need.
Beyond using debt and equity, Berkshire has benefitted in a major way from two less-common sources of corporate funding. The larger is the float I have described. So far, those funds, though they are recorded as a huge net liability on our balance sheet, have been of more utility to us than an equivalent amount of equity. That’s because they have usually been accompanied by underwriting earnings. In effect, we have been paid in most years for holding and using other people’s money.
As I have often done before, I will emphasize that this happy outcome is far from a sure thing: Mistakes in assessing insurance risks can be huge and can take many years to surface. (Think asbestos.) A major catastrophe that will dwarf hurricanes Katrina and Michael will occur — perhaps tomorrow, perhaps many decades from now. “The Big One” may come from a traditional source, such as a hurricane or earthquake, or it may be a total surprise involving, say, a cyber attack having disastrous consequences beyond anything insurers now contemplate. When such a mega-catastrophe strikes, we will get our share of the losses and they will be big — very big. Unlike many other insurers, however, we will be looking to add business the next day.
The final funding source — which again Berkshire possesses to an unusual degree — is deferred income taxes. These are liabilities that we will eventually pay but that are meanwhile interest-free.
As I indicated earlier, about $14.7 billion of our $50.5 billion of deferred taxes arises from the unrealized gains in our equity holdings. These liabilities are accrued in our financial statements at the current 21% corporate tax rate but will be paid at the rates prevailing when our investments are sold. Between now and then, we in effect have an interest-free “loan” that allows us to have more money working for us in equities than would otherwise be the case.
A further $28.3 billion of deferred tax results from our being able to accelerate the depreciation of assets such as plant and equipment in calculating the tax we must currently pay. The front-ended savings in taxes that we record gradually reverse in future years. We regularly purchase additional assets, however. As long as the present tax law prevails, this source of funding should trend upward.
(Here is a short article by QuickBooks with a few examples of deferred taxes.)
And here’s how Buffett articulates the value proposition of Berkshire for prospective sellers (connected to items #3 and #4 above):
Berkshire offers to the business owner who wishes to sell: a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed). Beyond that, any business we acquire dramatically increases its financial strength and ability to grow. Its days of dealing with banks and Wall Street analysts are also forever ended.
Another important consequence of their approach to risk minimization is that Berkshire has been able to move decisively when others simply can’t.
We have some significant advantages in buying businesses over time. We would be the preferred purchaser, I think, for a reasonable number of private companies and public companies as well.
Our checks clear. We will always have the money. People know that when we make a deal, it will get done, and it will get done as fast as anybody can do it. It won’t be subject to any kind of second thoughts or financing difficulties. And we bought, as you know, we bought Johns Manville because the other group had financing difficulties.
People know they will get to run their businesses as they’ve run them before, if they care about that, and a lot of people do. Others don’t.
We have an ownership structure that is probably more stable than any company our size, or anywhere near our size, in the country. And that’s attractive to people.
And we are under no pressure to do anything dumb. You know, if we do things dumb, it’s because we do things dumb. It’s not because anybody’s making us do it.
So those are significant advantages. And the disadvantage, the biggest disadvantage we have is size. I mean, it is harder to double the market value of a $100 billion company than a $1 billion company, using what we have in our arsenal.
Charlie: Yeah. This is not a hog heaven period for Berkshire. The investment game is getting more and more competitive. And I see no sign that that is going to change.
Warren: But people will do stupid things in the future. There’s no question. I mean, I will guarantee you sometime in the next 20 years that people will do some exceptionally stupid things in equity markets.
And then the question is, are we in a position to do something about that when that happens? But we do continue to prefer to buy businesses, though. That’s what we really enjoy.
What is the net result of having less exposure to risks?
Having less “things that could go wrong” means that you have actually increased your chances of having “things that could well.”
But that’s not all with Buffett.
When it comes to actually pulling the trigger and making an investment, Buffett does two additional things very well.
Firstly, Buffett treats every investment as a capital allocation decision that bears opportunity cost.
Before making any investment Buffett always consider all competing alternatives, including doing nothing and simply holding cash until something more certain appears.
From the 1997 Berkshire Hathaway Annual Meeting:
Charlie: I would argue that one filter that’s useful in investing is the simple idea of opportunity cost. If you have one opportunity that you already have available in large quantity and you like it better than 98% of the other things you see, you can just screen out the other 98% because you already know something better.
Warren: If somebody shows us a business, the first thing goes through our head is: Would we rather own this business or more Coca-Cola? Would we rather own it than more Gillette? It’s crazy not to compare it to things that you’re [already] very certain of. There are very few businesses that you will find that we’re a certain of the future about as company such as that. And therefore we will want [new] companies where the certainty gets close to that.
Charlie: With this attitude you get a concentrated portfolio, which we don’t mind. This practice of ours, which is so simple, is not widely copied. I do not know why.
In fact, because Berkshire is a diversified conglomerate able to play both in the private and public markets, he has a much broader universe to pick from (vs. most other insurers, vs. other professional money managers, etc).
And secondly and crucially, he is particularly disciplined on the price he buys anything. He seeks to buy only when he is indeed highly confident that the opportunity at hand meets his criteria.
This is yet another act to mitigate the risk of losing money. To reduce his chances of losing money due to predictions that might turn out to be too optimistic, Buffett seeks to buy only when there is a significant difference between his estimate of an asset’s intrinsic value vs. its current selling price.
Whenever he discusses this point, Buffett often refers to Ben Graham’s concept of margin of safety. He also draws an analogy between the stock market and baseball.
From the 2017 documentary Becoming Warren Buffett:
I was genetically blessed with a certain wiring that’s very useful in a highly developed market system, where there’s lots of chips on the table. I happened to be good at that game.
Ted Williams wrote a book called The Science of Hitting. In that, he had a picture of himself at bat, and the strike zone broken into, I think, 77 squares. He said that if he waited for the pitch that was really in the sweet spot, he would bat 0.400. And if he had to swing at something on the lower corner, he would probably bat 0.235.
In investing, I’m in a “no-called strike” business, which is the best business you can be. I can look at a thousand different companies, and I don’t have to be right on every one of them. Or even 50 of them. So I can pick the ball I want to hit.
The trick in investing is just to sit there and watch pitch after pitch go by — wait for the one right in your sweet spot.
[As for] people yelling “Swing, you bump”, [simply] ignore them. There’s a temptation for people to act far too frequently in stocks simply because they’re so liquid.
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There you have it — my current understanding of Warren Buffett and Charlie Munger’s remarkable investing system.
Now, read how Buffett and Munger themselves have described their approach to investing over the decades.
Up next: The Buffett-Munger system in their own words.
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Clearly, the four filters that I have listed are somewhat intertwined. And all of them, in a way or another, tie back to the question of predictability. For instance, what is a business he “understands”? It is, of course, one that he can confidently predict their owner’s earnings decades ahead! ↩