In honor of Warren Buffett’s 95th birthday, here are five timeless investing lessons I’ve learned from studying his remarkable career.
1. The Importance of Permanent Capital
One of the most overlooked aspects of Warren Buffett’s career is the institutional structure of his investment vehicle, Berkshire Hathaway, Inc.
By investing through a publicly traded holding company, rather than a mutual fund or hedge fund, Buffett didn’t have to worry about investor redemption’s. This allowed Buffett to have a long-term focus which he would not have had in a typical investment fund.
Yes, Buffett started his investment career managing a private partnership, or what we might call today a hedge fund. He managed the private fund from 1956 until 1969.
In 1962, the Buffett Partnership bought into a New England textile manufacturer called Berkshire Hathaway, Inc. Within several years, the Buffett Partnership had a controlling interest in the company. To Buffett, the once-thriving Berkshire was a “cigar butt” investment whose only good quality was a bargain price:
“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.”
When Buffett shuttered the partnership in 1969, partners were given the option of redeeming their interests in cash or in shares of Berkshire Hathaway. Although Buffett didn’t indicate his plans for the company, he did indicate that he would be taking shares in Berkshire. Smart investors took the stock and remained invested with Buffett in what would become his new, and highly superior, investment vehicle.
Buffett recognized that the textile business was in terminal decline and that it made more sense to diversify into other industries with better economics. In 1967, Berkshire acquired an insurance company called National Indemnity.
Insurers had a particular appeal to Buffett. Insurers generate “float,” meaning that they collect premiums upfront but pay out claims later. In the meantime, insurers can invest the float and keep the investment profits. Buffett used the float and underwriting profits from National Indemnity to acquire operating businesses and invest in common stock. The operating profits from those businesses enhanced Buffett’s capital base, creating a virtuous feedback loop of capital which Buffett has deployed successfully over many decades.
2. Insistence on a Margin of Safety
Buffett studied under and later worked for Benjamin Graham – the man considered the “father of value investing.”
Graham’s key innovation was a concept known as the margin of safety. According to Graham, the margin of safety is “… a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck.”
Buffett took this lesson to heart and has employed it throughout his investment career. To Buffett, long-term compounding requires the mitigation of risk, and the margin of safety concept is a key instrument for protecting the investor’s capital:
“… we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”
3. How to View Stock Prices
Another insight that Buffett learned from Graham is the attitude which investors should have regarding public stock prices:
“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.”
As I discussed in a earlier post Investment vs. Speculation: Investing Defined, understanding fundamentals is key to knowing whether the market’s price swings represent opportunity or risk. Mr. Market will usually quote a fair price—i.e., a price reflecting underlying business fundamentals. But at times, the price can be very irrational:
“…the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high price ….. At other times he is depressed and can see nothing but trouble ahead …. On these occasions he will name a very low price…”
The key is how an investor reacts to Mr. Market’s actions:
“… Mr. Market is there to serve you, not guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”
4. Placing Emphasis on Business Quality
Buffett evolved as an investor. Whereas Graham was interested in “statistical bargains,” Buffett became more interested in businesses that have durable competitive advantages, what Buffett calls an “economic moat.” An economic moat is a company’s durable competitive advantage—something that keeps rivals at bay and protects long-term profits. Buffett conducted comprehensive fundamental business analysis that incorporated qualitative and quantitative considerations.
Buffett realized that companies with strong economic moats could generate significant cash flows which could either be reinvested in the business at high rates of return or redeployed into other investments.
Arguably the major turning point in Buffett’s thinking was the 1972 acquisition of See’s Candies. The owners of See’s were asking $30 million for the business. Buffett was still glued to the narrow definition of business value that he learned from Graham, and the price represented a significant premium over book value. But Buffett’s partner, Charlie Munger, convinced Buffett to make a serious offer. Buffett acquired the company through a Berkshire Hathaway subsidiary for $25 million, or about three times book value.
See’s Candies had a very loyal following throughout California. The product loyalty allowed See’s to consistently raise prices, while having to deploy relatively little capital back into the business. Over the years, See’s has generated many billions of dollars of operating profits, which Buffett has reinvested in other opportunities.
5. Strength of Conviction
Buffett always differed from other investment managers in his willingness to make concentrated bets. This was the case even when Buffett ran his investment partnership.
In 1964, shares of American Express dropped precipitously as a result of the “salad oil scandal.” At the time, American Express had a warehousing subsidiary which issued receipts verifying the existence of barrels of salad oil. This inventory was used by the owner to take out millions of dollars in loans. It was later revealed that the barrels contained mostly seawater, with a foot or so of salad oil on top to fool inspectors. The revelation left American Express with tens of millions in liabilities. The stock sank as a result.
Buffett sensed a bargain. He visited a local steakhouse and sat behind the counter, watching how many customers continued to use their American Express cards. Reasoning that customer loyalty for American Express’s main credit card and traveler check businesses was still intact, Buffett put 25% of the partnership assets into American Express stock, reaping a significant gain when he later sold the stock.
Few investment managers would have made such a bet, preferring instead to embrace the comfort wide diversification. But Buffett has engaged in many such concentrated bets over the years. On portfolio concentration, Buffett states:
“We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”
These are just a handful of the many lessons Warren Buffett has shared throughout his career. For even more wisdom, you can check out The Essays of Warren Buffett which I have reviewed for you. When once asked how he’d like to be remembered, Buffett simply said: “as a teacher.” And it’s true—his lessons will continue to guide investors for generations to come.
