Superb businesses
As if we were buying into a private business
The topic today is investors’ mindset when constructing a portfolio of equities in the stock market. Do investors think they are investing in stocks or do they think they are investing in businesses. There is a world of difference. Although it is not easy to see the distinction.
Let’s start with a quote from Warren Buffett from 1987: “Whenever Charlie and I buy common stocks… we approach the transaction as if we were buying into a private business.”
He explains: “We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.”
In a nutshell: “When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Lawrence A. Cunningham, The Essays of Warren Buffett: Lessons for Corporate America, 1998) p63 cited as (Buffett, 1998).
A failure to check it out
That all sounds sensible but many investors, including many professionals, completely fail to carry out reasonable due diligence into the business as opposed to the stock. And I think I know why.
Many investors will do more spadework when looking to buy a new car than they will when buying shares in a public company. We know we will own the car for many years. We better get it right. When buying a house we think about the neighborhood, check out schools, look at umpteen prospective houses, get a condition report and much more. We know we will own the house for many years.
When buying shares on the stock market many investors will content themselves with advice from a friend or broker, read a story in a newspaper or on the internet, note the fact the company is a household name, note that the products or services are pretty good and take a quick look at an analyst’s report and its projected sales and earnings growth for the next year or two. Analysts reports contain target prices which almost unfailingly suggest handsome returns over the next twelve months.
At this point they figure they like the stock and can go ahead and buy at the market price.
Sadly, they will never have made the effort to truly understand the business nor do they have any idea whether they are buying the stock at a very attractive price relative to fair value.
Here’s why
I think most investors think themselves incapable of carrying out the business analysis. What’s more, with the tip, advice, like the product and sell/side report they figure the homework is done.
Not so. In truth, carrying out a business analysis is no more difficult than checking out a potential house purchase or a new car. And critically important, the investor must do it themselves. Only laziness stands in the way.
I leave the issue of fair value is for another day.
Back to Warren Buffett on business analysis
He tells us: “Our equity-investing strategy remains little changed from what it was…when we said in the 1977 annual report: ‘We select our marketable equity securities in much the way we would evaluate a business for acquisition it its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and, (d) available at a very attractive price.’ We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, 1998, p.85) (Emphasis added)
As an aside, I would point out that the individual investor is not bothered by the ‘size’ constraint placed on Berkshire Hathaway’s equity investing. At the time of writing this Berkshire Hathaway has a portfolio with a market price of hundreds of billions of dollars. To make large enough equity investments to move the needle Berkshire Hathaway is seriously restricted in the size of companies it can invest in. So, for Berkshire, buying a “meaningful amount of stock” is a substantial challenge.
The idea that we invest only in businesses we understand is straightforward enough. It means not only understanding the product or service but also how the company goes about making money. Buffett always used to shy away from high tech businesses on the theory he didn’t understand them. At the same time, he was comfortable with financial services companies like American Express and Geico. He understood the soft drink business with a major position in Coca Cola where the business was easy to understand and the economics of the business were easy to understand, and so on.
Favorable long-term-prospects is easier to say than assess. Let’s turn to some words of wisdom from a great 16th century real estate investor William Shakespeare:
“If you can look into the seeds of time,
And say which grain will grow and which will not,
Speak then to me.”
– Macbeth, Act 1, Scene 3
Who indeed? Who is to know which seeds will grow? This is a subject that turns on Buffett’s notion of business moats, generation of excess capital through high returns on invested capital and businesses with opportunities to invest back in the business at high rates of return.
So back to the quote at the beginning of this post: “Whenever Charlie and I buy common stocks… we approach the transaction as if we were buying into a private business.”
Conclusion
If you are buying a car or a house you have a certain mindset. You are going to become an owner. You will be stuck with it for a long while. Better get it right. That is why Buffett approaches investing “as if we were buying into a private business.” You are not going to be selling it anytime soon. Do your homework. Make sure you understand the business: how it makes its money; how profitable it is; the strength of its business franchise, the opportunities it has to reinvest excess capital (free cash flow) back in the business at high rates of return. It takes a little effort but it pays off.
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A related post that goes a little deeper, including thoughts about management:
The tenets of companies Buffett invests in
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For readers wanting to study up on this subject, take a look at the Motherlode Chapter 31. General approach to choosing common stocks
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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