In Warren Buffett’s annual letters to Berkshire shareholders, Buffett consistently repeats that Berkshire’s goal is to purchase, at a sensible/fair price, businesses with excellent, sustainable economics (enduring competitive advantages) and honest, able management.
The more average or commodity-like the business, the better management must be. In his 1994 letter to shareholders, Buffett talks about Scott Fetzer’s excellent performance following Berkshire’s acquisition, which he attributes not to monopoly-like business strength but to managerial excellence:
“Scott Fetzer’s earnings have increased steadily since we bought it, but book value has not grown commensurately. Consequently, return on equity, which was exceptional at the time of our purchase, has now become truly extraordinary. . . .
You might expect that Scott Fetzer’s success could only be explained by a cyclical peak in earnings, a monopolistic position, or leverage. But no such circumstances apply. Rather, the company’s success comes from the managerial expertise of CEO Ralph Schey . . . .
The reasons for Ralph’s success are not complicated. Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results. In later life, I have been surprised to find that this statement holds true in business management as well. What a manager must do is handle the basics well and not get diverted. That’s precisely Ralph’s formula. He establishes the right goal and never forgets when he set out to do.”
Buffett’s favorite businesses have both excellent, sustainable economics and excellent management, and include Berkshire investments like Coca-Cola (hard-to-copy product), GEICO (hard-to-copy low cost business model), and See’s Candies (hard-to-copy product). He says it’s better to own a business with both sustainable economics and excellent management, because at some point management will change and a business with sustainable economics will survive even if the new management isn’t as good. Buffett covers some of this subject in his 1995 annual letter, in a comment on retailers (Berkshire owns a few):
“Buying a retailer without good management is like buying the Eiffel Tower without an elevator. . . .
Retailing is a tough business. During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy. This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is always copying and then topping whatever you do. Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants. In retailing, to coast is to fail.
In contrast to this have-to-be-smart-every-day business, there is what I call the have-to-be-smart-once business. For example, if you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades. . . .”
In his letters Buffett repeatedly emphasizes how simple his investing formula is. The following comes from his 1994 annual letter:
“Our investments continue to be few in number and simple in concept: The truly big investment idea can usually be explained in a short paragraph. We like a business with enduring competitive advantages that is run by able and owner-oriented people. When these attributes exist, and when we can make purchases at sensible prices, it is hard to go wrong (a challenge we periodically manage to overcome).
Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.
We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?”
Finally, consistent with the notion of only making informed, rational decisions, rather than engaging in guesswork, Buffett doesn’t try to value most companies. He only tries to value simple, understandable businesses with highly predictable, sustainable earnings. Applying DCF analysis to these prospects, he calculates intrinsic value by discounting future cash flows and preparing a range of rough estimates. He uses the long term T-bill rate as his discount factor.
Buffett trained under Benjamin Graham, but he’s largely moved away from investing based on multiples of earnings, cash flow, or book value. Thus the following quote from his 1994 annual letter:
“We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.”
Consistent with this quote, Buffett has said that “value investing” is a misnomer, since all investing based on intrinsic value and discounted future cash flows is a form of value investing (regardless of whether an earnings multiple suggests the investment prospect is a cigar butt or a growth stock). The key is that Buffett doesn’t try to apply DCF analysis to companies with unpredictable, unsustainable earnings —- if there’s too much uncertainty in the future earnings stream, Buffett just moves on to the next prospect. This is one reason he feels it’s okay to use the long term T-bill rate to discount his investment prospects — in his mind, he’s not investing in prospects with risky or uncertain future earnings.
A related point is Buffett’s repeated reference to buying wonderful businesses at fair prices rather than fair businesses at wonderful prices. This mindset drives the following language from his 1996 annual letter to Berkshire shareholders:
“Over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company. . . .
[T]he longer a shareholder holds his shares, the more bearing Berkshire’s business results will have on his financial experience — and the less it will matter what premium or discount to intrinsic value prevails when he buys and sells his stock. . . .“
This long term approach allows Buffett to defer capital gains taxes and get the full benefit of his investment’s long term, upward trajectory, making the passage of time his friend rather than his enemy. Hence Buffett focuses on long term, future earnings streams rather than past, current, or near-term earnings. In his 1994 annual letter Buffett discusses this point in the context of mergers and acquisitions:
“[I]n contemplating business mergers and acquisitions, many managers tend to focus on whether the transaction is immediately dilutive or anti-dilutive to earnings per share (or, at financial institutions, to per-share book value). An emphasis of this sort carries great dangers. Going back to our college-education example, imagine that a 25-year-old first-year MBA student is considering merging his future economic interests with those of a 25-year-old day laborer. The MBA student, a non-earner, would find that a ’share-for-share’ merger of his equity interest in himself with that of the day laborer would enhance his near-term earnings (in a big way!). But what could be sillier for the student than a deal of this kind?
In corporate transactions, it’s equally silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value. Our approach, rather, has been to follow Wayne Gretzky’s advice: ‘Go to where the puck is going to be, not to where it is.’ As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism.”
With many low PE or cigar butt companies, future business prospects are often so uncertain that it’s impossible to evaluate the most relevant determinant of intrinsic value: future earnings streams. In assessing whether a cigar butt is undervalued, the investor is effectively forced to rely on quickly changing multiples like PE or price to cash flow, which place most of the weight on past, current, or near-term earnings and give little to no weight to long term future earnings and “where the puck is going to be.” Buffett appears unwilling to accept this kind of short-term, rear-view focus, and he clearly believes Berkshire has benefitted — by “many billions of dollars“ — by instead focusing on whether a company has a long term, future earnings stream that’s defensible and predictable, with attractive future returns on equity and invested capital.
Below are some combined tweets I recently posted on these subjects. My comments assume it’s possible to estimate the “fair value” of a cigar butt, but for reasons detailed above, the future earnings of a troubled company are often too uncertain to estimate intrinsic value using DCF analysis. In assessing a cigar butt’s value, earnings and cash flow multiples, while imperfect, are often the best alternative:
“@JohnHuber72 One interesting thing about Buffett’s permanent holding approach is that after you’ve bought a great company at a fair/undervalued price, you can ignore the stock’s volatility because you’re not trying to make money on short term swings. Instead, your investment thesis rests on the long term success of the company, making it much easier to ignore short term swings. Another thing I remember is Phil Fisher’s line about the relative benefits of buy and hold approaches (like Buffett’s). It’s not that you can’t make money with approaches other than buying and holding forever, but you’re unlikely to make as much. So cigar butt investing works fine (exploiting volatility), but buy and hold forever works better if you can identify great companies with moats and buy in at a fair price. . . .
@beardedactuary @Greenbackd Great tweet! My only comment would be that with wonderful company at fair price — one generating high ROIC and allocating capital wisely — you may never have to sell the company (even if it’s a bit overvalued). So low cap gains tax and no angst over when to sell. With fair company at wonderful price you usually have to sell at close to fair value because the company’s long term prospects are questionable and ROIC’s aren’t great. Also, if you buy a cigar butt at too close to fair value you can’t just hold it & make money (since long term prospects are bad). If you buy a wonderful company at fair value & are patient, you can still make money over long term & relevance of purchase price decreases over time. Hence Buffett’s quote, which I never fully understood until recently, ‘time is the friend of the wonderful business, the enemy of the bad business.’”
The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.