Investors using DCF analysis to make concentrated investments in companies selling below estimated present value must be careful to avoid (1) companies they don’t fully understand and (2) companies with uncertain prospects over the next 10 to 20 years. When Charlie Munger and Warren Buffett look for investments to concentrate in, they put companies in the “too hard” pile unless they meet both these criteria. Very few companies make the cut, and Buffett is willing to wait a long time for the right prospect at a fair price. Citing Ted Williams, Buffett says he gets his results by only swinging at fat pitches in his “happy zone” — otherwise he keeps the bat on his shoulder.
I think the too hard concept — and the importance of patience — is often forgotten or ignored by investors trying to imitate Buffett’s concentrated approach. Impatient for returns, these investors apply DCF analysis, and estimate future earnings, even though they don’t understand the business and therefore can’t assess earnings resilience and competitive threats. An investor may also understand the current business but still be uncertain of future prospects because the company lacks a unique, defensible strategy — a competitive moat — or because the product or industry changes too fast due to competition or new technologies. Despite these issues, many investors project long term earnings, incorporate these figures into present value estimates, and make concentrated investments in companies that should be placed in the too hard pile. Lacking patience, they swing at bad pitches. Mistakes like these can devastate the value of a concentrated portfolio.
You could argue that Buffett’s best investments have generally been in companies with the simplest businesses and the clearest long term prospects. Coca-Cola, See’s Candies, and GEICO come to mind — all simple businesses with wide competitive moats and very long runways of profitable, predictable demand (especially when Buffett made his original purchases). Buffett has encountered trouble when the business is more complicated, the competitive moat isn’t obvious, and long term demand is less clear: IBM, Oracle, U.S. Air, Solomon Brothers, and even Wells Fargo (with its more recent troubles) quickly come to mind.
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.