Buffett's best: The 5 factors of investment success
I’ve always been a believer that while we all need to live our own life and carve out our own niche, learning from the best goes a long way to helping us reach our full potential. This is a philosophy that rings especially true when it comes to investing. Which of course leads me to the oracle of Omaha, Warren Buffett.
My entry into the world of investing is about as clichéd as it gets. Around the turn of the century, I picked up a book written about Warren Buffett and his investing philosophy. Thousands of Buffett-related pages and more than two decades later, I’ve recently had some time to reflect on some of Buffett’s greatest teachings. Such is the magnitude of his contribution to the world of investing, this could be a tome of epic proportions. Instead, I’ve attempted to distil all these learnings into the five key factors of investment success.
I’ll admit that this is purely from my own personal perspective and that a multitude of Buffett’s other teachings could make the list. But of all the investment-related lessons handed out by Buffett, it’s these that have impacted me the most. At the same time, I’ll also attempt to bring in some context for the Australian investor. It’s therefore my hope that these five lessons can help you on your own investing journey too:
- The snowball started with small caps
- A principled approach to management
- Buy commodities, sell brands
- How to think about macro
- The power of focus
1. The snowball started with small caps
Small caps, big opportunities
Once upon a time, Berkshire Hathaway (NYSE: BRK.A) was a small-cap, and an underperforming one at that. When Buffett first bought Berkshire Hathaway stock in the early to mid-1960s, he paid between $7.60 and $14.86 per share. Today, Berkshire Hathaway stock trades for about $500,000 per share (USD).
However, long before the Buffett-controlled Berkshire Hathaway juggernaut got moving, he made his start as a fund manager running several investment partnerships, in aggregate named ‘Buffett Partnership Limited’ (BPL). Family and friends contributed $105,000 in seed capital, while the man himself put in $100. While earlier partnerships had slightly differing fee structures, by the early 1960s all were operating with one uniform approach: BPL would charge no management fees but would charge a performance fee equivalent to 25% of the return above a 6% hurdle.
The early musings of Buffett, gleaned from BPL letters written between 1957 and 1970, highlighted several factors that became the cornerstone of Buffett’s breakthrough success. The first consistent message was that “primary attention is given at all times to the detection of substantially undervalued securities.” (BPL 1957 letter, page 1). Regardless of what was happening in the world, Buffett’s enduring focus was on finding value, wherever it may lie. And more often than not, it was to be found in small caps.
Though Buffett would often shy away from identifying his ‘general’ type investments (note: this was the term Buffett used to describe generally undervalued securities where he had nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself) publicly, he did provide a couple of early insights into stock selection. The BPL letter of 1958 introduced a ‘typical situation’ in the form of the partnership’s largest investment at that time, the obscure Commonwealth Trust Co. of Union City, New Jersey, a small regional bank. The rationale was simple enough:
At the time we started to purchase the stock, it had an intrinsic value $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend at all despite earnings of about $10 per share which was largely responsible for a depressed price of about $50 per share. So here we had a very well managed bank with substantial earnings power selling at a large discount from intrinsic value.
Thus we had a combination of 1. Very strong defensive characteristics; 2. Good solid value building up at a satisfactory pace and; 3. Evidence to the effect that eventually this value would be unlocked although it might be one year or ten years. If the latter were true, the value would presumably have been built up to a considerably larger figure, say, $250 per share.
In an Australian context, Buffett's Commonwealth Trust investment would be akin to buying a less liquid version of the regional bank MyState (ASX: MYS) on 5 times earnings, or about $1.95 per share. MYS currently trades at $4.88 per share.
Subsequently in the 1960 BPL letter to investors, Buffett detailed his thesis for his investment in Sanborn Map Co, another obscure small cap where he would seek to influence the company’s capital management. Sanborn’s core business serviced insurance companies and was a publisher of extremely detailed maps of all cities of the United States, though ultimately the investment was an asset play. Buffett explains:
During the early 1930's Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project.
In 1958, Sanborn sold at $45 per share. Yet during that same period (1938 - 1958), the value of the Sanborn investment portfolio increased from about $20 per share to $65 per share. In 1958 the map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.
Incredibly, 35% of BPL’s assets were invested in Sanborn at that time. It was a high conviction play that ultimately paid handsomely for Buffett and his co-investors.
To provide a contemporary Australian flavour to the above example, we could consider Brickworks (ASX: BKW), whose current market capitalisation approximates $3.5bn.
Although involved in the manufacture and distribution of building products for the best part of a century, BKW today has much more capital deployed in its two other divisions: Investments and Industrial Property. Buffett’s purchase of Sanborn at $45 per share would be roughly equivalent to buying BKW at about $15 per share. The latter today trades at about $23.64 per share.
Later on, as Berkshire Hathaway was garnering more attention, Buffett acknowledged the diseconomies of scale that can come with managing very large amounts of capital. In the 1983 Annual Report, he noted:
Our long-term economic goal is to maximize Berkshire’s average annual rate of gain in intrinsic value on a per-share basis.
We are certain that the rate of per share progress will diminish in the future - a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.
Size often kills relative returns, even for the very best. The following two tables provide a useful illustration of this and compares BPL’s first 12 years of returns to Berkshire’s most recent 12 years.
Figure 1: Buffett Partnership Relative Results 1957 - 1968.
Source: Buffett Partnership Letters.
Figure 2: Berkshire Hathaway Relative Results 2010 - 2021.
Source: Berkshire Hathaway 2021 Annual Report
In his own words, Buffett ‘killed the Dow’ in the early days, and in 1999 told investors ‘It’s a huge structural advantage not to have a lot of money’.
In the first 12 years of its operation, BPL outperformed the Dow by a simple average of 15.5% per annum (net outperformance). Whilst the modern colossus that is Berkshire Hathaway has done solidly over the past 12 years, relative returns have been far less exciting.
The implication for individual investors? Consider the amount of capital your domestic fund managers are currently managing.
Some are so large they simply can't invest in the small-cap space, thus depriving you of the chance for meaningful outperformance over time. More ‘DIY’ style investors may wish to roll up their own sleeves to research the small-cap space. Others may wish to consider an allocation to a high-quality small-cap manager. In the latter instance, one further question should also be asked: does your small-cap manager have a policy on fund capacity?
2. A principled approach to management
The concept of management encompasses a great deal for investors. At a company level, assessments need to be made about those who are entrusted with our capital to manage operations sensibly, inclusive of capital management decisions. At a personal level, there’s our own investment management generally linked to style, people and process. Over the years, Buffett has had a great deal to say on such matters.
Buffett is well known as a man of principle, someone who highly values integrity. His views on what to look for in management are perhaps summed in the following quip, famously noting:
Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don't have the first, the other two will kill you. You think about it; it's true. If you hire somebody without integrity, you really want them to be dumb and lazy.
There are few things more satisfying in life than going on a journey with high-quality people. This is certainly the case when it comes to investing. Intelligent owner-managers and founders that are meaningfully invested alongside you, that treat you as an owner, are more likely to deliver better outcomes for minority investors.
Thankfully there’s a healthy list of Australian examples, including ARB Corp’s (ASX: ARB) Brown family, Goodman Group’s (ASX: GMG) Greg Goodman, Hansen Technologies’ (ASX: HSN) Andrew Hansen, Jumbo Interactive’s (ASX: JIN) Mike Veverka, Minerals Resources’ (ASX: MIN) Chris Ellison, Nick Scali’s (ASX: NCK) Anthony Scali, Seven Group’s (ASX: SVW) Stokes family and Washington H. Soul Pattinson’s (ASX: SOL) Millner family.
Conventional doesn’t always mean conservative
In the BPL days, Buffett asserted that his investment style was conservative but not necessarily conventional. In most letters, Buffett provided a comparison of partnership and mainstream fund results, largely in order to provide a broader context for the BPL offering. It did however lead to questions and subsequent appraisals of the shortcomings of the more ‘traditional’ methods of investment management.
Figure 3: BPL performance relative to mainstream fund managers, 1957 - 1964.
Source: BPL 18 January, 1965 letter to investors
Buffett mused on why mainstream mediocrity persisted and what conservative investment management meant to him in the following excerpt from his 1965 letter to investors:
The repetition of these tables has caused partners to ask: "Why in the world does this happen to very intelligent managements working with (1) bright, energetic staff people, (2) virtually unlimited resources, (3) the most extensive business contacts, and (4) literally centuries of aggregate investment experience?"
In the great majority of cases, the lack of performance exceeding or even matching an unmanaged index in no way reflects a lack of either intellectual capacity or integrity.
I think it is much more the product of: (1) group decisions - my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is "safe" and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.
Perhaps the above comments are unjust. Perhaps even our statistical comparisons are unjust. Both our portfolio and method of operation differ substantially from the investment companies in the table.
It is unquestionably true that the investment companies have their money more conventionally invested than we do.
To many people, conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative. Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy.
We certainly think it makes more sense than saying “We own (regardless of price) AT & T, General Electric, IBM and General Motors and are therefore conservative.”
‘Conventional’ and ‘conservative’ may have a similar connotation, but in the investing world they can at times be starkly different.
Going with convention potentially provides a false sense of security in investing, as by the time a security has become ‘conventional’ the price opportunity is no longer present. What matters with respect to conservative decision making, as Buffett explains, are the facts, and whether the facts are reflected in prices.
No discussion on capital management would be complete without considering the use of debt. Cash is king - a simple, age-old concept that Buffett certainly subscribes to. To be fair, for many decades Buffett has had the advantage of investing in an ever-growing insurance float. But nonetheless, he has always espoused the benefits of maintaining a conservative capital structure, best described in his 1992 letter to Berkshire shareholders:We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet.
This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. As one of the Indianapolis 500 winners said: “To finish first, you must first finish.”
The financial calculus that Charlie (Munger, BRK.A Vice Chairman) and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return. I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.
I’ll carry one particular story with me for the remainder of my investing career. Several years ago, we were invested in a promising ASX-listed small-cap that decided to take on a large amount of debt to fund an ambitious acquisition pipeline. Unnerved by these developments, we organised a meeting with the CEO to discuss his attitude to capital management, among other things.
The nonchalant CEO not only dismissed our concerns but actually laughed them off, scoffing: “if we were in America, you guys would be asking me to take on more debt!” We sold our stock, and the company subsequently didn’t survive the double whammy of an industry downturn and black swan event. To finish first, you must first finish.
One final and equally important Buffett lesson on capital management is the line of thinking on payout ratios. One of his more famous quotes, included below, simply suggests that higher returning businesses should retain capital for reinvestment. Such companies can compound earnings at attractive rates of return. Conversely, lower returning businesses are better off paying out earnings out as dividends.
Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will only happen if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
3. Buy commodities, sell brands
I had the great privilege of attending the 2012 Berkshire Hathaway AGM in Omaha, Nebraska. It was a fantastic experience and one that acted to reinforce several worthwhile investment lessons. One of the more prominent points of discussion was best summed up by Buffett’s quote at that time:
Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See's Candy since we purchased it 40 years ago.
The idea of taking commodities to produce high quality branded products is not new but, when done well, it can be highly profitable. And it's all in the margin. With high quality branded products comes pricing power. The extraordinary margins made by Buffett’s Coca Cola or French luxury goods multinational LVMH, certainly attest to it.
Domestically, the likes of ARB Corp (ASX: ARB), Breville Group (ASX: BRG) and Nick Scali (ASX: NCK) have long delivered double-digit EBIT margins.
Each produces high quality branded products and are leaders in their respective niches. The ability and willingness to reinvest in design-focused research and development (R&D) only serves to maintain margins whilst reinforcing competitive advantages, incrementally widening the economic moat around each business.
Figure 4: EBIT Margins 2007 to 2021 for ARB, BRG and NCK.
Source: S&P Capital IQ
4. How to think about macro
Buffett has long been lauded as a beacon of rational thinking. While it doesn’t hurt, intelligence alone doesn’t ensure investment success. It’s those that can couple good sense with emotional control that succeeds with long term investing. It’s not easy when the world appears to be falling apart, but a calm and steady hand will do wonders for long term wealth creation.
In his 1994 letter to Berkshire shareholders, Buffett commented:
We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.
But, surprise – none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of the unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but friend of the fundamentalist.
Macro events, while always worrisome at the time, often provide opportunities to build positions in high quality companies at attractive prices. It does however remain important to be selective, as Buffett noted in his 1996 letter to Berkshire shareholders:
Your goal as an investor should simply be to purchase, at a rational price, a part interest in a business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.
Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.
The past 20 years have again proven that almost anything can happen. Financial crises, geopolitical turmoil, wars, fire and flood have all come to bear from time to time. Interest rates and inflation now loom large on the wall of worry. But high-quality companies endure, and so do portfolios full of them. Are you prepared for the next downturn? What high quality stocks are on your watchlist?
5. The power of focus
Of all the lessons I’ve personally gleaned from Buffett, this would have to be my favourite. I’ve both read and watched accounts of the one single factor that Buffett most attributes his success to, and without question it is focus.
In HBO’s 2017 documentary ‘Becoming Warren Buffett’, one particular reflection from Buffett articulates this well:
Shortly after I met Bill Gates, Bill's dad asked each of us to write down on a piece of paper one word that best described what had helped us the most. Bill and I, without any collaboration, each wrote the word focus.
Focus has always been a strong part of my personality. If I get interested in something, I get really interested. If I get interested in a subject, I want to read about it, I want to talk about it, I want to meet people that are involved in it.
While obviously pertinent to investing, this is one characteristic that facilitates success in all fields of human endeavour. An athlete’s talent means little without sustained effort. A scholar’s ideas are not progressed without diligent research. An overburdened portfolio manager overseeing a multitude of different strategies will not outperform.
When it comes to an investment manager, nothing sharpens the mind like investing much of the family wealth alongside clients, in a sensible manner and on the same terms. Buffett has spent a lifetime showing the way.
At the 2012 AGM during shareholder question time, Buffett was asked what he would have done differently if he had his time again. He replied: “I would have aggregated the partnership money quicker. Get an audited track record and then buy entire businesses for keeps.” This again speaks to his desire to focus his efforts on one endeavour.
I suspect that if Buffett were asked that if he could only focus on one particular financial metric, he would suggest profitability. Time and again he has alluded to this factor as the driving force of value creation. In his 1983 letter to Berkshire shareholders, he noted:
Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries.
He later added:
The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return.
We continue to live in interesting times, and the temptation to divert our focus is omnipresent. But as the great man once said, intensity is the price of excellence.
Condensing a lifetime of investment excellence into one whitepaper is no easy task. Hopefully what I’ve distilled here provides some insights into factors worth considering when approaching the complex world of investing.
Buffett has again offered valuable insights for investors in the 2021 Berkshire Hathaway Annual Report. The unfortunate reality is that at some point father time will catch up with the legendary investor and his equally notable sidekick, Charlie Munger. His teachings and principles, however, will endure. I suspect the same Buffett lessons will be relevant for future generations of investors of all types.
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Adrian has over 15 years of investment experience across a broad range of sectors. Researching and investing in some of Australia’s most dynamic emerging leaders and small caps is Adrian's great passion.