Warren Buffet's Tenets

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Warren Buffett Methodology
Content
Who Is Warren Buffett?The Warren Buffett Investment MethodologyBuffett's TenetsSummary of Buffett's Investment Process

Who Is Warren Buffett?
Warren Buffett is Chairman of Berkshire Hathaway Inc., a holding company, with interests in several subsidiaries engaged in a number of diverse business activities. Included in these subsidiaries is GEICO Corporation, the seventh largest auto insurer in the United States. Publicly traded companies include a 10.5% holding in American Express Company, 8% of The Coca-Cola Company, 9.5% of Federal Home Loan Mortgage Corporation, 8.5% of The Gillette Company, 16.5% of The Washington Post Company and 8% in Wells Fargo & Company. Berkshire Hathaway Inc. also has holdings or owns several private companies.
The Warren Buffett Investment Methodology
Warren Buffett's investment methodology is based on the following 12 tenets.
Buffett's Tenets
Business Tenets
Is the business simple and understandable?
Does the business have a consistent operating history?
Does the business have favourable long-term prospects?
Management Tenets
Is Management rational?
Is Management candid with its shareholders?
Does management resist the institutional imperative?
Financial Tenets
Focus on return on equity, not earnings per share
Calculate "owner earnings"
Look for companies with high profit margins
For every dollar retained, make sure the company has created at least one dollar of market value
Market Tenets
What is the value of the business?
Can the business be purchased at a discount to its real value?
Summary of Buffett's Investment Process
When Buffett invests, he sees a business whilst most investors see a stock price. According to Buffett, the investor and the business person should look at the company in the same way, because they both want essentially the same thing. The business person wants to buy the whole company and the investor wants to buy portions of the company. Buffett believes that in the long run, the price of the stock should approximate the change in value of the business. He believes it is foolish to use short-term prices to judge a company's success. Instead, he lets his companies report their value to him by economic progress. Once a year, he checks several key variables:
Return on beginning shareholder's equity
Change in operating margins, debt levels and capital expenditure needs:
The company's cash generating ability
If these economic variables are improving then Buffett concludes that the share price should reflect this in the long term.
Buffett avoids companies that are in need of major overhauls. He will only purchase companies that have shareholder-orientated managers. His investment methodology follows a four step process.
Step 1: Turn off the stock market
Buffett does not have a stock quote service in his office. He believes that by owning shares in an outstanding business for a number of years, what happens in the market on a day-to-day basis is inconsequential.
Step 2: Don't worry about the economy
Except for his preconceived notions that the economy has an inflation bias, Buffett dedicates no time or energy to analysing the economy. He prefers to buy a business that has the opportunity to profit regardless of the economy.
Step 3: Buy a business not a stock
Before investing in a company Buffett addresses the following key questions:
Is the business simple to understand?
Does the business have a consistent operating history?
Does the business have favourable long-term prospects?
Is management rational?
Is management candid with its shareholders?
Does management avoid the institutional imperative – irrationality?
From a financial point of view Buffett advocates.
Focus on return on equity, not earnings per share – a true measure of annual performance because it takes into consideration the company’s ever-growing capital base, the ratio of operating earnings to shareholders equity.
Calculate the "owner earnings" – Buffett seeks out companies that generate cash in excess of their needs as opposed to companies that consume cash. To determine owner earnings add depreciation and amortisation charges to net income and then subtract the expenditures the company needs to maintain its economic position and unit volume
Look for companies with high profit margins
For every dollar that has been retained, make sure the company has created at least one dollar of market value – to calculate this subtract from the company’s net income, all dividends paid to shareholders. Add the company’s retained earnings over a 10-year period. Then find the difference between the company’s current market value an its market value 10 years ago. If the change in the market value is less than the sum of retained earnings, the company is going backwards.
Then from a market perspective Buffett asks:
What is the value of the business – the value of the business is determined by the estimated cash flows expected to occur over the life of the business discounted at an appropriate interest rate. Buffett uses the 30-year US Treasury bond rate to discount expected cash flows.
Can the business be purchased as a significant discount to its real value – Buffett’s rule is: purchase the business only when its price is at a significant discount to its value.
Importantly, it is only at the final step that Buffett looks at the stock’s market price.
Buffett believes that whilst calculating the value of the business is not difficult, problems can arise when an analyst wrongly estimates a company’s future cash flow. Buffett deals with this problem in two ways:
He increases his chances of correctly predicting future cash flows by sticking with businesses that are simple and stable in character; and
He insists that each company he purchases there must be a margin of safety between the purchase price and the determined value.
Step 4: Manage a portfolio of Businesses
Buffett believes that wide diversification is only required when investors do not understand what they are doing. "On the other hand if you are a know-something investor able to find five to ten sensibly priced companies that possess long-term competitive advantages, conventional diversification makes no sense to you".
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