Buffett is able to maintain this high level of knowledge about Berkshire’s businesses because he purposely limits his selection to companies that are within his area of financial and intellectual understanding. His logic is compelling. If you own a company (either outright or as a shareholder) in an industry you do not fully understand, you cannot possibly interpret developments accurately or make wise decisions.

Source:   The Warren Buffett Way

“Invest in your circle of competence,” Buffett counsels. “It’s not how big the circle is that counts; it’s how well you define the parameters.”

Source:   The Warren Buffett Way

“Severe change and exceptional returns usually don’t mix,” Buffett observes. Most people, unfortunately, invest as if the opposite were true. Investors tend to be attracted to fast-changing industries or companies that are in the midst of a corporate reorganization. For some unexplained reason, says Buffett, investors are so infatuated with what tomorrow may bring that they ignore today’s business reality.

Source:   The Warren Buffett Way

[Buffett] defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated. These traits allow the company to hold its prices, and occasionally raise them, without the fear of losing market share or unit volume. This pricing flexibility is one of the defining characteristics of a great business; it allows the company to earn above-average returns on capital.

Source:   The Warren Buffett Way

In particular, [Buffett] looks for three traits: 1. Is management rational? 2. Is management candid with shareholders? 3. Does management resist the institutional imperative?

Source:   The Warren Buffett Way

The most important management act is the allocation of the company’s capital. It is the most important because allocation of capital, over time, determines shareholder value. Deciding what to do with the company’s earnings in the business or return money to shareholders—is, in Buffett’s mind, an exercise in logic and rationality. “Rationality is the quality that Buffett thinks distinguishes the style with which he runs Berkshire—and the quality he often finds lacking in other corporations,” wrote Carol Loomis of Fortune magazine.

Source:   The Warren Buffett Way

A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below-average rates, (2) it can buy growth, or (3) it can return the money to shareholders. It is at this crossroads that Buffett keenly focuses on management’s decisions, for it is here that management will behave rationally or irrationally.

Source:   The Warren Buffett Way

A company with poor economic returns, excess cash, and a low stock price will attract corporate raiders, which is the beginning of the end of current management tenure. To protect themselves, executives frequently choose the second option instead: purchasing growth by acquiring another company.

Source:   The Warren Buffett Way

When management repurchases stock, Buffett feels that the reward is twofold. If the stock is selling below its intrinsic value, then purchasing shares makes good business sense. If a company’s stock price is $50 and its intrinsic value is $100, then each time management buys its stock, it is acquiring $2 of intrinsic value for every $1 spent. Transactions of this nature can be very profitable for the remaining shareholders.

Source:   The Warren Buffett Way

“What needs to be reported,” argues Buffett, “is data—whether GAAP, non-GAAP, or extra-GAAP—that helps the financially literate readers answer three key questions: (1) Approximately how much is the company worth? (2) What is the likelihood that it can meet its future obligations? (3) How good a job are its managers doing, given the hand they have been dealt?”

Source:   The Warren Buffett Way

...management stands to gain wisdom and credibility by facing mistakes, why do so many annual reports trumpet only success? If allocation of capital is so simple and logical, why is capital so poorly allocated? The answer, Buffett has learned, is an unseen force he calls “the institutional imperative”—the lemming-like tendency of corporate managers to imitate the behavior of others, no matter how silly or irrational it may be. It was the most surprising discovery of his business career. At school he was taught that experienced managers were honest and intelligent, and automatically made rational business decisions. Once out in the business world, he learned instead that “rationality frequently wilts when the institutional imperative comes into play.”

Source:   The Warren Buffett Way

Buffett believes that the institutional imperative is responsible for several serious, but distressingly common, conditions: “(1) [The organization] resists any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will quickly be supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”

Source:   The Warren Buffett Way

Buffett isolates three factors as being most influential in management’s behavior. 1. Most managers cannot control their lust for activity. Such hyperactivity often finds its outlet in business takeovers. 2. Most managers are constantly comparing their business’s sales, earnings, and executive compensation to other companies within and beyond their industry. These comparisons invariably invite corporate hyperactivity. 3. Most managers have an exaggerated sense of their own capabilities.

Source:   The Warren Buffett Way

Buffett considers earnings per share a smoke screen…To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.

Source:   The Warren Buffett Way

“Good business or investment decisions,” he says, “will produce quite satisfactory results with no aid from leverage.”

Source:   The Warren Buffett Way

Buffett explains, “Within this gigantic auction arena, it is our job to select a business with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”

Source:   The Warren Buffett Way

Buffett thinks the whole idea that price volatility is a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty,” he says. “If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing."

Source:   The Warren Buffett Way

...there are times when long-term interest rates are abnormally low. During these periods, we know that Buffett is more cautious and likely adds a couple of percentage points to the risk-free rate to reflect a more normalized interest rate environment.

Source:   The Warren Buffett Way

All the shorthand methods—high or low price-to-earnings ratios, price-to-book ratios, and dividend yields, in any number of combinations—fall short. Buffett sums it up for us: Whether “an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investment . . . irrespective of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.”

Source:   The Warren Buffett Way

“When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well.” [says Buffett]...“If IBM’s stock price averages say $200, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.”

Source:   The Warren Buffett Way

Wall Street’s method of using accounting ratios to determine value may capture the here and now but does a woefully poor job of calculating sustainable long-term growth. Or, put differently, more often than not, sustainable long-term growth is mispriced by the market.

Source:   The Warren Buffett Way

We have all heard this mantra of diversification for so long that we have become intellectually numb to its inevitable consequence: mediocre results. Both active and index funds do offer diversification, but, in general, neither strategy will give you exceptional returns.

Source:   The Warren Buffett Way

“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do,” says Buffett. “It’s imperfect but that’s what it is all about.”

Source:   The Warren Buffett Way

Keynes prepared a full policy report for the Chest Fund, outlining his principles: 1. A careful selection of a few investments having regard to their cheapness in relation to their probable actual and potential intrinsic [emphasis his] value over a period of years ahead and in relation to alternative investments at the time; 2. A steadfast holding of these fairly large units through thick and thin, perhaps several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake; 3. A balanced [emphasis his] investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible opposed risks.

Source:   The Warren Buffett Way

Lest you think Keynes, with his macroeconomic background, possessed marketing timing skills, take further note of his investment policy. “We have not proved able to take much advantage of a general systematic movement out of and into ordinary shares as a whole at different phases of the trade cycle,” he wrote. “As a result of these experiences I am clear that the idea of a wholesale shift is for various reasons impracticable and indeed undesirable. Most of those who attempt to [do so] sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative state of mind, which if it is widespread has besides the grave social disadvantage of aggravating the scale of the fluctuations.

Source:   The Warren Buffett Way

“Typically, people start out their careers in an analyst function but aspire to get promoted to the more prestigious portfolio manager designation. To the contrary, we have always believed that if you are a long-term investor, the analyst function is paramount and the portfolio management follows naturally.” [said Bill Ruane]

Source:   The Warren Buffett Way

Buffett, Munger, Ruane, Simpson. It is clear the superinvestors of Buffettville have a common intellectual approach to investing. They are united in their belief that the way to reduce risk is to buy stocks only when the margin of safety (that is, the favorable discrepancy between the intrinsic value of the company and today’s market price) is high. They also believe that concentrating their portfolios around a limited number of these high-probability events not only reduces risk, but helps to generate returns far above the market rate of return.

Source:   The Warren Buffett Way

To eliminate any notion that the five superinvestors of Buffettville are nothing more than statistical aberrations, we need to examine a wider field. Unfortunately, the population of focus investors is very small. Among the thousands of portfolio managers who manage money, there are only a scant few who manage concentrated portfolios. Thus we are left with the same challenge.

Source:   The Warren Buffett Way

Interestingly, Cremers reports that in 1980, 50 percent of large-cap mutual funds had an active share score of 80 percent or more. That is, half the mutual funds had a portfolio that was significantly different from their benchmark. Today, just 25 percent of mutual funds are considered truly active. “Both investors and fund managers have become more benchmark-aware,” says Cremers. “As a manager, you want to avoid being in the bottom 20% or 40% (of your peer group). The safest way to do that, especially when you’re evaluated over the shorter time periods, is to hug the index.”

Source:   The Warren Buffett Way

The Real Measure of Worth In that famous speech about Graham-and-Doddsville, Warren Buffett said many important things, none more profound than this: “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

Source:   The Warren Buffett Way

The financial writer Joseph Nocera has pointed out the inconsistencies between what mutual fund managers recommend shareholders do—namely, “buy and hold”—and what managers actually do with their own portfolios—namely, buy-sell, buy-sell, buy-sell. Reinforcing his own observations of this double standard, Nocera quoted Morningstar’s Don Phillips: “There is huge disconnect between what the fund industry does and what it tells investors to do.”

Source:   The Warren Buffett Way

Today, there is substantial pressure on portfolio managers to generate eye-catching short-term performance numbers. These numbers attract a lot of attention. Every three months, leading publications such as the Wall Street Journal and Barron’s publish quarterly performance rankings of mutual funds. The funds that have done the best in the past three months move to the top of the list, are praised by financial commentators on television and in newspapers, rush to put out self-congratulatory advertising and promotional pieces, and attract a flurry of new deposits. Investors, who have been waiting to see which fund manager has the so-called hot hand, pounce on these rankings. Indeed, quarterly performance rankings are increasingly used to separate those managers deemed gifted from those who are mediocre.

Source:   The Warren Buffett Way

Warren Buffett once said he “wouldn’t care if the stock market closed for a year or two. After all, it closes on Saturday and Sunday and that hasn’t bothered me yet.” It is true that “an actively trading market is useful, since it periodically presents us with mouth-watering opportunities,” said Buffett. “But by no means is it essential.”

Source:   The Warren Buffett Way

“A prolonged suspension of trading in securities we hold would not bother us any more than does the lack of daily quotations for [Berkshire’s wholly owned subsidiaries]. Eventually our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial [in the form of shares of stock] or total.” [says Buffett]

Source:   The Warren Buffett Way

...performance of a publicly traded company is no different. “Charlie and I let our marketable equities tell us by their operating results—not by their daily, or evenly yearly, price quotations—whether our investments are successful,” [Buffett] explains. “The market may ignore a business success for a while, but it eventually will confirm it.”

Source:   The Warren Buffett Way

With stocks held three years, the degree of correlation between stock price and operating earnings ranged from .131 to .360. (A correlation of .360 means that 36 percent of the variance in the price was explained by the variance in earnings.) With stocks held for five years, the correlation ranged from .374 to .599. In the 10-year holding period, the correlation between earnings and stock price increased to a range of .593 to .695. This bears out Buffett’s thesis that, given enough time, the price of a business will align with the company’s economics. He cautions, though, that translation of earnings into share price is both “uneven” and “unpredictable.” Although the relationship between earnings and price strengthens over time, it is not always prescient. “While market values track business values quite well over long periods,” Buffett notes, “in any given year the relationship can gyrate capriciously.” Ben Graham gave us the same lesson: “In the short run the market is a voting machine but in the long run it is a weighing machine.”

Source:   The Warren Buffett Way

“If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business,” says Buffett. “Second, assess the quality of the people in charge of running it; and third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town. Why, then, should Berkshire take a different tack when dealing with the larger universe of public companies? And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? Our motto is: If at first you do succeed, quit trying.”

Source:   The Warren Buffett Way

Focus investing is necessarily a long-term approach to investing. If we were to ask Buffett what he considers an ideal holding period, he would answer, “Forever”—so long as the company continues to generate above-average economics and management allocates the earnings of the company in a rational manner. “Inactivity strikes us as an intelligent behavior,” he explains.

Source:   The Warren Buffett Way

“Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit has reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses?” [says Buffett]

Source:   The Warren Buffett Way

What strategies lend themselves best to low turnover rates? One possible approach is a low-turnover index fund. Another is a focus portfolio. “It sounds like premarital counseling advice,” say Jeffrey and Arnott, “namely, to try to build a portfolio that you can live with for a long, long time.”

Source:   The Warren Buffett Way

The study of the psychology of misjudgment every bit as valuable to an investor as the analysis of a balance sheet and an income statement.

Source:   The Warren Buffett Way

In recent years we have seen what amounts to a revolution, a new way of looking at issues of finance through the framework of human behavior. This blending of economics and psychology is known as behavioral finance, and it has slowly moved down from the universities’ ivory towers to become part of the informed conversation among investment professionals . . . who, if they look over their shoulders, will find the shadow of a smiling Ben Graham.

Source:   The Warren Buffett Way

Warren Buffett, [Graham's] most famous student, explains, “There are three important principles to Graham’s approach.” The first is simply looking at stocks as businesses, which “gives you an entirely different view than most people who are in the market.” The second is the margin-of-safety concept, which “gives you the competitive edge.” And the third is having a true investor’s attitude toward the stock market. “If you have that attitude,” says Buffett, “you start out ahead of 99 percent of all the people who are operating in the stock market—it is an enormous advantage.”

Source:   The Warren Buffett Way

Developing an investor’s attitude, Graham said, is a matter of being prepared, both financially and psychologically, for the market’s inevitable ups and downs—not merely knowing intellectually that a downturn will happen, but having the emotional ballast needed to react appropriately when it does. In Graham’s view, an investor’s appropriate reaction to a downturn is the same as a business owner’s response when offered an unattractive price: ignore it. “The true investor,” says Graham, “scarcely ever is forced to sell his shares and at all other times is free to disregard the current price quotation.”

Source:   The Warren Buffett Way

Is this constant fixation on stock prices healthy for investors? Richard Thaler has a crisp answer. He lectures frequently at the Behavioral Conference sponsored by the National Bureau of Economic Research and the John F. Kennedy School of Government at Harvard University, and he always includes this advice: “Invest in equities and then don’t open the mail.” To which we might add, “And don’t check your computer or your phone or any other device every minute.”

Source:   The Warren Buffett Way

...loss aversion, and it is, in my opinion, the single most difficult hurdle that prevents most investors from successfully applying the Warren Buffett approach to investing.

Source:   The Warren Buffett Way

Warren Buffett’s approach to investing, thinking of stocks as businesses and managing a focus portfolio, is directly at odds with the financial theories taught to thousands of business students each and every year. Collectively, this financial framework is known as modern portfolio theory. As we will discover, this theory of investing was built not by business owners but by ivory tower academicians. And it is an intellectual house that Buffett refuses to reside in. Those who follow Buffett’s principles will quickly find themselves emotionally and psychologically disconnected from how a majority of investors behave.

Source:   The Warren Buffett Way

Buffett has a different definition of risk: the possibility of harm or injury. And that is a factor of the “intrinsic value risk” of a business, not the price behavior of the stock. The real risk, Buffett says, is whether after-tax returns from an investment “will give him [an investor] at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.”

Source:   The Warren Buffett Way

Risk, for Buffett, is inextricably linked to an investor’s time horizon. This alone is the single greatest difference between how Warren Buffett thinks about risk and how modern portfolio theory frames risk. If you buy a stock today with the intention of selling it tomorrow, Buffett explains, then you have entered into a risky transaction. The odds are no better than the toss of a coin—you will lose about half the time. However, says Buffett, if you extend your time horizon out to several years, the probability of its being a risky transaction declines meaningfully, assuming of course that you have made a sensible purchase.

Source:   The Warren Buffett Way

...you can easily see how applying the Buffett approach will put you in conflict with its proponents. Not only are you intellectually at odds with modern portfolio theorists, but you are also vastly outnumbered, both in the classroom and the workspace. Embracing the Warren Buffett Way makes you a rebel looking out across the field at a much larger army of individuals who invest totally differently. As you will learn, being an outcast has its own emotional challenges.

Source:   The Warren Buffett Way

Tucked near the back, on page 424, is my favorite article—“Long-Term Investing.” It first appeared in the May–June 1976 issue of the Financial Analysts Journal. Treynor begins by talking about the ever-present puzzle of market efficiency. Is it true, he wondered, that no matter how hard we try we’ll never be able to find an idea that the market hasn’t already discounted? To address the question, Treynor asks us to distinguish between “two kinds of investment ideas: (a) those whose implications are straightforward and obvious, take relatively little special expertise to evaluate, and consequently travel quickly and (b) those that require reflection, judgment, and special expertise for their evaluation, and consequently travel slowly."“If the market is inefficient,” he concludes, “it will not be inefficient with respect to the first kind of idea, since by definition the first kind is unlikely to be misevaluated by the great mass of investors.” To say this another way, the simple ideas—price-to-earnings ratios, dividend yields, price-to-book ratios, P/E-to-growth ratios, 52-week-low lists, technical charts, and any other elementary ways we can think about a stock—are unlikely to provide easy profits. “If there is any market inefficiency, hence any investment opportunity,” says Treynor, “it will arise with the second kind of investment idea—the kind that travels slowly. The second kind of idea—rather than the obvious, hence quickly discounted insight relating to ‘long-term’ business developments—is the only meaningful basis for long-term investing.”

Source:   The Warren Buffett Way

Intelligence alone is not enough to ensure investment success. The size of the investor’s brain is less important than the ability to detach the brain from the emotions. “Rationality is essential when others are making decisions based on short-term greed or fear,” says Buffett. “That is when the money is made.”

Source:   The Warren Buffett Way

“It’s not that I want money,” Buffett has said. “It’s the fun of making money and watching it grow.”

Source:   The Warren Buffett Way

...the success of some who continually beat the major indexes—most notably Warren Buffett—suggests that the efficient market theory is flawed. Others, Buffett included, argue that the reason most money managers underperform the market is not because it is efficient, but because their methods are faulty.

Source:   The Warren Buffett Way

“How did you get here? How did you become richer than God?” Buffett took a deep breath and began: “How I got here is pretty simple in my case. It is not IQ, I’m sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which the motor works—depends on rationality. A lot of people start out with 400 horsepower motors but only get 100 horsepower of output. It’s way better to have a 200 horsepower motor and get it all into output. “So why do smart people do things that interfere with getting the output they’re entitled to?” Buffett continued. “It gets into the habits and character and temperament, and behaving in a rational manner. Not getting in your own way. As I have said, everybody here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For those who won’t, it will be because you get in your own way, not because the world doesn’t allow you.”

Source:   The Warren Buffett Way

When Buffett invests, he sees a business. Most investors see only a stock price. They spend far too much time and effort watching, predicting, and anticipating price changes and far too little time understanding the business they partly own. Elementary as this may be, it is the root of what distinguishes Buffett.

Source:   The Warren Buffett Way