It’s not IQ.
Buffett will be the first to admit that it’s not supernatural brain-power that made him a great investor. He says his edge is Rationality. His partner-in-crime, Charlie Munger, agrees. What does that really mean? Are they the most rational people in the world? I think the answer is a bit more complicated. It points to a unique mix of mental sharpness and emotional restraint – half sniper and half monk. But there’s more. I’ve listed what we think are the components of his “rationality”.
Ok, maybe it is IQ. A little bit.
Of course, he’s very sharp, especially when it comes to his art: Investing. He’s been a keen student of investing since he was 11. But it’s not sharpness in the academic sense that sets him apart. It’s not that his math skills or knowledge of finance or accounting that gives him an edge. His IQ level keeps increasing because he thinks incessantly. Bertrand Russell’s had observed that “Most men would rather die than think. Many do.”. Buffett is not afraid to think, for hours and hours in his modest Omaha office. He enjoys reading and thinking more than most people, especially more than the hyperactive, trigger-happy “players” in the markets. He thinks about everything – businesses, the economy, accounting, markets, history, literature, politics, people and so on. He even thinks deeply about thinking itself, which I can tell you from experience that many analysts and traders happily avoid doing. He doesn’t take theories and opinions on face value. He questions everything and drills down to the basic elements of a concept or an investment. And he’s constantly learning, even into his late 80s. Observing, reading, thinking, synthesizing all that – that’s the meat of investing. That’s what Munger and he do better than almost anyone in their field. “People calculate too much and think too little”, he had observed about the Wall Street machine. Buffett probably thinks too much and calculates just as much as he needs to. That’s his edge.
He is a learning machine.
Buffett’s philosophy on investing has evolved over time. He bought his first stock when he was 11 and he dabbled in investing all through his teenage years. Back then, by his own admission, he was a “chartist”. This is the art of trying to read into charts of stocks price movements to make trading decisions. Buffett had soon realized that this is a dubious science. While he was in college, he came across a certain book called “The Intelligent Investor”, which did more to form his philosophy on investing than anything else. He even made it a point to go to Columbia Business School where Benjamin Graham, the author of The Intelligent Investor, was teaching at that time. Within a few years from that transformative experience, Buffett started his investment fund – Buffett Partnership. He invested according to the tenets of Intelligent Investing and amassed a fantastic track record. Along the way, he met Charlie Munger, who added a new dimension to Buffett’s philosophy. Together, they have amassed an even more impressive record. So, Buffett has come a long way – from a chartist to a Graham-ite to eventually forming at his own brand of Intelligent Investing with Munger. He never stopped learning. He still hasn’t.
Two wise men: Benjamin Graham and Charlie Munger.
Graham, according to Buffett, was his “intellectual father”. Buffett says that the best investment he’s ever made is on his old copy of The Intelligent Investor, second only to his two marriage licenses. Buffett met Graham at Columbia Business School. It wasn’t long before Graham saw something special in him. This significance of this teacher-student relationship is hard to overstate. Imagine if a very young Roger Federer was coached by Pete Sampras at his peak – that’s what was happening in the investment world. It seems to me that two very significant concepts were imprinted in Buffett’s mind during his time with Graham: Margin of Safety and the concept of Mr. Market. In short, he learned that he should never compromise on buying companies or stocks at a significant discount to its intrinsic value, and that he should treat “Mr. Market” as a manic-depressive rather than a hyper-efficient know-it-all. He learned that if you buy something at a big enough discount, chances of losing money will be very low. And eventually, this manic-depressive would snap back to its senses and make you an offer you can’t refuse. This approach worked wonders for a while but, in hindsight, it led Buffett to make some big mistakes; the most famous of these, ironically, was Berkshire Hathaway. But before that, while Buffett was still running Buffett Partnership in the 1960s, he met Charlie Munger, which proved to another turning point in Buffett’s intellectual development. Munger was (and still is) a polymath. He was (and still is) convinced that investing is a liberal art and that an investor should use facts and theories from all major fields of life – economics, politics, history, biology, physics, psychology and so on. It is this hunger for knowledge, Munger thinks, that makes an investor great. He calls this intellectual exercise “building a latticework of mental models”,which should serve as foundational framework for evaluating investment opportunities. It’s no surprise that he and Buffett got along. Buffett was always a voracious reader and thinker. And he always knew investing was not some scientific experiment that’s divorced from reality. But Munger nudged him over the line into thinking about investing as more of a polymathic exercise than a numerical one. Munger’s influence on Buffett can be summarized in (yet another) succinct one-liner from Buffett: “If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.” This was the most significant change Munger triggered in Buffett, who until then was a devout Grahamite “value-investor”, happy to pick up almost anything if the price was low enough, if there was enough Margin of Safety. Without the influence of these two men – Graham and Munger – we wonder if Buffett would have turned out to be the investor that he is. Unlikely, in my opinion.
He’s a businessman at heart.
I think that Buffett’s interest in investing was an offshoot of his interest in business. Even before he started dabbling in stocks as a teenager, he was always trying to figure out how to start a business. One of his first ventures was wholesaling of sodas in Omaha. Soon after, he started dabbling in stocks, and he never looked back. He knew he had found his calling. Even though he started out as a “chartist”, it didn’t take him too long to know he was missing something. That something was putting in the time and effort to do a thorough valuation of the businesses behind these stocks and their charts. We think that unless he was already interested in the businesses to begin with, his chance encounter with “The Intelligent Investor” would have rang hollow. And by interest in “business” we mean his interest in solutions to the world’s problems – somebody taking an initiative to make a product or provide a service that the world wants or needs. Legend has it that no one gets more excited to read an annual report of a company than Warren Buffett; even he doesn’t to invest in that company. His motivation was probably not intrinsic in the beginning. When he was a kid, he was interested in business to make a quick buck. Maybe the intrinsic motivation was a strong sense of self-reliance. I don’t know for sure because I’m not a psychologist and I don’t know him personally. What I do know is that over time he realized that he doesn’t particularly enjoy money. He enjoys the process of making it and watching it grow. He prefers the journey to the destination. “It’s not that I want money,” Buffett has said. “It’s the fun of making money and watching it grow.”
Berkshire Hathaway’s structure is a blessing.
Buffett says that being a businessman makes him a better investor and being an investor makes him a better businessman. After closing Buffett Partnership in 1969, his day job was managing a failing textile mill called Berkshire Hathaway. Over the next few years, Buffett used some of Berkshire’s capital, and his own, to acquire other companies, many of which were insurers. Over time, he transformed Berkshire Hathaway from a failing textile mill to a very successful insurance company. The structure ended up looking something like this: Berkshire, like any insurance company, collects premiums almost continuously. Buffett calls this Berkshire’s “float”. But, like any insurance firm, it’s in the business of paying relatively rare but big claims when their customers unfortunately face unforseen events. To pay for these potential claims, Berkshire must set some money aside. But that’s not enough, mainly because the probability of these unforeseen events occurring, and the size of these claims are both random variables. These events are hard to predict, despite advances in complicated actuarial mathematics. So, Berkshire needs a margin of safety in its business – it does this by investing the premiums it keeps accruing. This not only helps in creating a wider margin of safety between funds available and potential claims payments, but it also allows Berkshire to a) charge lower premiums in future contracts and b) insure risky events that no other insurance companies would touch. It’s an enviable virtuous cycle like no other. This structure creates another feedback loop that works wonders: it allows Buffett to invest the way he likes – focused portfolios of companies in which he’s invested for the long haul. This is a massive advantage he has over regular “fund managers”. Fund managers are too concerned about not losing “AUM” (asset under management) and not taking “active risk” (deviate too much from an assigned “style” or benchmark) that might upset investment consultants or their bosses. They’re too concerned about career risk. All these shenanigans hurt their portfolio returns. Buffett doesn’t have to worry about all that. And ultimately, Buffett runs an insurance business that is also a holding company for various other types of businesses. That’s a unique vantage point almost nobody else has in the investment management business. That’s why he’s better at spotting top-notch managers than almost anyone else.
He puts ethics over everything else.
Berkshire Hathaway is Buffett’s karma. It’s his craft. It’s his life’s work. As much as he doesn’t want bad investing decisions to ruin his work, what really sends him over the edge is ethical lapses in people. He knows that it takes a lifetime to build a reputation and a moment of indiscretion to ruin it. In his own business – Berkshire Hathaway – he puts ethics and integrity above all else. He’s clear, concise, and transparent about what he does. And he’s equally candid when he’s wrong. This is evident in his (now legendary) Berkshire Hathaway shareholder letters, which provide a lot of intellectual fodder to The Buylyst. It’s clear that he sees a very high correlation between good ethics and good business. And good business leads to good returns. At Berkshire, Buffett invests in both publicly held and privately held companies. He treats both types of investments similarly – he looks at himself as a part owner of the company. All these ownership stakes roll up into Berkshire Hathaway - of which he owns a large part. This makes him hold the managers of his various stakes to the same standards that he holds for himself. A management team at any company, Buffett believes, has one major task above all else – allocate the firm’s capital prudently, in a way that generates high returns on the capital invested. Management has a lot of power over how shareholder capital is invested, and they could make decisions for spurious reasons – such as to prop up stock prices temporarily or to increase their compensation or spend millions on an unnecessary merger, again to increase their compensation. Buffett has no tolerance for these shenanigans. He believes that if management has its heart in the right place, chances are that returns will take care of themselves. Being a businessman himself, gives him a big advantage in picking out managements with integrity. He’s got a pretty good batting average with that.
He sticks to his circle of competency.
We’ve seen how Berkshire’s structure allows him to invest the way he thinks is prudent – without any institutional imperatives or nasty politics. Buffett is the quintessential Intelligent Investor, which means that he is happy to wait for the right investment, even if it means sitting on cash for a long time. And because he’s content with making very few investments, he likes to know a lot about them. Sticking to his core competency is his main tool of Risk Management. Buffett’s definition of Risk is: Permanent Loss of Capital. That is the only definition of Risk that matters to him. And he thinks that “Risk comes from not knowing what you’re doing”, which means investing in companies you don’t fully understand operating in an ecosystem that’s hard to predict with any degree of certainty. For example, most tech companies fall into this category according to Buffett. And he’s ok with that. It’s outside his circle of competency. This method of managing risk should be common sense: don’t invest in things that don’t make sense, so you won’t lose money. I can tell you from experience that most of the investment management industry doesn’t think like that. And the root of the problem, I believe, is something called the Modern Portfolio Theory. The basic symptoms of this pervasive illness are these: 1) A flawed definition of Risk, 2) A fear of veering away from an assigned benchmark, and 3) the default assumption that the market is always right. Bear with me here: the flawed definition of Risk is “Standard Deviation” or Volatility, which makes the process of managing it very short-term oriented. The primary tool for “managing” this risk is Diversification. The industry has taken diversification to new levels, to the point being stretched too thin to keep track of the actual risks in the portfolio – how companies respond to stresses and shocks in the ecosystem in which they operate. Then there is the fear of being too different from their benchmark, which is a proxy for the “market”. Nobody wants to be wrong alone. The sentiment is best captured in an old industry quip: “Nobody gets fired for buying IBM” (because chances are that IBM is a big part of the index). So, they try to mimic their index by buying a lot of stocks or bonds that they don’t particularly care about to manage another type of flawed risk: Career Risk. And finally, it’s the default assumption that the market is a hyper-rational and omniscient entity, and the idea that going against it is lunacy. Put these three symptoms together and you have an industry that is overdiversified in its portfolio, overactive to not veer away from the market and overanxious about what everyone else (the market) is saying about their holdings. You almost get the impression that many of them don’t really know what they’re doing.
He’s comfortable being a renegade.
The biggest difference between Buffett and the rest of the industry is this: he doesn’t treat the “market” as a hyper-rational and omniscient entity that is almost always right. He views the market as manic-depressive who swings between optimism and pessimism. He learned this, intellectually and viscerally, form Benjamin Graham back in the 1950s. And in the 70+ years since then, Buffett remains convinced that markets are not as “efficient” as the industry seems to accept. Graham taught Buffett something else that he takes to heart: “You are neither right or wrong because the crowd disagrees with you. You are right because of your data and reasoning.” This looks like good advice that’s easy to follow. It turns out it isn’t. It takes an odd mix of self-confidence and emotional restraint to follow that advice. Very few people possess this odd mix. Buffett has it, which allows him to practice Intelligent Investing because of the combination of all the factors mentioned above. His investment “style” is this: don’t put all your eggs in one basket, but don’t carry too many baskets either. And watch those baskets very carefully. Most of his peers have too many eggs in too many baskets, and they often fumble. Buffett, is perfectly happy to watch them drop the ball, or the basket, and eggs in them. The main prerequisite of becoming an Intelligent Investor is this kind of self-confidence and temperament. It can be cultivated. I try to, every day.
In his own words...
“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.”
– from The Warren Buffet Way by Robert G. Hagstrom