Buffett: Understanding a business

Buying the business

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Warren Buffett believes, as did Benjamin Graham, that investors should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, or a partnership in the business, they are only buying a tiny share.

A prudent investor never buys a business that they do not understand. Similarly, a prudent share investor should never buy shares in a company, whose business they do not understand.

What Warren Buffet says about buying a business

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their company would only invest in a business that the directors could understand.. He has repeated this message many times since. In 1992, he expanded on this theme:

‘[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.’

Warren Buffett companies

In 2002, Berkshire Hathaway disclosed that it had substantial minority shareholdings in the following listed corporations:

• The Coca Cola Company (see case study)
• American Express
• The Gillette Company
• H and R Block Inc
• M and T Bank
• Moody’s Corporation
• The Washington Post Company
• Wells Fargo and Company

With the exception perhaps of M & T Bank, these are all not only brand name companies but also businesses that are relatively easy to understand. Some examples:

• The Coca Cola Company is the world’s largest beverage company, making and distributing worldwide such products as Coke, Fanta, Sprite, Evian and Minute Maid. It has been in business many, many years and is perhaps the world’s most recognised name.

• American Express is a world-recognised name and makes its money through the sale of traveller’s checks and its brand name credit card. It has been in business a very long time and has a simple business model that even the most unsophisticated investor should be able to understand.

• H & R Block is a worldwide firm that makes its money preparing tax returns for people either unable or unwilling to do it themselves.

Warren Buffett and Keynes

In Warren Buffett’s own words, he did not invest in these companies, and many other successful investments, without acquiring as full a knowledge as possible about the company, its business, its management, and its financial position. He has advised individual investors to do the same, as did the great economist and successful investor John Maynard Keynes.

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about …’ - Jim Keynes

Why Warren Buffett does not invest in Microsoft

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft Corporation but has never invested in it because he does not understand the way that the company works.

Complex companies

Take however, a company like Unilever NV. This is a corporation that has been around a long time, has a worldwide reputation and market, and is successful. But how easy is it to understand the way it operates?

According to Value Line, it has two parent holding companies, one in Great Britain, and one in The Netherlands. It operates as one company but each of the two holding companies owns shares in operating subsidiaries. The director component of both holding companies is the same and there are agreements that equalise dividends and set trading ratios for their respective shares. The business may be good but this complex structure is just too difficult for the average person to understand.

Knowing a company

Knowing a company involves research as well as personal experience and successful investors approach share investment the way that they would the purchase of a business.

They buy a business in an industry area that they know or that they have learned about, they investigate the financials, they look at how the business operated in the past, they weigh up future potential, and they then make a reasoned decision to buy at the price offered or not buy.

Just as the cobbler should stick to his last, investors should stay with what they know. They should not stray into areas beyond their expertise. As Warren Buffett said in 1992:

‘What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.’

Robert Hagstrom has looked extensively at Warren Buffett’s investments over the years and agrees that Buffett has made it his business to understand the business of the companies where he puts the money of Berkshire Hathaway. According to Hagstrom, Buffett:

‘understands the revenues, expenses, cash flow, labor relations flexibility and capital-allocation needs of each of Berkshire’s holdings.’

Hagstrom argues that the prudent individual investor should do no less.

Getting preliminary information – Conscious Investor

One difficulty for the individual investor is getting this information. Investors can track through a series of company reports and financial and other announcements and do their own summaries and analysis. Other investors may choose to simplify their approach and get the summarised information from an investment service such as Conscious Investor.

Personal experience

A careful investor will use a service such as Conscious Investor to cull potential investments but will, before investment, reach their own conclusions based on the original source issued by the company.

Anecdotal evidence and personal experience can also be useful to an investor. There are various anecdotes of Warren Buffett, in early days, making personal visits to company offices and asking for information. Not all investors can do this but they can relate their personal experience of a product or service to their investment decisions.

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