In his 1976 letter to shareholders, Warren Buffett laid out his four simple rules for whether a business is worth investing in. While simple, very few investments meet this criteria, which makes it very effective when applied rigorously and honestly.
1. Does it have favourable long-term economic characteristics?
This rule has effectively two components. First, what are the growth opportunities for the business? What is the TAM? If the industry is growing rapidly, the businesses within it have a good shot at growing themselves as they capture that value. Second, does this business in particular have characteristics that position it to capture that growth. In other words, does it have a moat which enables it to ward off competition and protect its margin. An investment candidate does not need to have the first, though it is certainly helpful. But it does need to have the second. Buffett has said in the past that he would rather have an excellent business in a mediocre industry than a mediocre business in an excellent industry.
2. Does the business have honest and competent management?
Another paraphrased quote from Buffett is that you want management to be smart, hardworking and honest. But if they aren’t honest, you want them to be dumb and lazy. It’s funny, but the point is important. You cannot invest in a business, no matter how attractive, if you do not trust management. The risk associated with having management that either lies, misleads or commits fraud is catastrophic. This can be very difficult to assess as a retail investor without access to management in person. However, I think the beauty of the internet today is that for many large cap businesses, there is likely to be interviews, presentation and other content available for the investor to use in their assessment. Reputation is also are really import thing to take into account. OpenAI is a good example. While you can listen to Sam Altman talk and he sounds very intelligent and level-headed, he has a reputation for lying. He was almost ousted from OpenAI for lying to the board. Whether this is true cannot be known by us, but there is too much smoke for the risk to be worth it.
3. Is the purchase price attractive relative to value?
This is actually probably one of the more straight forward steps, assuming you have done the work to answer the previous two questions. You can use a reverse DCF to estimate what the market is pricing in, and then a DCF to estimate your own valuation of the company. A margin of safety should be applied in order to protect the investor against the possibility that they are wrong. However, once the work is performed, its really just a yes-no decision on whether the price is fair.
4. Is this an industry you understand and can judge?
This is the step that requires the most intellectual honesty. We all know less than we like to think we know, and mistaking knowledge for understanding can cost the investor a lot. How confident are you that you have made the right call on the three assumptions above? Do you have an edge on the rest of the market, or are you just disagreeing for the sake of it. Buffett would probably say that any business you don’t understand should go in the “too hard” pile, however, I think there is an argument to be made for working your confidence level into the margin of safety. For me, for example, even in industries that I have experience and experience in, or I am a passionate customer and understand the value of the product, I struggle to judge my own confidence as a yes-no decision. Instead, it’s easier for me to say that I am 50%, 70%, 90% confident that I am right and the market is wrong. In this case, I can use this confidence level as my margin of safety that I want baked into the price before buying. For example, if I have answered the previous 3 questions and estimate the value of the stock at $100, but the stock is priced at $80, then I have a 20% margin of safety on my decision. If I am only 70% confident in my judgement however, this would still not be low enough to trigger an entry on the investment.
Connections
Capital Cycle Purchase Candidates
Link Explanation:
The capital cycle and the purchase candidates frameworks provide a straightforward approach to assessing the answer to the first of Buffett’s questions. By understanding the industries position in it’s capital cycle, and whether the business has either a larger TAM than the market assumes, or the moat protects the business against competition longer than the market assume, the investor can make a confident decision in either direction for whether the candidate passes.
Reference
Berkshire Hathaway Letters to Shareholders, 2021