Warren Buffett’s background

Warren Buffett wanted to get rich from an early age and had a newspaper route that made him plenty of money. Then he used the money to buy some pinball machines. Then he plowed through every book he could get his hands on about how to make money. Then he found Benjamin Graham’s Intelligent Investor and got hooked.

One of Warren Buffett’s worst buys was Berkshire Hathaway, which was originally a textile company. It was bad because the factories and machinery cost a lot of money (Fixed Costs) and the earnings unfortunately did not increase as the investment in new machinery made up for it.

Warren Buffett’s strategies for value investing

Warren Buffett’s career as a value investor can be divided into three parts: (1) the young Buffett who learned from Benjamin Graham to buy cheap companies – in terms of the balance sheet, (2) the middle-aged Warren Buffett who wanted to buy quality companies a la Philip Fisher, and preferably also strong brands for everyday items (“essentials”) that the population buys and it is easy to predict the consumption patterns demographically, such as razors (Gillette) or candy (Mars), or soft drinks (Coca Cola). Finally, (3) today’s Buffett, who is very restricted in what he (or perhaps rather Berkshire’s investment team) is forced to buy because of their size.

Value investing tips from Warren Buffett:

• Buy companies that enjoy producer surplus, not consumer surplus. The mistake of Berkshire Hathaway (the textile mill) was that reinvesting in the business did not benefit them, because all their competitors were doing the same. Thus, it was the consumers who benefited, not the producers. Furthermore, Berkshire Hathaway was not a cash flow positive company….
• Buy cash flow positive companies. Companies that have low fixed costs relative to the revenue they bring in. Why is that? Because then you, as an investor, can be more confident that they won’t need a lot of reinvestment in the future. (Not liquidity problems.) It also makes your analysis  easier, because you don’t have to guess or worry about how or when the company is going to make money, like a start-up.
• What might these cash-flow positive companies look like? Usually it’s a company with large (government) contracts that run for many years (where they get the money upfront), or a strong brand like See’s Candy, or a subscription company like Bloomberg.
• Don’t lose money.
• Don’t invest without an established margin of safety – a margin of error.
• It’s not enough to say “I believe in that company and they’re going up”, you have to be able to say, “I believe in that company and they’re going up and I’m buying them at a 30% discount”. The reason why so many people invest lightly is because they have no margin for error in their valuation models.
• You are likely to get the best results by investing in a particular area that you understand better than others. For Warren Buffett, this has been the financial industry; insurance companies and banks mainly. His best buys are probably in the early GEICO.
• This means that you should be (or learn to be) comfortable with passing on maybe 9 out of 10 stocks, until you find one where you are absolutely sure that it is actually cheap. The exception to this, of course, is during recessions or depressions, when virtually everything goes down more than warranted due to sentiment, rather than some qualitative factor of the business that has worsened irreparably.

Warren Buffett knows most things about most things when it comes to value investing, however….

Warren Buffett and Berkshire are not able to do all kinds of investments or trades, because they have such enormous amounts of assets under management that they have two problems: (1) fast-growing small companies are simply too small to be worth their time, and (2) if they find something interesting, they generally have to buy a large stake, which will drive up the share price. Therefore they prefer private takeovers of whole or large parts of companies.

Too bad for them. But as a private investor, you don’t have those problems. You can learn from Buffett & Co, but you should rather learn from Warren Buffett aged 18-40, than today’s Buffett.

• Probably the best source is his shareholder letters when he had a private hedge fund, before founding Berkshire Hathaway. You can read it here.

Uncommon Knowledge: 3 Little-Known Facts About Warren Buffett and His Success as an Investor

1. Warren Buffett has, for a long time, had the unfair advantage of being able to get much better (private) deals than almost anybody else. There are several examples, but perhaps the most famous ones are Solomon Bank and Fannie Mae. This is not something a private investor can do. The only lesson is that he was consistently good at structuring his deals so as to get a large percentage in preferred shares or some type of guaranteed annual dividends (minimum return) and then normal stocks or options, so as to enjoy the upside of an eventual (highly probable) stock price appreciation.
2. Together with Charlie Munger, he realized the power of “Float” — to have a negative cash conversion cycle whereby they retain more cash in the business operations than they need to pay out. This was mainly done by owning insurance companies (where the premiums are often paid 1 year in advance). The surplus cash can then temporarily be invested in other (super-safe) assets, such as bonds, extremely safe stocks, or even used to help other stocks in Berkshire. That means they could continually “arbitrage” this money at 3-10% per year with almost zero risk, for 40 years. They did this before anyone else did, at a bigger scale, and with better execution. That compounds to a large number. This single big idea may actually account for as much as 50% of Berkshire’s success today, not just the stock-picking. In other words, Buffett wasn’t just a great investor, he created a way to amplify this ability, like taking steroids except without the negative effects. This ties nicely in with the final point.
3. Warren Buffett is easily one of the best investors of all time, but there are several other investors who can be said to be “better”, as in having better percentage-wise returns, or better risk-adjusted returns, but in absolute numbers Warren Buffett is easily #1. What is the difference? Buffett stopped being a normal investor (who just owns the stock) and started becoming actively involved in running and selecting management for businesses. Buffett himself said it best:

“I am a better investor because I am a businessman, and a better businessman because I am an investor.”

This may actually be Warren Buffett’s single best piece of advice.

Read on: About the strategies of 20 other value investors.