When I was at a group dinner with Warren Buffett 16 years ago, I asked him: what do you look for when you evaluate a stock? He answered: First he decides whether he can roughly estimate the business’s key economic characteristics 5–10 years out. If he can’t then he eliminates it from consideration right then and there.
Warren Buffett has always followed an intrinsic value approach: one in which a security is deemed to be attractive based on the relationship between its price and the value that a knowledgeable buyer would pay for the whole business. Yet, in the time between leaving Benjamin Graham’s Security Analysis class at Columbia University and his current role as Chairman and CEO of Berkshire Hathaway, Buffett’s process has undergone a substantial evolution. It is this evolution and continuous learning that has allowed him to generate the results that he has, far superior to those of other successful value investors.
The Early Warren Buffett
When he started the Buffett Partnership in the late 1950s, Warren Buffett’s investment approach was very similar to that of his teacher, Benjamin Graham. The focus was on the value of the business right now, either based on assets on the balance sheet or due to the earnings power of an established business with a long track record of similar results. As Graham had taught him, the future was something to be guarded against, lest the past record on which the business’s appraisal was built be adversely affected by unforeseen future developments.
His portfolio was split between general issues, situations where Buffett exercised control over the company, and what he called “work-outs” (sales, mergers, liquidations, tenders and other special situations). In his 1960 letter to his partners Warren Buffett described one of the partnership’s earliest large investments, Sanborn Map Company, which at its peak represented nearly 35% of assets. The situation can be summarized as follows:
Sanborn Map’s operating business had sharply declined in profitability in recent years due to new competition
The company had an investment portfolio of bonds and stocks worth approximately $65 per share
Warren Buffett was able to acquire a meaningful minority ownership in the company at a price of approximately $45 per share
He used his large stake in the business to get on the board of directors and agitate for change, namely separating the investment portfolio from the remaining business in order to unlock the value
Warren Buffett ended up settling with the company, with the latter agreeing to an exchange of stock for each shareholder’s share of the investment portfolio to stockholders who desired such an exchange
This meant that shareholders who agreed to the exchange had to give up their ownership of the greatly-diminished map business, but were given a portfolio of securities worth $65 per share that they could then sell on the open market
In this case, Warren Buffett was able to act as the catalyst for his own investment. By adopting an activist stance, he was able to unlock the value in a short period of time. Note that this necessitated leaving some value on the table in the form of the operating business which he had to forego in order to reach a quick settlement.
Warren Buffett’s Intangibles Phase
The next phase in Buffett’s evolution as an investor was to place a far greater emphasis on the intangible assets of a business. Intangibles include things such as brands, entrenched competitive position and intellectual property. This is in contrast with tangible assets such as inventories or property and equipment that underpinned Buffett’s earlier investments.
Two things likely caused Buffett to evolve in this direction. First was his friendship and later partnership with Charlie Munger, who always adopted an approach much more focused on intangible assets than Buffett had. It is likely Munger who brought to Buffett’s attention the work of Phil Fisher, who in his seminal work Common Stocks and Uncommon Profits describes a style of investing focused on deeply analyzing a business’s qualitative characteristics.
The second reason behind Buffett’s evolution was likely the fact that investments available at large discounts to liquidation value were becoming more rare. In Graham’s days it was not difficult to find a company trading below two-thirds of adjusted net working capital (an estimate of liquidation value of a company). However, as time went on, those situations became a lot less frequent. By the time that Buffett returned his partners’ capital in 1969 after citing a dearth of attractive opportunities, his mind was likely fertile to new ideas for how to find bargains in this new environment.
A representative investment from this era was See’s Candy. The company was acquired by Berkshire Hathaway (by way of Blue Chip Stamps, which was controlled by Buffett and Charlie Munger) in 1972. The purchase price was $25M and the pre-tax earnings were under $5M. That meant that at the then corporate tax rate of 48% Buffett was paying around 10X after-tax profits for the company. Another way of looking at this valuation is that his initial earnings yield was around 10%, certainly a far cry from the kind of total returns he was looking for from his typical investments.
However, See’s Candy was a special business with a very large competitive advantage, or as Buffett calls it moat, around its business. In the 2007 letter to Berkshire Hathaway shareholders he described the investment thesis for the company and the subsequent results:
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.
Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings…
Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital… Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion.
You can see how the paradigm shifted. Where the goal previously had been to find hard assets trading at a discount, now it was the intangible qualities of the business – its competitive position and ability to earn abnormal returns on capital that were prized. Consequently, the price paid in relation to profits could also increase without reducing the potential for long-term returns. In his early years Buffett would want to pay a much lower multiple of earnings, translating into a much higher initial earnings yield; this allowed him to generate strong double-digit returns if the future roughly approximated the past earnings record. As the quality of the companies that he invested in improved, he could afford to have a lower initial earnings yield since there was a strong likelihood of those earnings increasing above inflation for a long time.
Warren Buffett’s “Compounders” Phase
Buffett considered it exceptionally rare for a business with a strong competitive advantage and the resulting high return on capital to be able to redeploy capital back into the business at similar rates of return. If such a business could be found it would be the perfect business: strong competitive advantage with accompanying high returns on invested capital, high returns on incremental capital that can be redeployed back into the business, and a large amount of capital that can thus be redeployed over time. The result would be a compounder – a business that could both generate sustainably high returns and grow at above-average rates for a long time.
Warren Buffett found such a business in Geico, the low-cost auto-insurance business that he initially got to know as a 20-year old. By 1995 Berkshire Hathaway owned 50% of the company, and it then proceeded to purchase the other half at what Buffett considered to be a steep price of $2.3B, or over two times the equity invested in the business. Buffett described the investment in his 1995 letter to Berkshire Hathaway shareholders as follows:
Then, in 1995, we agreed to pay $2.3 billion for the half of the company we didn't own. That is a steep price. But it gives us full ownership of a growing enterprise whose business remains exceptional for precisely the same reasons that prevailed in 1951. In addition, GEICO has two extraordinary managers: Tony Nicely, who runs the insurance side of the operation, and Lou Simpson, who runs investments…
GEICO, of course, must continue both to attract good policyholders and keep them happy. It must also reserve and price properly. But the ultimate key to the company's success is its rock-bottom operating costs, which virtually no competitor can match. In 1995, moreover, Tony and his management team pushed underwriting and loss adjustment expenses down further to 23.6% of premiums, nearly one percentage point below 1994's ratio. In business, I look for economic castles protected by unbreachable "moats." Thanks to Tony and his management team, GEICO's moat widened in 1995.
Looking back on the Geico investment in his 2007 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:
When Tony Nicely, GEICO’s CEO, took over in 1993, that share was 2.0%, a level at which it had been stuck for more than a decade. GEICO became a different company under Tony, finding a path to consistent growth while simultaneously maintaining underwriting discipline and keeping its costs low.
Let me quantify Tony’s achievement. When, in 1996, we bought the 50% of GEICO we didn’t already own, it cost us about $2.3 billion. That price implied a value of $4.6 billion for 100%. GEICO then had tangible net worth of $1.9 billion.
The excess over tangible net worth of the implied value – $2.7 billion – was what we estimated GEICO’s “goodwill” to be worth at that time. That goodwill represented the economic value of the policyholders who were then doing business with GEICO. In 1995, those customers had paid the company $2.8 billion in premiums. Consequently, we were valuing GEICO’s customers at about 97% (2.7/2.8) of what they were annually paying the company. By industry standards, that was a very high price. But GEICO was no ordinary insurer: Because of the company’s low costs, its policyholders were consistently profitable and unusually loyal.
Today, premium volume is $14.3 billion and growing. Yet we carry the goodwill of GEICO on our books at only $1.4 billion, an amount that will remain unchanged no matter how much the value of GEICO increases. (Under accounting rules, you write down the carrying value of goodwill if its economic value decreases, but leave it unchanged if economic value increases.) Using the 97%-of-premium-volume yardstick we applied to our 1996 purchase, the real value today of GEICO’s economic goodwill is about $14 billion. And this value is likely to be much higher ten and twenty years from now. GEICO – off to a strong start in 2011 – is the gift that keeps giving.
In Geico, Buffett was able to purchase a true compounder that had a strong competitive advantage and a long runway for profitable growth. He recognized in 1995 that such a company deserves a very large premium to what an ordinary business would be worth. He was willing to pay some of that premium to acquire a superb business well below its intrinsic value even though on the surface the implied valuation statistic that he paid for it would not be considered cheap by traditional value investing standards.
Warren Buffett’s Journey
Buffett started out as a superb securities analyst, having been trained by the father of modern value investing, Benjamin Graham. His early investments reflect that approach – looking to buy what was already tangibly there at a deep discount. Over the years, he evolved into a superb business analyst. As his understanding of businesses deepened, he was able to move beyond buying cheap securities and on to buying exceptional businesses at a large discount to their intrinsic value which took into account their future prospects that were expected to be substantially better than the past. Had he not evolved, Buffett would likely have done well. Because he did evolve he has done exceptionally well. He was able to widen his circle of competence – something that we must all strive to do to continue to excel.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
Note: An earlier version of this article was published on Forbes.com and can be found here.