Don't Buy the New Buffett Book Until You Read This

Andy Obermueller's picture

Tuesday, December 1, 2009 - 4:10pm

by Andy Obermueller

It's the sixth such tome from Mary Buffett, who was, a long time ago, married to Warren's son Peter, a musician. The new book will examine Buffett's management secrets.

This is silly.

Buffett is a renowned investor -- and for good reason -- but certainly he's no great manager. "We delegate to the point of abdication," he says in Berkshire Hathaway's (NYSE: BRK-B) owners' manual. In fact, Buffett only takes over or buys shares in companies with exceptional leaders already in place. Management, Buffett says, is the one thing that Berkshire can't provide. The closest thing to a "Buffett management strategy" is that he relies only on people he trusts. He has proven to be a good judge of both character and talent.  

If you want to learn how to lead a company, read Peter Drucker. If you want to learn about Buffett, pick up Alice Schroeder's 2008 "Snowball," his authorized biography. But if you want your portfolio to emulate that of the world's most successful investor, you don't really need to buy a book. Just follow the Oracle's advice, which he has freely dispensed --

I've been studying Buffett since eighth grade.   

Here's what I've learned:

1. Don't invest in anything you don't understand.

A business model -- how the company makes money -- should be exceedingly simple. While the most obvious example of Buffett's adherence to this tenet is his famous refusal to participate in the tech bubble, he has always looked to venerable companies that make money the old-fashioned way: A bank lends money. A candy company sells chocolates. Insurers write policies. Those are three examples that Buffett understands and are companies that he owns. But other, more complex "New Economy" companies -- even good ones like Yahoo (Nasdaq: YHOO) or Microsoft (Nasdaq: MSFT) -- Buffett just doesn't get. They're not within his circle of competence, notwithstanding the fact that the Yahoo CEO and Microsoft founder sit on Berkshire's board.

Buffett's lesson: If you can't figure out how a company makes money and explain it in two sentences to an eight-grader, don't buy the business.

2. The best companies generate lots of cash with very little additional investment.

Buffett's ideal business model is a toll bridge: You buy the thing and it generates tolls for decades. Maybe it requires a little additional maintenance every so often, but it mostly just pays a slow, steady, dependable return.

Buffett has occasionally violated this rule. FlightSafety, for example, is a Berkshire company that offers training to pilots. It requires scores of millions of dollars a year to keep up with expensive and ever-changing aviation technology. Now, the company is profitable and Buffett isn't going to sell it, but he'd much rather have the predictable stodgy returns of a company like See's Candies, which participates in a no-growth market but requires no additional capital. See's has generated far more cash than Buffett paid for it in the early 1970s.  Given the choice between 10 FlightSafetys and ten See's Candies, Buffett would take the candy stores every time.

Buffett's lesson: It takes money to make money, sure, but they money you're forced to put into the business -- to "reinvest" comes right off the bottom line. Don't buy those companies.
 
3. Seek industry leaders with sustainable competitive advantages.

If you build a castle, someone without a castle will try to take it. So when you build it, make sure that it has a wide and deep moat that no rival can cross. The result is your castle will always be protected. The castle, of course, is a business. And the moat represents its sustainable competitive advantage.

Buffett seeks companies that have a dominant and inviolate market positions. No one can touch the awesome power of the Coca-Cola (NYSE: KO) or American Express (NYSE: AXP) brands, for example. If you're going to own a retailer, buy one that no one can compete with. (Buffett recently upped his stake in Walmart (NYSE: WMT).)

Buffett's lesson: A sustainable competitive advantage means secure revenues and earnings and, thus, the investment carries less risk than its competitors.

4. The tortoise wins.

Buffett thinks short-term gains are a sucker's bargain. He always invests for the long term. The best length of time to hold a stock, Buffett says, is forever. That doesn’t mean one shouldn't take gains -- Buffett has certainly done that -- but the rule should be long-term growth of invested capital. Buffett has said he invests under the premise that the stock market could close tomorrow for five years and he'd be just fine when it reopened.

That's a good policy.

It also, if applied properly, changes an investor's perspective. Buffett never looks at himself as an investor, he looks at himself as an owner of the business. He looks beyond the current value of the business but its future earnings potential during the years and decades to come. Buffett refers to this as a company's intrinsic value. An investor sees a company's earnings as a dividend check; Buffett sees them as lowering his cost basis on an investment and, eventually, paying for it.

Buffett's lesson: A dependable, modest return with no losses over the long term will beat the market average and the competition nine times out of ten. Go for slow and steady.

5. The best money is free money.

To understand Warren Buffett an investor must understand the business of insurance. Buffett's affinity for insurance is based on one thing: He loves free money.

An insurance company expects to pay out more in claims than it takes in as premiums. That's what's known as an "underwriting loss." The way most insurance companies actually make a profit is by investing policyholders' premiums until claims are presented that are deemed valid and due. If those investments generate enough return to cover underwriting losses and expenses -- plus a reasonable return on the company's own capital -- then the insurer is worthwhile as a going concern.  

Here's the kicker: Some of Buffett's insurance operations actually generate an operating profit. His underwriters are experts at charging customers the appropriate amount to protect them from financial loss. There's no such thing as a bad risk, Buffett says, only a bad price. An underwriting profit means its customers are paying the insurance company to use policyholder money to make a profit the insurance company gets to keep. That's a business model that makes Warren Buffett very happy and has made him very, very wealthy. The best way to make a profit is with someone else's money, and Buffett has made billions of dollars using the float from his insurance companies.
 
Buffet's Lesson: It's not enough to understand the business. An investor must also understand the cost of capital. (And if someone will pay you to make money, always take them up on it.)

6. Patience is paramount.

Buffett is almost Zen-like in his patience. If he can't find a business at a reasonable price, then he waits. As he waits, he builds a cash hoard so he has money when everyone else doesn't. At no point was this more vividly illustrated than in the financial crunch, when Buffett was the only major player who had cash and was willing to lend it. Oh, and whom did he lend it to? Industry leaders like Goldman Sachs (NYSE: GS). Companies with a sustainable competitive advantage like Harley-Davidson (NYSE: HOG). And each of those deals compensated him for his patience and his risk as he priced long-term deals that would more than cover his cost of capital. He followed all his rules, and he'll reap hundreds of millions for years to come.

Buffett's lesson: Building wealth is a marathon, not a sprint. Be patient, be careful and keep plenty of cash on hand so you can buy when everyone wants to sell.

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.