Berkshire Ruminations

Friday, June 23, 2006

Value investing, in a (very small) nutshell.

People familiar with him will usually be able to identify a “Warren Buffett” stock when we see one, but at times I have been stumped as to explain why a certain company is consistent with his philosophy. Teaching the Warren Buffett Course at MU and being forced to design a framework for making investment decisions made things immensely clearer to me. For one, and contrary to popular belief, there is no set of rules that every company must follow in order to be a good Berkshire investment. Rather, there is an array of different structures and characteristics that when operating concurrently produce a profitable and value-producing business.

For example, we often think of a Buffett company as having tremendous brand equity – “franchise value” as Mr. Buffett calls it. Mr. Buffett prefers to avoid companies that sell commodity products on which a customer will base his purchase decision primarily on price. How then, do we reconcile this principle with his investments in insurance or energy, neither of which has an important brand identity? The answer to the insurance question is simply “float” and the answer to the energy question is the favorable regulatory outlook that Berkshire foresaw. The point is, however, that there are numerous variables, all of which may make for a good investment. Not every company needs to a have a strong brand, nor does every company need management that behaves a certain way, say for instance one that expenses stock options.

This is because all of the characteristics we think of as prerequisites for a Berkshire investment, are nothing more than an indication of value. In the end, every purchase comes down to this one word. After all, Mr. Buffett is the world’s greatest value investor. A strong brand adds value. Good management adds value. The existence of float adds value and a favorable regulatory outlook adds value. The way we measure this value, in my opinion, is a general assessment of all the qualities that a make a company good, adjusting for all the other qualities that make it bad. If, after careful thought and consideration, Mr. Buffett decides that on the whole the company has more value than its current price would suggest, he will consider buying. It is that simple.


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