Question: What’s your philosophy in buying businesses?
Buffett: The first question I ask is: “Does the owner love the business or does he/she love the money?” It’s very easy to tell the difference.
I am proud to be able to provide a safe home for many businesses. It is like finding a home for a painting. Business owners who are looking to sell can either sell their businesses to Berkshire (like putting a painting in the Metropolitan Museum of Art) or sell to an LBO and let them tear it up, dress up the accounting, and resell it (like the sale of a painting to a porn shop).
Source: Buffett Vanderbilt Notes, Jan 2005
It’s a question of being able to identify businesses that you understand, and you are very certain about. If you recognize those markets, and many people do, but Charlie and I don’t, then you have the opportunity to evaluate them. If you decide they’re reasonably priced, and they have marvelous prospects, you’re going to do very well. But there’s a whole group of companies–a vast group of companies–that Charlie and I just don’t know how to value. And that doesn’t bother us.
I mean, we don’t know how to figure out what cocoa beans are going to do, or the Russian ruble–there’s all kinds of financial instruments that we just don’t feel we have the knowledge to evaluate. It might be a bit too much to expect somebody would understand every business in the world. We find some that are much harder for us to understand. When I say understand–my definition of understanding is that you have to have a pretty good idea of where it’s going to be in ten years. I just can’t get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, as you pointed out, or something like that. It would be better for you–it certainly would have been better for you if we had had the insights about what we regard as the more complicated businesses you describe–because there was and may still be a chance to make a whole lot more money if those growth rates that you describe are maintained.
I don’t think you’ll find better managers than Andy Grove at Intel or Bill Gates at Microsoft, and they certainly seem to have fantastic positions in the businesses they’re in, but I don’t know enough about those businesses to be sure that those companies are fantastic as I am about being sure that Gillette and Coca-Cola’s businesses are excellent. You may understand those markets better than you understand Coke and Gillette because of your background or just the way your mind is wired. But I don’t, and therefore, I have to stick with what I think I can understand.
Source: BRK Annual Meeting, May 1997
We favor businesses where we think we know the answer. If we believe the business’s competitive position is shaky, we won’t try to compensate with the price. We want to buy a great business, defined as having a high return on capital for an extended period, where we think management will treat us right. We like to buy at 40 cents on the dollar but will pay a lot closer to $1 on the dollar for a great business.
If we see someone who weighs 300 pounds or 320 pounds, it doesn’t matter – we know they’re fat. We look for fat companies.
We don’t get paid for the past, only the future [profitability of business]. The past is only useful to give you insights into the future, but sometimes there’s no insight. At times, we’ve been able to buy businesses at one-quarter of what they’re worth, but we haven’t seen that recently [pause] except South Korea.
Munger: Margin of safety means was getting more value than you’re paying. There are many ways to get value. It’s high school algebra; if you can’t do this, then don’t invest.
Munger: When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can just be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly.
Buffett: Let’s say you decide you want to buy a farm, and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume Agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7% return, so you’d pay $1,000/acre. If it’s for sale at $800, you buy, but if it’s at $1,200, you don’t.
Buffett: If you’re going purchase a farm, you’d say, “I bought it to earn $X growing soybeans.” It wouldn’t be based on what you saw on TV or what a friend said. It’s the same with stocks. Take out a yellow pad and say, “If I’m going to buy GM at $30, it has 600 million shares, so I’m paying $18 billion,” and answer the question, why? If you can’t answer that, you’re not subjecting it to business tests.
We have to understand the competitive position and dynamics of the firm and look out into the future. With some companies, you can’t. The math of investing was set out by Aesop in 600 BC: a bird in the hand is worth two in the bush. We ask ourselves how certain we are about birds in the bush. Are there two? Might there be more? We just choose which bushes we want to buy from in the future.
The ability to generate cash and reinvest it is critical. It’s capacity to generate cash that gives Berkshire value. We choose to retain it because [we think we can reinvest each dollar to make more than $1 of value].
If you were thinking about paying $900,000 or $1.3 million for a McDonald’s stand, you’d think about things like whether people will keep eating hamburgers and whether McDonald’s could change the franchise agreement. You have to know what you’re doing and whether you’re within your circle of competence.
Munger: We have no system for estimating the correct value of all businesses. We put almost all in the “too hard” pile and sift through a few easy ones.
Buffett: We know how to recognize and step over one-foot bars and recognize and avoid seven-foot bars.
Source: BRK Annual Meeting 2007 Tilson Notes