Buffett’s Tenets - On Selecting Businesses (Part 1)
Now that Warren Buffett has shown us how oppportunities arise when the market is at its emotional extremes, it’s time to pick his brain on how he selects businesses. If you were just joining us, Investorial is running a series of Buffett’s tenets — his ideas on investing. We’ve already covered some of Buffett’s tenets on the market. If you want to catch up, by all means! We’ll wait for you.
The overriding tenet for all the discussion in this chapter will be that investors should “never invest in a business you cannot understand“. If you’ve ever played poker or know someone who does, you’ll often hear the notion that “poker players are not gamblers”. The good players win on their skill, temperment, and intimate knowledge of the game. “Dead money” describes the unskilled poker players; having to rely more on luck than skill to sit at the same table. Are you “dead money” when it comes to stock investing? Have you ever invested in a stock that you couldn’t understand? Were you blinded by the hype, the potential return, or because that stock-tip came from a relative working in the financial services industry? This Buffett tenet is so important that I’ve decided to emphasize it first before we examine his next few doctrines.
Buffett On Management
- Is management rational?
- Is management candid with the shareholders?
- Does management resist the institutional imperative?
No matter how management denies that they have no knowledge of accounting scandals in their company, management is in the leadership role and whether the ship floats or sinks largely depends on their competence. Rational management describes a management team whose every decision at every turn is about what is good for the business, what can create value for the shareholders. How are the company’s retained earnings reinvested back to generate above-average returns? Are they buying back shares rationally? (meaning they’re not buying back shares when prices are at their highest to benefit the executive sell-offs) If they cannot generate above-average returns, will they return the cash back to shareholders?
On a side note, I also believe that management constantly needs to be focused on the right things — running the business. Some CEOs would rather take on the market, the shorters and the hedge funds in an effort to boost up their share price. Creating value for shareholders is not about artificially boosting the stock price but by proving success through operations. What they should realize is that if they were focused on building a fundamentally sound business, there would not exist an environment for such stock price manipulation. For me, examples like OverStock and Fairfax don’t show how management is acting rationally. Those ligitation and battles serve to only distract from the underlying instability in their business operations.
A company’s executive team must be candid with shareholders. They are YOUR employees! On the flip-side, if you have a 9-to-5 career, how much of your dissatisfaction comes from the fact that your superiors will not be candid with you about your projects, your development and your career? Nobody likes to be kept in the dark, but managements that choose to because they can should really examine this. Honestly, would you like to be an owner of a business that has such a culture?
The “institutional imperative” that Buffett referred to can simply be explained as “corporate peer pressure”. Are the companies you invested in, constantly looking over their shoulder? If competitor A acquires competitor B, does your CEO immediately take a “whatever it takes” approach to acquire competitor C because others are doing it? How many technology companies will take a stance against stock option grants? Can companies attract great executive talents without resorting to the same ridiculous contracts that their competitors do? The guiding principle should always be what’s right for our business, not what’s happening with their business.
Buffett On Business Trends
- “Turn-arounds” seldom turn.
- Does the business have a consistent operating history?
- Does the business have favourable long term prospects?
- Do not take yearly results too seriously. Instead, focus on four or five-year averages.
At first, Buffett’s opinions on turn-around situations surprised me because I’m an admitted contrarian. But the more I think about it, the more it makes sense. Contrarians are not so much about betting on turn-arounds, but more about taking advantage of market over-reactions. The difference in the latter is that the market is focusing on a short-term blip in company operations and by no means is in the dire straits that warrant a “turn-around” when you are looking at the long-term view. Notable names such as Sun Microsystems, Corel, Nortel, K-Mart (acquired by Sears) come to mind when we think about turn-arounds that have not happened yet. Of course, there are always exceptions to the case such as Apple, but those exceptions are rare. For most rational investors, their efforts could be better spent looking at other businesses.
But instead of a turnaround, wouldn’t you rather own a company that makes money, and keeps making money and will keep doing it in the future? That’s the ethos behind looking for a consistent operating history. We have that “past data is not an indication of the future” burned into our minds but you know consistency when you see it! Take for example: Exxon Mobil who has been arguably one of the most consistent operating histories. Buffett looks for companies that have demonstrated competence in generating above-average returns. A player who can get a hit-on-base every time at bat helping to drive runs in, versus a home-run hitter who gets it out of the park once every 20 times he steps up to the plate.
However, consistency should also be married with the long-term prospects of the business. One of the reasons I am not bullish on the telecom industry is because they are currently cannibalizing themselves; trying to compete with Voice over IP solution providers. It’s not to say that the industry will not eventually stablize or transform itself into a winning industry. But it’s prospects are far more hazy to investors who are seeking clarity in their decisions.
Finally, I could write an entire book ridiculing why Wall street is still thoroughly obssess about the short-term performance of a company. There isn’t one company out there that will not encounter obstacles during their existence. The lackluster returns of within the last year is not a true indication of a management team’s proven execution over the last four or five years. Don’t misread me, investors should still consider those data. But Wall Street often overreacts to the data, and that’s what Buffett is suggesting that investors avoid the herd mentality and think for themselves.
A Sneak Preview …
We’re not done with Buffett’s tenets on selecting businesses. So far, we’ve merely scratched the surface on what rational we should build into our thesis. The next part of this will be focusing on the metrics and evaluation methods that allows Buffett to qualify companies as quality businesses. And after that, we’re continuing with Buffett’s tenets on being a successful investor and some of his counter-culture views on investing. With all that happening, you can’t afford to miss out, right? Grab the site’s syndication feed (also located at top-right corner) or subscribe to email updates to stay informed when new editorials show up on Investorial!
Related Posts:
- Buffett’s Tenets - On Contrary Thoughts
- Buffett’s Tenets - On Selecting Businesses (Part 2)
- Buffett’s Tenets - On The Market
- Buffett’s Tenets - On Being An Investor
