Investment Process: When Evaluating Businesses, Stay within Your Strengths

Investment Process: When Evaluating Businesses, Stay within Your Strengths

Warren Buffett is widely regarded as the world’s most successful investor. He buys companies that he believes are trading for less than what they are worth. Although this concept might go against the grain of popular understanding, Warren Buffett relies intensely on stable companies with steady, predictable products and services because companies with such businesses allow him to precisely forecast the future cash flows of the business. This is indispensable because without being able to guesstimate these statistics, he’s unable to assess the true value of the business.

Warren Buffett takes into consideration the future streams of cash flows an asset will generate, independent of what the market thinks of the asset today. He is not affected with short-term performance and the effect it might have on asset flows, nor with being measured versus a benchmark or having his returns matched to a peer group. In Berkshire Hathaway’s 1996 Chairman’s letter and annual report, Warren Buffett wrote,

Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.

Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.

If Buffett cannot comprehend a company’s business, it’s services or products, and evaluate it’s prospects over the long term, then he deems that the company lies beyond his circle of competence, and he won’t endeavor to value it. He legendarily avoided technology stocks in the flourishing ‘nineties in part because he had no know-how in technology. In contrast, Buffett continued to buy and hold what he knew, the companies and the businesses that were in his circle of competence. For example, he was prepared to purchase a large share in Coca-Cola because he understood the company’s products, its business model, and evaluate the future cash flow of the company. In Berkshire Hathaway’s 1993 Chairman’s letter and annual report, Warren Buffett wrote,

The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Although it might seem easily discernible that investors should stick to what they know, the enticement to step outside one’s circle of competence can be strong. What counts most for investors is not so much what they know but how convincingly they can define what they don’t know.

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