A Common Misconception About Buffett

Debunking one of the accepted myths about how Buffett values companies

Kevin over at the Kingswell Substack - worth a follow! - keeps track of all things Berkshire Hathaway. He recently shared and transcribed a 2008 clip from Buffett biographer, Alice Schroeder, who presented at a conference on Buffett’s investing process.

Specifically, she discussed Buffett’s 1960 investment in Mid-Continent Tab Card Co.

Schroeder sheds light on two important aspects of Buffett’s process for evaluating investment opportunities.

The first:

He said no [originally to Mid-Continent] because he went through the first step in his investing process. And this is where, I think, what he does that’s very automatic — but isn’t well understood. He acted like a horse handicapper.

The first step in Warren’s investing process is always to say, “What are the odds that this business could be subject to any kind of catastrophe risk that could make it just fail?” If there is any chance that any significant amount of his capital could be subject to catastrophe risk, he just stops thinking. No. And he won’t go there.

It’s backwards [to] the way that most people invest because most people find an interesting idea, they figure out the math, they look at the financials, they do a projection, and then at the end they ask themselves, “Okay, what could go wrong?”

This is very consistent with Buffett lore. Rule number one, and all. It’s classical value investing 101.

Schroeder continues to the second point. It’s here that it gets a bit confusing:

Here’s another point of departure from what almost anybody else would do. Everybody that I know — or knew as an analyst — would have created a model for this company and would have projected out its earnings and would have looked at its return on investment in the future. Warren didn’t do that. In fact, in going through hundreds of his files, I’ve never seen anything that resembled a model.

What he did is he did what you would do with a horse. He figured out the one or two factors that could make the horse succeed or fail — and, in this case, it was sales growth and making the cost advantage continue to work. Then, he took all of the historical data, quarter by quarter for every single plant, he got the similar information as best he could from every competitor they had, and he filled pages with little hen scratches of all this information and he studied that information.

And, then, he made a yes/no decision. He looked at it: They were getting 36% margins [and] they were growing over 70% a year on a million of sales. Those were the historic numbers. He looked at them in great detail — just like a horse handicapper studying the tip sheet — and then he said to himself, “I want a 15% return on $2 million of sales.” And then he said, “Yeah, I can get that.” And he came in as an investor.

I listened to and read this section a few times and it wasn’t immediately clear what she meant by “15% on $2 million of sales.”

What did the company’s operational revenue have to do with Buffett’s prospective investment return?

Upon further reflection, it sounds like Buffett was referring to the company’s potential earnings growth if it bought a new Carroll Press with the proposed capital raise. He arrived at the 15% figure using assumptions about margins and asset turnover.

Photo by Thomas Dewey on Unsplash

As we discussed in this post, Buffett is more interested in generating returns from fundamental growth (dividends and earnings) than speculative returns (change in multiple).

Using that lens, it’s consistent that he associated earnings growth with a prospective investment return.

But the misunderstanding many have about Buffett’s process is that he doesn’t do any forecasting. This dissonance is in part supported by some of Buffett and Munger’s famous disparaging remarks about forecasters.

"We've long felt that the only value of stock forecasters is to make fortune tellers look good."

- Buffett

“I don’t let people do projections for me because I don’t like throwing up on the desk.”

- Munger

An attendee at Schroeder’s conference asked about Buffett’s notebook of historical figures he used to analyze Mid-Continent Tab Card, to which she responded:

The difference from a model is [Buffett’s] would not add the quarters up and it would not project anything into the future. Nothing.

In other words, he looked at what had been reported and he said, “They’ve had a million in sales. They’ve earned this many thousand. I want this much. They’ve earned this and I want this. Can they do it? Yes [or] no.” That’s the decision.

There’s a saying — I think it’s from The Intelligent Investor — that the purpose of the margin of safety is to render forecasts unnecessary.

Maybe, but to me, that sounds a lot like a model and forecast.

Look, perhaps I’m splitting hairs here, but I think this is an important distinction. Even if Buffett didn’t make explicit projections with the historical data, as one might with a discounted cash flow model, he still made implicit assumptions about the future.

Buffett has long preached that the present value of an asset is its future cash flows discounted back to the present. Anytime you’re valuing an asset, then, you’re making assumptions - a forecast - about its future.

It might be a conservative forecast using base rates, for example, but even those numbers are based on an assumption that past trends will continue. You might be using multiples instead of a model, but implicit in the multiples are assumptions about the future growth and profitability of the business.

To be sure, investors can get themselves in trouble by forecasting unreasonable growth to justify an investment at current prices. Ideally, conservative assumptions are enough to make the current price look cheap. Either way, however, you’re making decisions about “what might be” rather than “what is.”

Perhaps the key here is that Buffett can run forecasts in his head while us mortals are relegated to an Excel spreadsheet.

What do you think? Please let me know in the comments.

Stay patient, stay focused.

Todd

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Todd Wenning is the founder of KNA Capital Management, LLC, an Ohio-registered investment advisor that manages a concentrated equity strategy and provides other investment-related services.

At the time of publication, Todd, his immediate family, KNA Capital Management, LLC, and/or its clients, own shares of Berkshire Hathaway.

Please see important disclaimers.