Lessons from The Warren Buffett Way

The 30-year-old classic sheds light on Buffett's thoughts on inflation, franchises, permanent holding criteria and much more.

Recently, while perusing a used bookstore, I came across a first edition of Robert Hagstrom’s The Warren Buffett Way, published in 1994.

Having read just about everything by and about Buffett, including Hagstrom’s follow-on book, The Warren Buffett Portfolio, I hesitated to read this one.

However, at $3 it was too good to pass up. It turned out to be a good value investment.

I didn’t realize that The Warren Buffett Way pre-dated Roger Lowenstein’s best-seller, Warren Buffett: The Making of an American Capitalist, by a year. Now celebrating its 30th anniversary with a new edition, The Warren Buffett Way was the first mass-market book about Buffett’s investment philosophy.

Hagstrom, being a practitioner, extracted important nuances to Buffett’s approach that I hadn’t seen in other books on Buffett. It’s well worth a read, even if you are steeped in the Buffett canon.

What follows are some key lessons I took from my first reading of the book. Three topics jumped out: the dangers of inflation, how franchises combat inflation, and what separates permanent from “available-for-sale” holdings.

Inflation

“(Buffett) seeks to avoid those businesses that will be hurt by inflation…and the ones that are hurt the least are those with significant amounts of economic goodwill.”

Over his career, Buffett has regularly warned of inflation's negative impacts on equities. His 1977 article in Fortune magazine, "How Inflation Swindles the Equity Investor," tears apart the false but (still) popular notion that stocks are a natural hedge against inflation.

Some businesses can be good inflation hedges—more on those in a moment. Still, if we break apart the components of return on equity, which my students will recognize as the DuPont analysis (below), we can see how inflation indeed swindles equity investors.

Using this analysis, Buffett lists the five ways that companies can increase return on equity:

1. Increase asset turnover (increases sales relative to assets)

2. Widen profit margins (increases net income relative to sales)

3. Pay lower taxes (increases net income relative to sales)

4. Increase leverage (reduces equity relative to assets)

5. Use cheaper leverage (increases net income relative to sales)

Inflation may initially increase reported asset turnover as inflated sales grow faster than assets held at their original cost.

However, due to the same inflation effects, the assets will eventually need to be replaced at a higher price. Over an economic cycle, then, inflation's impact on the asset turnover ratio is minimal and depends on the capital intensity of the business and the length of the asset replacement cycle.

Profit margins are also pressured in inflationary environments. As we saw in the most recent inflation spike, company executives are challenged to raise prices against dynamic labor, energy, and materials costs. Meanwhile, increasingly price-sensitive customers resist the hikes.

Buffett makes a compelling case that, in an inflationary environment, federal, state, and local governments are inclined to take a more significant share of corporate profits through higher tax rates. These entities have their own budgets and spending needs to consider and are ahead of investors in line to get paid. Do not assume lower corporate tax rates in such an environment, Buffett argues.

With rising asset prices, margin headwinds, and the prospect of higher taxes, companies will naturally seek to borrow to make ends meet. While increasing leverage boosts ROE, all else equal, higher borrowing costs accompany inflation as lenders become more risk-averse.

Even if companies don't seek to increase leverage, they are met with higher debt refinancing costs, dampening the ability to increase profit margins.

As such, debt-dependent companies will not be safe havens during inflationary periods.

“An irony in business is that those companies who can best afford debt usually require little, and those companies that struggle to remain profitable are always standing in front of the banker’s window.”

The inflation spike in 2021-2022 and concurrent market sell-off was a taste of the damage inflation can do to equity owners. It’s a risk that wasn’t top of mind for much of the last 30 years until it was.

Franchises

To limit the risks of inflation, Buffett seeks franchises loaded with "economic goodwill," a lesson Hagstrom notes Buffett learned through his investment in See's Candy.

“Economic goodwill not only produces above-average returns on capital but its value tends to increase with inflation. This appreciation is fundamental in understanding Buffett’s equity-investment strategy.” (my emphasis)

As an investor who has long studied Buffett's approach to moats, I found it curious—and refreshing—that the word "moat" does not appear in the first edition. Instead, Hagstrom explores the concept of a “franchise” versus “commodity” businesses.

“(Buffett) defines a franchise as a company providing a product or service that is (1) needed or desired, (2) has no close substitute, and (3) is not regulated. These traits allow a franchise to regularly increase the prices of its product or service without fear of losing market share or unit volume.”

Though moats and franchises have a lot of natural overlap, I like the simplicity of the above definition. If you spend no time thinking about network effects, switching costs, or another type of moat analysis, you'll do better than you would have by filtering ideas through these three points.

A franchise possesses the economic goodwill necessary to raise prices in all environments without commensurate capital expenditures, particularly during inflationary ones.

Economic goodwill is an intangible asset that doesn’t show up on the balance sheet or require much capital to sustain. Firms with economic goodwill therefore tend to generate high returns on invested capital. An uptick in the cost of capital will not eliminate their ability to create shareholder value.

In an inflationary environment, capital-intensive, undifferentiated commodity businesses must spend much of their cash flow on more expensive capital expenditures to remain in place. Their dividends come under pressure and they lack the ability to repurchase stock when it gets cheap. Conversely, franchises loaded with economic goodwill are under no such obligation and can continue raising dividends and repurchasing stock. This makes the latter more valuable.

“(Franchises) can tolerate mismanagement. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.”

Franchises and moats provide management time to recover from mistakes. In a commodity business, the margin for error is tiny, and capital allocation decisions with poor outcomes - due either to bad luck or lack of skill - can impair the business's prospects. Franchise businesses, in contrast, can push through poor outcomes (see Microsoft Zune) and carry on.

Giving management time is essential because, as Buffett noted elsewhere, a moat is not static. It's getting stronger or weaker every day, in often imperceptible ways. The more time management has to course correct, the better.

To this end, I liked Hagstrom's framing of the four stages of a franchise:

1. Franchise

2. Weak franchise

3. Strong business

4. Commodity

A franchise is a business in full bloom, able to employ all its advantages to increase long-term shareholder value. As competition enters or the moat erodes from the inside due to poor management, the company can slip to a "weak franchise" and further to just a "strong business" and finally to an undifferentiated commodity business.

I appreciate these distinctions because it's easy to confuse a "strong business" with a franchise until you have a deep understanding of the company’s reality. An example of a strong business might be a local car dealership that, through years of clever advertising and good service, has carved out local brand recognition and generated brisk traffic.

Ultimately, however, the dealer is at the whim of the OEMs that supply new vehicle inventory and financers who set loan rates. Customers can also defer purchases or choose another dealer with no switching costs.

Strong businesses can do well over time and can have narrow moats. Relative to franchises, investors should demand a greater margin of safety when investing in strong businesses.

The underlying operations of a strong business aren't good in inflationary periods when the stakeholders in their ecosystem with real bargaining power press their advantages. Poorly timed capital allocation decisions can also push strong businesses into commodity business territory.

On the other hand, franchise businesses like Copart, Visa, and Fair Isaac only seem to get stronger during inflationary periods. They aren't reliant on debt financing, there aren't close substitutes for their products and services, and they have the upper hand in bargaining power across their ecosystems. These are bona fide wide-moat businesses that are dominant in their space.

Weak franchises fall somewhere in between on the quality scale, but these are outstanding businesses—the top 10-20% of all companies. They have some economic goodwill and pricing power to consistently outearn their cost of capital. Still, there might be substitutes for their products or natural limits to their ability to generate higher ROIC due to capital intensity or barriers to exit. Waste management companies fall into this category.

Thinking in terms of franchise levels has been a useful addition to my process for thinking about moats. Teasing out the relative strength of a company’s moat and management characteristics was one of the points I addressed in this post on quantifying the qualitative.

Permanent holdings

“The primary difference between permanent holdings and ‘nonpermanent’ holdings is one of personal relationships.”

Much is made of Buffett's famous quote that his favorite holding period is forever, but Hagstrom emphasizes that "a company is not automatically 'permanent' on the day Buffett buys it."

To be elevated to a permanent holding—non-controlled, marketable securities that Buffett said he wouldn't sell even if overvalued—requires a monitoring period and the establishment of relationships between the operator and the investor.

For example, Buffett bought Coca-Cola in 1988 but did not elevate it to permanent status alongside The Washington Post, Capital Cities/ABC, and GEICO until 1990. In practice, it took much longer than two years.

The change in Coca-Cola management seven years prior to his initial purchase piqued Buffett’s interest. That year, Roberto Goizueta became CEO and teamed up with Buffett's old neighbor Don Keough, Coca-Cola's COO at the time, to execute a new growth strategy.

So, while it seems like a short two-year dating period before Buffett tapped Coca-Cola as a permanent holding, it was decades in the making - and required forming relationships going back to Buffett and Keough being neighbors in the 1960s.

Before knighting one of your stocks a permanent holding - or at the very least giving it a wide berth valuation-wise - aim to understand the people behind the business as much as you study the operations themselves.

• Are they trustworthy?

• Do they bring out the best in the company?

• Do they have a “nose for value”?

Appreciate above all that this process takes years to be done properly and shouldn’t be rushed into.

Hagstrom illustrates:

“To reach the status of permanent holdings, a company must possess good economic and good management - people who are able and trustworthy and, equally important, people with whom Buffett enjoys associating…

Over the years, the managers of these businesses have proven their trustworthiness. They have protected the interests of shareholders and summarily increased the value of their investments. Each manager has an aversion to corporate waste and a passion for higher profitability. They all understand the rational allocation of capital.” (my emphasis)

The longer you invest, the more you realize how few companies are even worthy of such consideration. Even if you don’t intend to have any permanent holdings in your portfolio, the process behind evaluating candidates for permanent status is worthwhile as it can help you quickly weed out the wrong candidates.

Bottom line

Whether you are new to investing or a grizzled veteran, The Warren Buffett Way is worth a read in full. I’ve only scratched the surface on some topics I want to spend more time thinking about after finishing the book. Congrats to Robert Hagstrom on the 30th anniversary of its publication!

Stay patient, stay focused.

Todd

You can view a list of the profiled companies at Flyover Stocks by clicking here. Paid members have full access to the reports, which include moat, management, and valuation analysis.

At the time of publication, Todd and/or his immediate family owned shares of Berkshire Hathaway.

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