These 3 criteria apply to investing in shares of public companies as much as they do for acquiring entire companies. At the core of Warren Buffett's investment philosophy in public companies, is to treat shares as what they are - ownership in a business.
Investing. It's simple, but it's not easy.
- Successful investing is about consistently buying assets for less than their future value. That sounds simple enough, buy low sell high. I got this.
- You don't have unlimited money to invest with, so successful investing also requires efficient capital allocation. To be a successful investor you must consistently predict which assets will increase in value the most. Hmm sounds kind of hard, there's a lot of things to invest in...
Asset Types
- Assets with intrinsic value
- A productive asset that can be used for a purpose, produces goods / services, or generates income.
- Examples could be a farm, a rental apartment, a dry cleaning business, an oil well, etc.
- Their value is determined by how much they produce, now and in the future.
- Assets without intrinsic value
- Assets that aren't purchased for any practical function and don't produce anything.
- Examples could be artwork, sports cards, wine, bitcoin, etc.
- An interesting one that might fall in this category are pro sports teams. Although they are businesses, the recent prices of them are aren't justified by current or future business results. Their prices are inflated by the strong demand from bored mega billionaires that want to live out lifelong dreams.
- There are other gray area items that have some intrinsic value but they sell for prices way over the cost of their inputs or utility they provide. Think designer clothes and many other luxury items.
- Their value is determined solely by how much someone will pay for them.
Investing vs Speculating
- Investing: valuing assets based on how much intrinsic value you expect them to produce.
- Speculating: valuing assets based on how much you think someone will pay for them in the future, independent of how much intrinsic value they might produce.
There is inevitably some disagreement on the distinction, but generally speaking... you can't invest in assets that do not have intrinsic value, but you can speculate in them. While you can invest or speculate in assets that do have intrinsic value.
- buying/selling Assets without Intrinsic value in the hopes of earning a profit is not investing and is necessarily speculating
- buying/selling Assets with Intrinsic value in the hopes of earning a profit can be either investing or speculating depending on the decisioning process.
Looping back to what Warren Buffett looks for in a business
If it's not clear yet, I'll spare you the suspense and let you know that Warren Buffett is an investor. Everything about his 3 criteria screams a focus on intrinsic value. Philosophically Warren Buffett is as far from speculating as possible.
He wants to see a history of strong and stable earnings and doesn't value projections pontificating future growth. He wants high returns on equity and minimal/no debt. That means he wants businesses that generate a lot of profit relative to how much capital they require. And he is interested in simple businesses so that he can more accurately predict their performance over the long term.
Patience
A frequent analogy that Warren Buffett uses is that investing is a game with no called strikes. For the non-baseball fans, a called strike is a pitched baseball that the batter doesn't swing at but that passes through the strike zone. So it's a strike even though it was never swung at. That never happens in investing.
Investing has a pitcher throwing balls at you from 9:30am to 4pm EST 5 days a week, and you can never get a strike by not swinging. The pitcher will throw a lot of balls way out of your zone, and they'll throw some balls that might make it in the edge of your zone. You don't have to swing at any of them. But eventually you'll get a pitch exactly in your sweet spot, and when it comes you should swing for the fences.
Know Your Sweet Spot
The 3 criteria at the top of this article are Warren Buffett's sweet spot. You should articulate yours and then have the conviction and patience to not swing until you get the right pitch.