Understanding the company

 Buying the business

Warren Buffett believes, as did Benjamin Graham, that investors should look
upon share investment as buying a part of a business. Investors should take the
same approach to buying shares as they would if they were buying a business.
The only difference is that instead of buying the whole of the business, or a
partnership in the business, they are only buying a tiny share.

A prudent investor never buys a business that they do not understand.
Similarly, a prudent share investor should never buy shares in a company, whose
business they do not understand.

What Warren Buffet says about buying a business

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their
company would only invest in a business that the directors could understand. He
has repeated this message many times since. In 1992, he expanded on this theme:

‘[W]e try to stick with businesses we believe we understand. That means they must be relatively
simple and stable in character. If a business is complex or subject to constant
change we’re not smart enough to predict future cash flows. Incidentally that
shortcoming doesn’t bother us.’

Warren Buffett companies

In 2002, Berkshire Hathaway disclosed that it had substantial minority
shareholdings in the following listed corporations:

With the exception perhaps of M & T Bank, these are all not only brand
name companies but also businesses that are relatively easy to understand. Some
examples:

  • The Coca Cola Company is the world’s largest beverage company, making and distributing worldwide
    such products as Coke, Fanta, Sprite, Evian and Minute Maid. It has been
    in business many, many years and is perhaps the world’s most recognized
    name.
  • American Express is a world-recognized name and
    makes its money through the sale of traveler’s checks and its brand name
    credit card. It has been in business a very long time and has a simple
    business model that even the most unsophisticated investor should be able
    to understand.
  • H & R Block is a worldwide firm that makes
    its money preparing tax returns for people either unable or unwilling to
    do it themselves.

Warren Buffett and Keynes

In Warren Buffett’s own words, he did not invest in these companies, and
many other successful investments, without acquiring as full a knowledge as
possible about the company, its business, its management, and its financial
position. He has advised individual investors to do the same, as did the great
economist and successful investor John Maynard Keynes.

‘As time goes on, I get more and more convinced that the right method in
investment is to put fairly large sums into enterprises which one thinks one
knows something about …’ - Jim Keynes

Why Warren Buffett does not invest in Microsoft

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft
Corporation but has never invested in it because he does not understand the way
that the company works.

Complex companies

Take however, a company like Unilever NV. This is a corporation that has
been around a long time, has a worldwide reputation and market, and is
successful. But how easy is it to understand the way it operates?

According to Value Line, it has two parent holding companies, one in Great
Britain, and one in The Netherlands. It operates as one company but each of the
two holding companies owns shares in operating subsidiaries. The director
component of both holding companies is the same and there are agreements that equalize
dividends and set trading ratios for their respective shares. The business may
be good but this complex structure is just too difficult for the average person
to understand.

 Knowing a company

Knowing a company involves research as well as personal experience and
successful investors approach share investment the way that they would the
purchase of a business.

They buy a business in an industry area that they know or that they have
learned about, they investigate the financials, they look at how the business
operated in the past, they weigh up future potential, and they then make a
reasoned decision to buy at the price offered or not buy.

Just as the cobbler should stick to his last, investors should stay with what they know.
They should not stray into areas beyond their expertise.

As Warren Buffett said in 1992:

‘What counts for most people in investing is not how much they know, but
rather how realistically they define what they don’t know.’

Robert Hagstrom has looked extensively at Warren Buffett’s investments over
the years and agrees that Buffett has made it his business to understand the
business of the companies where he puts the money of Berkshire Hathaway.
According to Hagstrom, Buffett:

‘understands the revenues, expenses,
cash flow, labor relations flexibility and capital-allocation needs of each of
Berkshire’s holdings.’

Hagstrom argues that the prudent individual investor should do no less. 

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