Robert Hagstrom, chief investment strategist at Legg Mason Investment Counsel, has always exhibited a keen interest in understanding what lies behind the scenes. His first book, The Warren Buffett Way, spent 21 weeks on The New York Times bestseller list and sold over 1 million copies. Outside the United States, The Warren Buffett Way still continues to be the book most commonly mentioned by young investors as the source from which they initially learnt about Buffett’s methodology. Hagstrom’s latest book, his eighth, is titled Investing: The Last Liberal Art.
In the spring of 1998, Carol Loomis wrote an article for Fortune, titled “The Inside Story of Warren Buffett”. It was the first full profile of Buffett and Loomis was the perfect writer for the story. Up until then, the only inside look of Buffett came from his Chairman’s Letters and his once-a-year appearance at Berkshire’s annual meeting at Omaha. But those who were aware that Loomis was a close friend of Buffett and had been editing the Berkshire Hathaway Annual Reports since 1977 knew if anyone could write an “inside” story on Buffett, it would be she.
Loomis said she wanted to write a different story, one that emphasised Buffett not just as an investor but also as an “extraordinary businessman”. She did not disappoint. It was a beautifully written 7,000-word article that indeed gave the Buffett faithful a more intimate look at the man now dubbed the Wizard of Omaha. Loomis gave us many insights, but none were more ground-shaking for me than three little sentences tucked neatly inside the article. “What we do is not beyond anybody else’s competence,” said Buffett. “I feel the same way about managing that I do about investing: It’s just not necessary to do extraordinary things to get extraordinary results.”
Now, I am sure many who read this chalked it up to Buffett’s Midwestern humility. Buffett is not a braggart. But nor does he mislead. I was sure he would have not made this statement if he did not believe it to be true. And if it were true, as I believed it was, it meant there was the possibility of uncovering a roadmap, or better yet, a treasure map, which would describe how Buffett thinks about investing in general and stock selection specifically. This was my motivation for writing The Warren Buffett Way.
Reading Berkshire Hathaway annual reports for two decades, the annual reports of the companies Berkshire purchased, and the many articles written about Buffett helped me gain an understanding of how Buffett thought about common stock investing. The single most important insight I gained was the knowledge that Buffett, whether he was purchasing common stocks or wholly owned businesses, approached each transaction in the same way. Whether he is buying a public or private company, Buffett goes through the same process, in more or less the same sequence. He thinks about the business, the people who run the business, the economics of the business and then the value of the business, and in each case he lays what he has learned against his own benchmarks. I label them the investment tenets and divide them into four categories: business tenets, management tenets, financial tenets and market tenets.
The goal of the book was to take the major companies that Buffett had purchased for Berkshire Hathaway and discover if they were, in fact, aligned with the tenets reflected in his writings and speeches. What would be valuable, in my opinion, and would be valuable to investors was a thorough examination of his thoughts and strategies aligned with the purchases that Berkshire made over the years, all compiled into one source. To that end, I believe we were successful.
The principle challenge I faced in writing the book was to prove or disprove Buffett’s confession that “what [I] do is not beyond anybody else’s competence”. Some critics argue that, despite his success, Buffett’s idiosyncrasies prevent his investment approach from being widely adopted. I disagreed. Buffett is idiosyncratic — it is the source of his success — but I have argued that his methodology, once understood, is applicable to both individual and institutional investors alike. It is the goal of the book to help investors employ the strategies that I believe made Warren Buffett successful.
Still, there were sceptics. The major pushback we have received over the years is that reading a book about Warren Buffett will not ensure you will be able to generate the same investment returns that Buffett achieved. One, I never insinuated that by reading the book an individual could achieve the same investment returns as Buffett. Two, I was puzzled why anyone would think so. It seemed to me that if you bought a book about how to play golf like Tiger Woods, you shouldn’t expect to become Tiger’s equal on the golf course. You read the book because you believe there are some tips in the book that will help improve your game. The same is true of The Warren Buffett Way. If by reading the book, you pick up some lessons that help improve your investment results, then the book is a success. Considering how poorly most people perform in the stock market, achieving some improvement will not be a herculean task.
It has been 20 years since the first edition of The Warren Buffett Way was published. The success of the book is first and foremost a testament to Warren Buffett. His wit, integrity and intellectual spirit have charmed millions of investors worldwide. It is an unparalleled combination that makes Buffett the single most popular model in investing today and the greatest investor in history.
But, I do have one regret. Despite Buffett’s celebrity and the amount written about how Buffett invests, I am disappointed that there are not millions and millions of individuals who apply his investment approach. I have met no one who has told me Buffett’s investment principles are invalid. The millions of investors I speak of could all apply Buffett’s investment tenets. You don’t have to be an MBA-trained security analyst nor do you have to write complex computer code to decide which company you want to invest in. I strongly believe that applying Buffett’s tenets “is not beyond anybody else’s competence”. So, what prevents so many investors, who I am sure would like to invest like Warren Buffett, to actually invest like Warren Buffett?
Being rational
According to those that know Buffett the best, the answer is “rationality”. Charlie Munger, vice-chairman of Berkshire Hathaway and Buffett’s intellectual partner for almost 50 years, tells us that Buffett’s “brain is a superbly rational mechanism”. Loomis concurs, telling me “rationality is the single most important trait in his investment success”. And Roger Lowenstein, author of Buffett: The Making of an American Capitalist, wrote, “Buffett’s genius is largely a genius of character — of patience, discipline, and rationality.”
Rationalism, according to The Oxford American Dictionary, is a belief that one’s opinions or actions should be based on reason and knowledge rather than emotional responses. A rational person thinks clearly, sensibly and logically. A rational person seeks to achieve one’s life goals using the best means possible. If you fail to achieve your stated goal, it is because you have succumbed to the many heuristics and biases that prevent individuals from making optimal decisions.
For Buffett, the best means possible for growing one’s networth is to buy a concentrated, low-turnover portfolio of high quality businesses selling at prices below intrinsic value and ignore the day-to-day vagaries of the economy and the stock market. Never mind that most investors are consumed thinking about the economy and the stock market and, as a result, are constantly buying and selling stocks. Never mind that owning a concentrated portfolio with fewer companies will subject the investor to higher volatility than a broadly diversified portfolio. In fact, one of the hallmarks of being a rational investor is the ability to handle volatility and the wide swings in market prices equably. If you panic due to volatility and abandon the market, you have succumbed to myopic loss aversion and can no longer call yourself rational.
The first thing to understand is that rationality is not the same as intelligence. Smart people do dumb things. Keith Stanovich, a professor of human development and applied psychology at the University of Toronto, believes intelligence tests such as IQ tests or SAT/ACT exams do a very poor job of measuring rational thought. “It is a mild predictor at best,” he says, “and some rational thinking skills are totally dissociated from intelligence.” In his book, What Intelligence Tests Miss: The Psychology of Rational Thought, Stanovich coins the term “dysrationalia” — the inability to think and behave rationally despite high intelligence. Research in cognitive psychology suggests there are two principal causes of dysrationalia. The first is a processing problem. The second is a content problem. Let’s look at them closely, one at a time.
Stanovich believes humans process information poorly. When solving a problem, he says, people have different cognitive mechanisms to choose from. At one end of the thinking spectrum are mechanisms that have great computational power. But this great computational power comes with a cost. It is a slower process of thinking and requires great concentration. At the opposite end of the thinking spectrum are mechanisms with very little computational power; they require little concentration and permit quick decisions. Overall, “humans are cognitive misers,” writes Stanovich, because our basic tendency is to default to the processing mechanisms that require less computational effort, even if they are less accurate. In a word, humans are lazy thinkers; as a result, their solutions are often illogical.
Buffett has often said “investing is easier than you think but harder than it looks”. When he talks about the “easier than you think” part, he reminds us we don’t have to spend countless hours worrying about the economy, pontificating about what will happen next in the stock market. The “harder than it looks” part is his gentle reminder that doing simple accounting ratios (price to earnings ratios, dividend yields, price to book value) are not enough to determine value, no matter how easy they are to calculate. If you want to determine the value of a company you will have to apply the investment tenets Buffett has outlined over the years. But remember, working your way through the business tenets, management tenets, financial tenets and market tenets is not equivalent to studying quantum mechanics. However, it does require a little effort on your part and if you are a “cognitive miser”, you may never be successful applying The Warren Buffett Way.
In Carol Loomis’ new book, Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, she quotes Buffett who is answering a question from a student who wants to know how he became successful. “How I got here is pretty simple in my case. It’s not IQ, I am sure you will be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but the output — the efficiency with which the motor works — depends on rationality. A lot of people start out with 400 horsepower motors but only get 100 horsepower of rationality. It is way better to have a 200 horsepower motor and get it all in output.”
