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Understanding the company

February 6th, 2013

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. Just to explain this further; whether you buy a business for yourself, or whether you buy shares in a company that runs a business, you are doing the same thing – buying into a business. The only difference is in the percentage of the business that you own. So, if you buy one share in a company that has issued a million shares, you effectively own a one millionth part of the business that the company runs.

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 Buffett 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 2012, Berkshire Hathaway disclosed that it had substantial minority shareholdings in the following listed corporations:

  • American Express
  • Coca Cola
  • Conoco Phillips
  • IBM
  • Johnson and Johnson
  • Kraft
  • Proctor and Gamble
  • Tesco
  • Sanofi
  • Walmart
  • Wells Fargo

These are all not only brand name companies but also businesses that are relatively easy to understand.

  • American Express is a world-recognized name and makes its money through the sale of  financial services 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.
  • 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 brand name.
  • Conoco is the largest integrated energy company in America and one of the five largest refiners in the world.
  • IBM still retains its position as a leader distributor of business hardware, despite the inroads of other American and foreign competitors.
  • Johnson and Johnson and Proctor and Gamble are world leaders in the fields of medical and personal care products.
  • Kraft is predominant in foods and food products.
  • Tesco is a huge British supermarket with excellent brand recognition.
  • Sanofi, a  French company, is one of the top pharmaceutical companies in the world.
  • Walmart needs no introduction and is a retailing phenomenon.
  • Wells Fargo has been around since the days of the Wild West. It no longer runs stage coaches to Dodge City but is a huge bank and provider of financial and other services with a well known brand name. Incidentally, it has its own museum.

In 2012, Berkshire Hathaway included in the businesses that it owns: MidAmerican Energy, CTB, TTI and ISCAR. Again these businesses are fairly easy to understand if you put in the time. MidAmerican sells electricity and gas, CTB does farm equipment, TTI primarily sells electronic components and ISCAR focuses on tools.

Update

Berkshire has recently reduced its holdings in Johnson and Johnson.

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? It seems to have 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.  Can you understand this? We can’t. This is obviously a good business but this complex structure is just too difficult for the average person to understand.

Or look at General Electric with its complex business structure and its multiple activities over the years that have  included electronics, energy distribution, television, movies, financing, plastics, health care, financing, and the rest. It may be and is a great company but it is not easy to understand.

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 … – JM Keynes

Why Warren Buffett did not invest in Microsoft

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft Corporation but he never invested in it because he did not understand the way that the company works. We would be very surprised if he ever took a position in Facebook.

This does not mean that Buffett will not invest in companies that use technology and information systems to run a good company. Quite the opposite. Berkshire Hathaway has a holding in Walmart which has been identified by Thomas Friedman in The World Is Flat as using advanced and innovative technology systems in the 1980s -supply chain management, inventory control, deliveries to and from stores, communication with customers,marketing – to grow from a small to medium sized operation to the huge international retail operation it is today. Or take McLane Company owned by Berkshire Hathaway. This company uses technology and communication systems at an advanced level to provide chain supply solutions to other businesses.

In today’s investment climate, knowing the business of a company must of necessity involve understanding how the company uses technology in a globalized world to run and improve its business. And it is necessary to recognize that a company may superficially be a technology company but it is not. For example, we believe that Amazon is not a technology company that markets books but is, rather, a giant book store that uses technology to sell its products.

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. Share buyers should take the same approach.

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.

Personal experience

Careful investors will use information services to cull potential investments but will, before investment, reach their own conclusions based on the original source materials issued by the company and other primary evidence.

Anecdotal evidence and personal experience can also be useful to an investor. There are various anecdotes of Warren Buffett, in early days, making personal visits to company offices and asking for information. Not all investors can do this but they can relate their personal experience of a product or service to their investment decisions.

Posted by Julian Livy on February 6th, 2013 | Posted in How Buffett invests, Warren Buffett |