Billionaire investor Warren Buffett‘s annual letters to Berkshire Hathaway shareholders are a must-read for me and I revisit them often. In the 2007 letter, he described four simple criteria he looks for when picking businesses to invest in. And, in his own words, he looks for companies that have:
a) a business he understands
b) favourable long-term economics
c) able and trustworthy management
d) a sensible price tag
Truly great businesses and moats
He went on to explain that he prefers to buy the whole business as an acquisition within his company Berkshire Hathaway. But when “control-type purchases of quality aren’t available”, he’s happy to buy “small portions of great businesses” by way of stock market purchases.
And in one of his many flowery analogies, he summed up his thinking by saying: “It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.” Although I admit that one hasn’t gained as much traction as some of his other well-known sayings!
Nevertheless, the message is clear. And to copy Buffett’s style, I need to approach stocks and shares with a business-like perspective. To me, that means following his succinct criteria above and adopting a long-term holding period measured in years and decades.
Buffett went on to say a “truly great” business must have an enduring ‘moat’. And that will protect the excellent returns on the capital the company has invested in its operations. He reckons the “dynamics of capitalism” means competitors will keep assaulting any business ‘castle’ that’s earning high returns.
To demonstrate, Buffett offered some examples using companies in his own portfolio. The business could be the low-cost producer, such as GEICO and Costco, he said. Another barrier is the ownership of a powerful brand, such as Coca-Cola, Gillette (now owned by Procter & Gamble) and American Express. Barriers like those are “essential for sustained success”, he insisted.
Avoiding Roman Candles
But Buffett offered a warning. Business history is filled with ‘Roman Candles’. And by that he means many company moats prove to be “illusory” and are soon crossed by competitors.
So in seeking enduring moats, Buffett said he rules out companies “in industries prone to rapid and continuous change.” And he summed up his reasoning behind this approach by saying: “A moat that must be continuously rebuilt will eventually be no moat at all.”
But on top of that, he avoids businesses whose success depends on having a great manager. If a superstar is required to deliver outstanding results, the business itself can’t be that great.
Buffett also said he looks for his moat-like long-term competitive advantages among businesses from stable industries. And if one of those businesses comes with rapid organic growth, “great!” But even without growth, he’s happy to take “the lush earnings of the business” and use them to invest elsewhere. “There’s no rule to say you have to invest money where you earned it,” he added.
And that’s the entire way he diversified away from the original, failing Berkshire Hathaway textile business he once bought many decades ago. And that approach led to multi-year gains measured in thousands of percent.
