Warren Buffett: "If you're applauded, worry"

Warren Buffett is America's favorite tycoon. Agenda analyzes the strategies that got him where he is today and considers what might be next

Warren Buffett once said some businesses were so strong they could be run by a ham sandwich or, to use another of his favorite examples, by "an egotistical orangutan". His admirable refusal to believe in the transformational power of human genius when confronted with a corporate train wreck, instinct for undervalued cash-generating businesses and willingness to look stupid in pursuit of the right deal have made Buffett an icon to fellow billionaires such as Bill Gates. Yet he is not lionized in business schools, where clever ideas – even if they are not borne out by nitty-gritty reality – are worshipped, and due-diligence and a thorough understanding of balance sheets and market sentiment don't resonate.

Buffett started young. "I became interested in stocks when I was six or seven. I bought my first stock when I was 11 and I picked up Ben Graham's The Intelligent Investor when I was 19," he said once. The Intelligent Investor is the definitive exposition of value investing. At its simplest, this means buying shares you believe are seriously undervalued. Buffett didn't just read Graham's book, he worked for Graham, using his theories to earn a small fortune. One of his most spectacular value investments was his purchase of Coca-Cola shares. In 1988, after the stock market crash and the New Coke launch had turned investors against Coke, he bought US$1.02bn (€750m) of stock in the soft drinks giant. By 2007, his investment was worth ten times the original sum and had generated an annual return of around 20% for Buffett.

Let's return to the beginning of this story. In 1956, when his mentor Graham retired, Buffett was already worth US$174,000 – US$1.4m (€1.03m) in today's money. Still in his mid twenties, Buffett returned to Omaha to invest in stocks. He had vowed to be a millionaire by the time he was 30 but had to wait until he was 31. When he was 34, he acquired his first significant business, an obscure textile mill called Berkshire Hathaway.

So much wealth so soon could have fatally inflated Buffett's ego. But Jonathan Davis, editor of Independent Investor and a regular Financial Times columnist, says Buffett turned his wealth into a competitive edge: "Buffett is a long term investor. Many people say they're long term investors but if you're working for a mutual fund, you can't be. The nature of long-term investments is that you have a bad year or two along the way – if that happens at a mutual fund you lose customers or your job. But Buffett soon got into a position where he was rich enough, and had enough control, to invest for long-term value."

Buffett's success as an investor owes a lot to shrewd use of the funds generated by his insurance companies. "He's careful what risks he insures against," says Davis. "But if those companies are performing well, the cash they generate is effectively free capital for him."


The supreme capitalist

Long-term value investing sounds absurdly simple but David L. Ikenberry, professor of finance at the University of Illinois's College of Business, says: "CEOs at a lot of public companies might want to think long term but they often focus on top-line growth in sales or market share. That doesn't resonate with Buffett. What he understands – probably better than almost anyone – is the equation between the cost of capital and the return on capital. So he studies the figures, and if that equation doesn't add up, he has the discipline to walk away."

That focus helps Buffett. "He really is one of those people who, if you ask him to buy your company, will say 'I'll ring you back in 30 minutes' and will call you back and give you a decision," says Davis. Microsoft founder Bill Gates says: "You can describe a business to Warren in ten minutes and he'll know the questions to ask."

Buffett only needs ten minutes because he has probably already done his homework. He is a voracious reader – of the Wall Street Journal, Moody's Manual of Industrial and Miscellaneous Securities and annual reports (he studies the footnotes and extraordinary items meticulously). In 2005, deciding South Korea was better value than Wall Street, he learned the Korean accounting code and leafed through a stock market guide for five hours (reviewing 1,700 firms) to create a US$100m (€73m) portfolio of stocks.

Through exhaustive research and tireless networking, Buffett probably knows the back story of every U.S. company he might invest in. With typical homespun wisdom, Buffett once explained his modus operandi: "If I get interested in an industry, I like to go in and ask every CEO: 'If you could put a silver bullet through the head of one competitor, who would you choose and why?"

Buffett can decide quickly because he relies on criteria identified in chapters eight and 20 of The Intelligent Investor and Berkshire Hathaway's annual report. In chapter 20, Graham urges investors to consider the margin of safety. Or, as Buffett once put it: "Don't buy a company for $80m if it's worth $83m." Ikenberry says Buffett's childhood reinforced this lesson. "A lot of entrepreneurs who were born in the Great Depression are debt averse. They saw the damage risk and debt can do." Before buying a stock or a company, Buffett rehearses a short sentence in his head: "I'm buying this because…" If he can't finish that sentence, he walks away.

Walking away is one of the secrets of Buffett's success. As he said once: "The disadvantage of being in a type of market environment like Wall Street in the extremes is you get over-stimulated." Wall Street makes its money on activity, but as an investor – and acquirer – it often pays to be inactive. Gerald S. Martin, associate professor of finance at the Kogod School of Business at American University, says managers could learn from him: "Buffett shows that it pays to be pragmatic and cautious. Many CEOs will enter into a transaction and get so wrapped up in it that it becomes a self-fulfilling prophecy. They won't walk away from it when they should."

The companies Buffett buys look very different – they make lollipops, run trains and sell insurance – but they resemble each other in crucial ways. They are run by owner/managers Buffett trusts ("If I could make US$100m with a guy who makes my stomach churn, I wouldn't do it – it'd be like marrying for money"), have little debt, generate capital, consistently grow earnings-per-share (ideally, with a gross profit margin of around 40%) and have a durable competitive advantage ("a moat" as Buffett calls it). As an investor, he likes stocks such as American Express, Coca-Cola and Procter & Gamble that have a grip on their customers' imaginations (or, to use his phrase, "a share of mind").

Buffett's credo is: "You only have to be able to evaluate companies within your circle of competence. The size of that circle isn't important, knowing its boundaries is vital." So he focuses on banking, insurance and manufacturing. Ikenberry says: "He doesn't invest in technology companies or businesses with strong intellectual property where it's hard to accurately value the assets."


The vindicated dinosaur

This strategy cost him dear in the 1999 dot com boom. At one point, a digital business making a US$9m (€6.6m) loss on sales of US$13m (€9.6m) enjoyed a market value of US$21.4bn (€15.8bn). Shunning such stocks, Buffett was derided as a dinosaur. Berkshire Hathaway shares rose by 20.5% less than Standard & Poor's index of America's top 500 listed companies. But Buffett stuck to his guns – and was vindicated as boom turned to bust. Buffett's stand proved the value – and difficulty – of value investing. As one analyst noted: "Most investors find it painful psychologically to buy stock no one else wants." Or, indeed, to ignore stocks that, by any rational yardstick, are horrendously over-valued.

Buffett's reputation as the Sage of Omaha has survived the dot com bubble (he invested in bonds and made a mint) and the credit crunch. Both disasters, for him, proved Graham's adage: "You can get into way more trouble with a good idea than a bad one because you forget the idea has limits." As early as 2001, after concluding that soaring U.S. stock prices could not be justified by any rational assessment of corporate profits or America's GDP, he felt that buying businesses often offered better value than stocks.

His management style suits austere times. Don Graham, chairman of the Washington Post, says: "There's no VP of PR, no VP of strategy, no VP of anything. Berkshire has fewer than 20 staff at its HQ. The next company with that many staff at HQ is probably outside the Fortune 1,000." But he doesn't need a big HQ because, Martin says: "He likes good managers who don't need micromanaging and gives them the capital they need to make a good business grow."


The inconsistent sage

The beauty of being a sage is that the aura can obscure occasional inconsistencies. Buffett is a long-term value investor but, paradoxically, as Martin says: "His annual returns from short-term risk arbritrage transactions have been great. But he only engages in risk arbitrage when the right opportunities are presented."

That aura has come in especially useful since he took on US$10bn (€7.6bn) of debt to clinch his largest ever deal, the takeover of railroad giant Burlington Northern. Some debt for a man who, in 1998, boasted: "I never borrowed money, even when I had US$10,000."

The deal concluded Buffett's two-year quest for what he called an "elephant acquisition". Davis says: "Berkshire Hathaway is so big there are relatively few companies it can acquire that would make a real difference." Absorbing Burlington Northern will take time, which is why Martin says: "He may take a breather. He always wants to know there's enough capital in case of emergency."

Burlington Northern suggests his appetite for risk has grown just as almost everyone else's has shrunk. The contradiction is typical of Buffett. The railroad deal and his bold investment in Chinese electric car maker BYD are long-term wagers on a big trend – the environment – and on businesses he believes have a "moat". Neither deal will be his last. He is eyeing up healthcare (see panel on p13) and his scouting for acquisitions and stocks is global: "His motto is 'it's got to be good value,'" says Martin, "and inside the U.S. it can be hard to find good prices."

The young Buffett had many advantages: an entrepreneurial spirit, a brilliant mentor and a small fortune. But the truly shocking aspect of his journey from millionaire speculator to billionaire folk hero is that there is no magic to it, just an extraordinary understanding of value and capital. It's not hard to say what Buffet does, the hard bit is understanding why more people don't do it. Buffett's success suggests more CEOs should have the guts to be misunderstood. As he said once: "If you're applauded, worry. Great moves are usually greeted by yawns."