Buffett's 12 Tenets For Business-Driven Investing

🌾 Welcome to StableBread’s Newsletter!

"Investment is most intelligent when it is most businesslike." These nine words from Benjamin Graham form the foundation of Warren Buffett's approach to investing, as explained in Robert Hagstrom's 2024 book "The Warren Buffett Way" (30th Anniversary Edition).

Hagstrom studied Berkshire Hathaway annual reports dating back to 1966 and identified 12 key tenets that guide Buffett's investment decisions. He groups these tenets into four categories:

This post covers these 12 tenets to help you think more like Buffett when picking stocks.

Buffett starts by understanding what a business actually does and how it operates. These three tenets help him evaluate if a company has sustainable advantages that will generate profits for decades, not just the next few quarters.

Buffett only invests in businesses he fully understands, and argues that your financial success is directly linked to how well you understand your investments.

This understanding depends on staying within your "circle of competence," as the visual below illustrates:

Investment success doesn't depend on knowing everything, but rather on clearly recognizing what you don't know. As Buffett explains:

If you can't interpret developments in an industry or make informed decisions about a company, you’re probably not investing within your circle of competence.

Therefore, understanding the business model, revenue streams, expenses, cash flows, and capital needs is a must before investing.

Buffett avoids companies undergoing major changes or trying to solve difficult business problems. Companies with steady production of the same products/services for several years typically deliver better returns.

As Buffett notes: "Severe change and exceptional returns usually don't mix."

Undergoing major business changes significantly increases the likelihood of committing major business errors. Buffett elaborates on this further:

While many investors are attracted to rapidly changing industries and/or companies in reorganization, Buffett prefers businesses with proven track records.

Buffett divides businesses into two groups: (1) great businesses (franchises) and (2) mediocre businesses.

A franchise is a company providing a product/service that is:

These traits give a company pricing flexibility—one of the key traits of a great business—enabling above-average returns on capital.

For Buffett, a great business should remain successful for 25 to 30 years, demonstrating his preference for companies with durable advantages that can withstand economic cycles, competitive pressures, and technological changes.

Buffett refers to a company's sustainable competitive advantage as its "moat"—similar to the water-filled ditches that protected medieval castles.

The wider and more durable this protective moat, the better the business can defend its profits from competitors who want to steal market share. As Buffett shares:

Mediocre businesses, by contrast, offer products/services virtually indistinguishable from competitors. They compete mainly on price, which squeezes profit margins.

In fact, these commodity businesses only become highly profitable during rare supply shortages.

The key factor in their long-term profitability is what Buffett calls the ratio of "supply-tight to supply-ample years." Since most commodity businesses face more years of abundant supply (with lower profits) than scarcity, they generally make poor long-term investments.

Buffett knows that even companies with great products/services can fail when led by poor managers. These three tenets help identify competent leadership.

The most important management action is capital allocation, deciding what to do with company earnings. How a company uses its profits ultimately determines shareholder value over time.

For Buffett, rational capital allocation depends on where a company is in its economic life cycle. Companies typically move through multiple stages:

The illustration below shows how a company's economic returns and reinvestment needs change throughout its competitive life cycle:

Economic returns (gold line) initially rise and then gradually fall over time, while reinvestment requirements (brown line) peak early and decline more rapidly. The horizontal dashed line represents the discount rate - the minimum acceptable return.

When a company reaches maturity with excess cash, management has three options:

Buffett judges management quality largely by how well they match these capital allocation decisions to their company's specific situation rather than following industry trends.

Buffett values managers who report their company's performance honestly, admit mistakes, and communicate clearly without hiding behind accounting rules (like GAAP).

He believes management reports should help financially literate readers answer three key questions:

Buffett practices this candor in his own Berkshire Hathaway annual reports, openly discussing both successes and failures. He regularly lists his mistakes in Berkshire's annual reports.

Buffett argues this approach benefits both managers and shareholders, stating: “The CEO who misleads others in public may eventually mislead himself in private.”

The "institutional imperative" is Buffett's term for the tendency of corporate managers to mindlessly imitate their peers, regardless of how irrational the behavior may be. This force causes several common problems:

Human nature drives this behavior. Most managers fear looking foolish with quarterly losses when competitors show gains, even if the industry is heading toward trouble.

In contrast, a competent manager should be able to convince shareholders that short-term losses will yield better long-term results.

Buffett identifies three factors as most influential in this behavior:

Another challenge is poor capital allocation skills. Many CEOs rise through non-financial career paths with little experience handling capital decisions.

When evaluating potential acquisitions, these CEOs often rely on staff who, sensing what the boss wants, miraculously calculate returns just above the required threshold.

The cycle perpetuates itself through mindless imitation. When companies A, B, and C all do something, company D follows along, believing they can't all be wrong. This dynamic makes it difficult to resist actions that are ultimately doomed to fail.

Overall, managers who can resist these pressures and think independently are far more valuable than those who follow the crowd.

Buffett uses financial measures that differ from typical Wall Street metrics. These four tenets help him judge a company's true economic performance and reveal how well managers use the money entrusted to them.

While analysts typically use earnings per share (EPS) to measure company performance, Buffett considers this misleading.

For context, EPS is calculated as follows:

Buffett points out that a company increasing EPS by 10% while growing its earnings base by 10% is not achieving anything special.

This is because when a company retains earnings (i.e., keeps profits instead of paying dividends or repurchasing shares), the company naturally grows its asset base. If it earns the same percentage return on a larger base, EPS will increase without any improvement in actual performance.

Instead, Buffett focuses on return on equity (ROE):

This measures how well management generates returns on the capital employed in the business, thereby revealing true capital efficiency rather than just absolute profit growth.

To improve accuracy, Buffett makes two adjustments when calculating ROE:

Buffett believes companies should achieve good ROE with little or no debt.

While borrowing can artificially inflate ROE by reducing the equity denominator in the calculation, it also increases risk during economic downturns when repaying debt becomes more difficult.

This is why Buffett prefers companies that achieve strong returns through operational excellence rather than financial engineering.

Buffett warns that not all earnings are created equal.

Companies with high assets compared to profits often report what he calls "ersatz earnings" - profits that look real on paper but don't represent actual cash an owner could take from the business.

Traditional cash flow calculations (net income plus non-cash charges like D&A) are flawed because they ignore necessary ongoing investments.

While a company can briefly delay capital expenditures (CapEx), most businesses need to reinvest at rates roughly equal to their depreciation to avoid decline.

To solve this problem, Buffett developed "owner earnings" to better reflect the cash available to business owners:

Buffett is particularly critical of how cash flow figures are misused during leveraged buyouts, where buyers justify inflated prices using cash flow numbers that ignore necessary future investments.

While calculating owner earnings requires some estimation of future capital needs, it provides a much more realistic picture of a company's true economic value than either GAAP earnings or standard cash flow metrics.

Buffett understands that great businesses must convert sales into profits by controlling costs, which isn’t a one-time event but an ongoing discipline.

He also observes that managers of low-cost operations constantly find ways to cut expenses, while managers of high-cost operations tend to add to overhead.

Buffett has little patience for managers who allow costs to escalate, then initiate restructuring programs to bring costs back in line. As he says:

Notably, Berkshire Hathaway itself demonstrates this principle. The company lacks legal, public relations, investor relations, and strategic planning departments. Its after-tax corporate expenses run less than 1% of operating earnings – about one-tenth the level of most companies its size.

Buffett's "one-dollar principle" provides a quick test of how well management creates shareholder value.

The concept is simple: when a company keeps profits rather than paying them as dividends, its market value should increase by at least that same amount.

For example, if a company retains $100M in earnings, its market value should grow by at least $100M over time.

This principle works as a reality check on management's capital allocation decisions:

Short-term stock price movements happen for many reasons unrelated to management decisions. However, over several years, Buffett believes the market will recognize value creation or destruction.

The best management teams exceed this one-dollar threshold, creating more than a dollar of market value for each dollar retained.

Buffett's final two tenets focus on the key question of price versus value. These tenets determine whether he actually buys a stock or walks away, regardless of how impressive the business might be.

In 1992, Buffett surprised many value investors by rejecting the idea that low price-to-earnings (P/E) or price-to-book (P/B) ratios determine value. Instead, he embraced John Burr Williams' definition:

In other words, Buffett estimates business value using the discounted cash flow (DCF) model. This primarily involves:

Buffett focuses on businesses where future earnings are highly predictable, seeking the same certainty that investors find in bond coupons.

For his discount rate, Buffett originally used the 10-year U.S. Treasury rate (~8.55% in the 1990s) because it represents the risk-free rate.

However, with today's lower interest rates, Buffett has shifted to using opportunity cost as his guide. Since stocks have historically returned about 10% annually, Buffett now typically uses this higher rate when estimating a business's intrinsic value.

Lastly, Buffett acknowledges that intrinsic value is an estimate, not a precise figure. He thinks in terms of probability distributions:

This approach recognizes that business outcomes exist as ranges of possibilities. Buffett prefers being "approximately right than precisely wrong" - a philosophy that stands in stark contrast to Wall Street's obsession with single-point target prices.

Finally, Buffett insists on buying businesses only when there's a significant margin of safety—the difference between a company's price and its estimated value:

This principle, which comes from Benjamin Graham, serves two important purposes:

Buffett's focus is not just identifying good businesses but buying them at attractive prices.

However, he notes that even with the right business and management, mistakes can happen for three reasons:

Regardless, by buying good businesses at prices well below their intrinsic value, Buffett creates potential for market-beating returns when prices eventually reflect the underlying value of the business.