How Buffett Beats the Market

Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) Chairman Warren Buffett has racked up market-beating returns over the long term. So what does Buffett look for in an investment? Is his success more art than science? Can individual investors really invest like Buffett? I recently asked Georgetown University McDonough School of Business professor Prem Jain, author of Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When Investing.

Mac Greer: You write that Buffett's investment philosophy has evolved. Initially, Buffett was focused on value. Now he's focused on value plus growth. Initially, he was focused more on quantitative issues but by 1967, he was saying that the really big money tends to be made by investors who are right on the qualitative decisions.  What are the key qualitative decisions Buffett focuses on when investing?

Prem Jain: First and foremost, Buffett focuses on downside risk. Before investing in a company, Buffett evaluates the company's products and services to ensure that the downside risk of the investment is extremely low. For example, Buffett has mentioned that it is almost impossible to take away Coca-Cola's (NYSE: KO  ) leadership. Consequently, the downside risk from investing in Coca-Cola is low. To further insure against the downside risk, Buffett invests only in well-established companies and has been known to study decades of a company's annual reports before investing.

Second, Buffett has often discussed the importance of sustainability and growth of a company's profitability for the foreseeable future. For example, a railroad like Burlington Northern Santa Fe, a retailer like Wal-Mart (NYSE: WMT  ) , or a consumer products company like Procter & Gamble (NYSE: PG  ) is unlikely to lose its market dominance and profitability for a long time. Since a company's future cannot be reliably predicted from quantitative metrics alone, Buffett emphasizes various qualitative metrics such as pricing power, brand equity, and company management. This is eminently evident in his large recent investment in Johnson & Johnson (NYSE: JNJ  ) .

Greer: What does Buffett look for in management?

Jain: Buffett looks for a successful track record of a company's management. He acquires a company only if he admires, likes, and trusts its management. Unlike other acquirers, Buffett would not buy a company unless the current management stays with the company and continues to run the company after the company is acquired by Berkshire. This unique requirement reflects his emphasis on people rather than products. No wonder Buffett has invested across many different industries. Had he relied on his knowledge of industries or their products alone, he could not possibly have invested in so many unrelated businesses. Beyond the track record, cost consciousness, return on equity, and integrity are among the most important management criteria for Buffett. With respect to integrity, he has famously said that he would be ruthless if an employee were responsible for hurting the company's reputation.   

I would like to emphasize an additional point that is generally overlooked. Often, when discussing management quality, investors focus on the current CEO or the current management. The investor focus on the current management is limiting; the focus should also be on the management development process. The ability of a company to continually produce outstanding managers in the long run is just as important as the ability of the company to maintain its market leadership in the long run. At a recent annual shareholder meeting, Buffett and [Charlie] Munger (Berkshire's vice chairman) mentioned that the management development process and succession planning at a company should be carefully examined from a long-term perspective. For example, Johnson & Johnson and Coca-Cola have produced outstanding management teams for many decades. Buffett's investments in these companies are not only inspired by the CEOs in place at the time of his investment but also by the management processes that have produced a string of outstanding CEOs.   

Greer: Is Buffett's investing success more of an art than a science? Is his success more a product of his unique ability to evaluate people and make qualitative decisions than it is an ability to crunch the numbers? And if so --- isn't it impossible for investors to replicate Buffett's success?

Jain: If finding outstanding companies were simply a science, number-crunching nerds would have amassed enviable wealth. But that has generally not happened. Researchers have shown that it is possible to beat the market by using sophisticated quantitative techniques, but only by about 2% annually. However, Buffett's record is far, far better: about 10% above the market. Buffett's success comes from studying and developing both value and the growth investing principles and then fine-tuning them over a long time, just as an artist takes a long time to perfect his or her style. While it is hardly possible to duplicate Buffett's record, patient investors can certainly learn a lot from analyzing Buffett's decisions, their own experiences, and by practicing through investing.

Mac Greer doesn't own any of the stocks mentioned. Berkshire Hathaway, Coca-Cola, and Wal-Mart Stores are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Johnson & Johnson, Coca-Cola, and Procter & Gamble are Motley Fool Income Investor choices. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Berkshire Hathaway and Coca-Cola. The Fool has a disclosure policy.


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