How Warren Buffett Uses Baseball to Measure Success

Warren Buffett shows investors how to keep their eye on the ball when evaluating their portfolio.

May 27, 2014 at 7:00PM

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By 1991, Warren Buffett had accumulated 27 years of investing experience, and his track record placed him among the all-time greats. The book value of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) had increased an astounding 23.7% compounded annually since he took the helm.

But Buffett often eschewed traditional measures of investment performance, especially when evaluating year-to-year results. In the early 1990s, he developed a better performance barometer for Berkshire that he described as "look-through" earnings.

Buffett At Meeting

Buffett at 2014 Berkshire Hathaway shareholders meeting in Omaha.

A different way to gauge growth
A "look-through" earnings approach, as the name implies, enabled Buffett to look beyond reported earnings – calculated according to standardized accounting principles – and specifically evaluate the income stream attributable to Berkshire by way of its investments and subsidiaries. This technique resulted in a true assessment of operating earnings, not just a recording of dividends received. Further, it considered the implications of capital gains taxes, and most importantly, provided valuable insight about Berkshire's performance that could be otherwise misconstrued by fickle stock prices. In the quote above, Buffett told investors exactly why this is a better way to invest.

Put into practice, the "look-through" method sharpens the focus of shareholders on what really matters in evaluating a business – the ebbs and flows of an earnings stream. This approach reveals what's actually happening on the "playing field" while providing valuable context. The stock price, on the other hand, is merely the "scoreboard." It may ultimately determine winners, but in the short-run it can be close to useless as an evaluative tool.

From Buffett's perspective, any shareholder attempting to assess a company's results would do well to focus on the underlying operating earnings. For example, if a company's stock ballooned 45% by year-end, but earnings growth was 10%, rather than the expected 15%, then an otherwise rosy year looked less so in the eyes of an observant investor.

The benefits of this approach, he figured, are two-fold. In the short run, it requires investors to more diligently study earnings and cash flow, which are ultimately the only agents by which a company can increase its intrinsic value. In the long run, it places an investor in the right mind-set to assess the staying power of a business. With this frame of reference, it is likely that investors will become more capable of evaluating a management team's performance, less influenced by Mr. Market's mood swings, and thereby more rational about their buying and selling decisions over the long haul.

For Buffett, the logic of this approach made perfect sense, regardless of whether it always worked in his favor. In 1991, for example, the "look-through" earnings method actually delivered a far more sobering assessment. Using two commonly referenced yardsticks, book value (the accountants' yardstick) and market value (the stock price), Berkshire's value soared by 39.6% and 18.4%, respectively. Buffett's method showed the opposite, however: "Look-through" earnings decreased by 14%.

By the market's standards, Berkshire had a phenomenal year. By Buffett's measure, it was subpar. Undeterred, he offered specific reasons for the decline -- a process that forced him to think more deeply about how the changing nature of two industries, specifically media and newspapers, were affecting his portfolio. For Buffett, it's this rigorous approach that helps him separate the signal from the noise and has enabled him to outperform the market year after year.

Think about the "long-run," not the "long ball"
In this regard, Buffett resembled many of the greatest performers in other professions, baseball included. An admirer of standout sluggers like the Red Sox's Ted Williams, Buffett portrayed characteristics similar to those of his baseball idols at the top of their game. In picking stocks or buying companies, he was patient and refused to chase stray pitches. But when the right pitch came, he was quick to swing, and swing big. He once remarked on the swiftness with which he and his partner Charlie Munger evaluated opportunities: "Almost every business we have bought has taken five or 10 minutes in terms of analysis."

Beyond his brilliant execution, however, Buffett adhered to a finely tuned process that he believed would deliver long-term gains. As exhibited in other professions, it's a technique that's all-too-common for those performing at their peak.

Pujols Homer

Los Angeles Angels of Anaheim's first baseman, Albert Pujols. Flickr/Keith Allison.

To compare Buffett's technique with his favorite sport, consider a remark made by one of the greatest sluggers of the current generation, Albert Pujols of the Los Angeles Angels of Anaheim. When asked how much he focused on blasting the ball out of the park, he said he didn't think about it at all. In his words, "I consider myself a line drive hitter with power. I just try to put my best swing on the ball every time."

Pujols, a nine-time all-star, tries to get the best crack at the fattest pitch, but he's not aiming for the upper deck. And, perhaps more importantly, just like Buffett, he's not even thinking about the scoreboard.

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Isaac Pino, CPA has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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