In the summary of a 19-page memo Warren Buffett sent to the Washington Post's (NYSE:GHC) Katharine Graham in 1975, he wrote:
A mildly non-conventional investment approach, emphasizing a business approach to security selection, gives some opportunity for long-term results slightly above average without corresponding increase in investment risk.
According to Fortune, this simple advice may have saved Washington Post's pension plan. It also remains the most sensible investment strategy around for ordinary investors, in my opinion.
Buffett has recently shared the original 19-page memo with Fortune. You can read the amazing document in its entirety here. The memo laid out some of the overall challenges facing Washington Post's pension plan in considerable depth. The discussion of investment management is simply outstanding, and it is one of the clearest expressions of Buffett's philosophy I've ever read.
Where everyone is actually below average
Buffett begins his section on investment management by confessing he's skeptical that professional money managers would be able to deliver outperformance for a pension fund. This, of course, makes complete sense if you look at conventional money management in the aggregate.
According to Buffett, professionally managed money makes up too much of the investing universe to be able to perform above average as a group. It's analogous, he says, to someone sitting down at the poker table and announcing, "Well, fellows, if we all play carefully tonight, we all should be able to win a little." All in all, Buffett declares that he's "virtually certain" that professional money management cannot deliver above-average performance. Indeed, it will deliver below-average performance because of fees.
So now what do we do, Warren?
If professional money management cannot deliver outperformance, then how should a pension fund manage its money? Buffett attempts to answer that question in the main body of the memo by suggesting and analyzing five options.
The first option would be for the pension fund to just go with conventional money managers with the "expectation that performance will be slightly poorer than average because of costs involved." The second option might be to create a portfolio that merely aims to recreate the market. The third option, which would be very difficult to implement, would be to identify superior, yet unknown, money managers whose record has been good for the right reasons. The fourth option would be to invest everything in fixed income.
Attitude is everything
Buffett tees up the fifth and final option by admitting that it's "the one to which I lean," even though it's somewhat unconventional. The key to this option is that it "involves treating portfolio management decisions much like business acquisition decisions by corporate managers."
Nowadays, many of us who are well-versed in Buffett's investing philosophy know all about option five. This strategy recommends buying shares of solid public companies at a reasonable valuation, then holding them for the long term. Investing decisions are governed by the fundamentals of the business, not by one's market outlook. That might sound overly simple until you think about all the media coverage -- day-in and day-out -- devoted to the ebbs and flows of the overall stock market. As Thelonious Monk once said, "simple ain't easy."
My favorite part of the entire memo is Buffett's comparison of his business-focused investing approach with conventional money management. He notes the biggest difference is one of attitude. With Buffett's approach, "the business becomes the standard against which the measurements are made rather than quarterly stock prices." Most importantly, I think, is that Buffett's approach "demands an excess of value over price paid, not merely a favorable short-term earnings or stock market outlook." The state of the overall stock market shouldn't be a primary factor in the purchase decision of an individual stock, according to Buffett. Rather, one needs to think like a potential owner of a business.
One final advantage of option five is that it could be handled by qualified analysts who understood Buffett's "rather unique selection criteria." And everything could be handled on a "quite infrequent basis."
What this means for you
While Warren Buffett was writing privately to Katharine Graham as a friend and board member of Washington Post, his advice is equally valuable and relevant to you.
If you are interested in obtaining above-average returns without taking on additional risk and paying exorbitant fees, then it might make sense to think about purchasing stocks in the same way you might purchase a business. This strategy will require a bit of work on your part, and will demand that you remain focused on the fundamentals even when the market acts irrationally.
But Buffett believes such an approach will deliver a good return, as long as your assessments of the underlying businesses are "reasonably correct."
This approach apparently worked quite well for Washington Post, which was able to deliver a healthy pension plan to Amazon.com's (NASDAQ:AMZN) Jeff Bezos, who recently purchased The Washington Post. And this strategy performed extremely well over the years for Warren Buffett, and for shareholders of Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), too.