HOW TO BUY BUSINESSES

1. If you can’t talk with management, and can’t read the annual report, and didn’t know the price, but could only look at the financial statements, what metric would you look at? Source: BRK Annual Meeting 2008

WB: Investing is laying out money now to get more money later on. Ask yourself: do I understand enough about the business so that the financials will be able to tell me meaningful things that will help me to foresee the statements in the future? I have bought stocks the way you describe. They were in businesses I understood, and if I could buy at 40% of X, I’d be okay with the margin of safety. If you don’t tell me the nature of the business, financial statements won’t tell me much. We’ve bought many securities, and with most, we’ve never met management. We use our general understanding of business and look to specifics from financial statements.

CM: One metric catches people. We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.

WB: We could value an apartment if we knew where the apartment is, and we know the monthly checks. I have bought a lot of things off the financials. There is a lot I wouldn’t buy even if it had the best management in the world, as it doesn’t make much difference in a bad business.

2. What’s your philosophy in buying businesses?

When I say understand my definition of understand is that you have to have a pretty good idea of where it’s going to be in ten years.

We don’t get paid for the past, only the future [profitability of a business]. The past is only useful to give you insights into the future, but sometimes there’s no insight.

Munger: When you’re trying to determine intrinsic value and margin of safety, there’s no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don’t think you can become a great investor rapidly, no more than you can become a bone tumor pathologist quickly.

Buffett: If you’re going to buy a farm, you’d say, “I bought it to earn $X growing soybeans.” It wouldn’t be based on what you saw on TV or what a friend said. It’s the same with stocks. Take out a yellow pad and say, “If I’m going to buy GM at $30, it has 600 million shares, so I’m paying $18 billion,” and answer the question, why? If you can’t answer that, you’re not subjecting it to business tests.

If you were thinking about paying $900,000 or $1.3 million for a McDonald’s stand, you’d think about things like whether people will keep eating hamburgers and whether McDonald’s could change the franchise agreement. You have to know what you’re doing and whether you’re within your circle of competence.

The idea of buying stocks without understanding the company’s operating functions – its products and services, labor relations, raw material expenses, plant and equipment, capital reinvestment requirements, inventories, receivables, and needs for working capital—is unconscionable, says Buffett.

3. What makes a company something that you like? Source: Lecture at the University of Florida Business School 1998

Our managers of the businesses we run, I have one message to them, and we want to widen the moat. We want to throw crocs, sharks and gators —I guess—into the moat to keep away competitors. That comes about through service, through quality of product; it comes about through cost, sometimes through patents, and/or real estate location. So that is the business I am looking for.

I certainly don’t know what his competitors will look like ten years from now. I know what the chewing business will look like ten years from now. The Internet is not going to change how we chew gum and nothing much else is going to change how we chew gum.

So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten (10) years from now.

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