BUFFETT'S TENETS

Roger Lowenstein, in his excellent book on Buffett, suggests that Buffett’s success can be traced to his adherence to the basic notion that when you buy a stock, you are buying an underlying business.

Business Tenets:

The business the company is in should be simple and understandable. In fact, one of the few critiques of Buffett was his refusal to buy technology companies, whose business he said was difficult to understand.

The firm should have a consistent operating history, manifested in operating earnings that are stable and predictable.

The firm should be in a business with favorable long-term prospects.

Management Tenets:

The managers of the company should be candid. As evidenced by the way he treated his own stockholders, Buffett put a premium on managers he trusted. Part of the reason he made an investment in The Washington Post was the high regard that he had for Katherine Graham, who inherited the paper from her husband.


The managers of the company should be leaders and not followers. In practical terms, Buffett was looking for companies that mapped out their own long-term strategies rather than imitating other firms.

Financial Tenets:

The company should have a high return on equity, but rather than base the return on equity on accounting net income, Buffett used a modified version of what he called owner earnings:


Owner Earnings Net income Depreciation and Amortization – Capital Expenditures

This concept is very close to a free cash flow to equity.

The company should have high and stable profit margins and a history of creating value for its stockholders.

Market Tenets:

In determining value, much has been made of Buffett’s use of a risk-free rate to discount cash flows. Because he is known to use conservative estimates of earnings and because the firms he invests in tend to be stable firms, it looks to us like he makes his risk adjustment in the cash flows rather than the discount rate.

In keeping with Buffett’s views of Mr. Market as capricious and moody, even valuable companies can be bought at attractive prices when investors turn away from them.


http://media.wiley.com/product_data/excerpt/32/04713450/0471345032.pdf