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Future Shock
decade
of f inancial management. Program trading, leveraged buyouts, junk
bonds, derivative securities, and index futures frightened many in-
vestors. The distinctions between money managers faded. The grind of
fundamental research was replaced by the whirl of computers. Black
boxes replaced management interviews and investigation. Automation
replaced intuition.
The late 1990s were, if anything, worse. That frenzied, overvalued
marketplace phenomenon generally known as the dot-com boom went
disastrously bust. Warren Buffett called it “The Great Bubble.” And we
all know what happens to bubbles when they get too big—they burst,
dripping sticky residue on everyone within range.
Many investors have become disenchanted and estranged from the
f inancial marketplace. The residue of the three-year bear market of
2000 through 2002 left many with a particularly bitter taste in their
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T H E W A R R E N B U F F E T T W AY
mouths. Even now, with so many money managers unable to add value
to client portfolios, it is easy to understand why passive investing has
gained popularity.
Throughout the past few decades, investors have f lirted with many
different investment approaches. Periodically, small capitalization, large
capitalization, growth, value, momentum, thematic, and sector rotation
have proven financially rewarding. At other times, these approaches have
stranded their followers in periods of mediocrity. Buffett, the exception,
has not suffered periods of mediocrity. His investment performance,
widely documented, has been consistently superior. As investors and
speculators alike have been distracted by esoteric approaches to investing,
Buffett has quietly amassed a multi-billion-dollar fortune. Throughout,
businesses have been his tools, common sense his philosophy.
How did he do it?
Given the documented success of Buffett’s performance coupled
with the simplicity of his methodology, the more appropriate question
is, why don’t other investors apply his approach? The answer may lie in
how people think about investing.
When Buffett invests, he sees a business. Most investors see only a
stock price. They spend far too much time and effort watching, predict-
ing, and anticipating price changes and far too little time understanding
the business they are part owner of. Elementary as this may be, it is the
root that distinguishes Buffett.
While other professional investors are busy studying capital asset
pricing models, beta, and modern portfolio theory, Buffett studies
income statements, capital reinvestment requirements, and the cash-
generating capabilities of his companies. His hands-on experience with
Stocks are simple. All you do is buy shares in a great business
for less than the business is intrinsically worth, with manage-
ment of the highest integrity and ability. Then you own those
shares forever.
2
W
ARREN
B
UFFETT
, 1990
T h e U n r e a s o n a b l e M a n
1 9 1
a wide variety of businesses in many industries separates Buffett from
all other professional investors. “Can you really explain to a f ish what
it’s like to walk on land?” Buffett asks. “One day on land is worth a
thousand years of talking about it and one day running a business has
exactly the same kind of value.”
3
According to Buffett, the investor and the businessperson should
look at the company in the same way, because they both want essentially
the same thing. The businessperson wants to buy the entire company
and the investor wants to buy portions of the company. Theoretically,
the businessperson and the investor, to earn a profit, should be looking at
the same variables.
If adapting Buffett’s investment strategy required only changing
perspective, then probably more investors would become proponents.
However, applying Buffett’s approach requires changing not only per-
spective but also how performance is evaluated and communicated. The
traditional yardstick for measuring performance is price change: the
difference between what you originally paid for a stock and its market
price today.
In the long run, the market price of a stock should approximate the
change in value of the business. However, in the short run, prices can
swoop widely above and below a company’s value for any number of il-
logical reasons. The problem remains that most investors use these
short-term price changes to gauge the success or failure of their invest-
ment approach, even though the changes often have little to do with
the changing economic value of the business and much to do with an-
ticipating the behavior of other investors.
To make matters worse, clients require professional money to report
performance in quarterly periods. Knowing that they must improve
short-term performance or risk losing clients, professional investors be-
come obsessed with chasing stock prices.
The market is there only as a reference point to see if anybody
is offering to do anything foolish.
4
W
ARREN
B
UFFETT
, 1988
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T H E W A R R E N B U F F E T T W AY
Buffett believes it is foolish to use short-term prices to judge a com-
pany’s success. Instead, he lets his companies report their value to him
by their economic progress. Once a year, he checks several variables:
• Return on beginning shareholder’s equity
• Change in operating margins, debt levels, and capital expendi-
ture needs
• The company’s cash-generating ability
If these economic measurements are improving, he knows the share
price, over the long term, should ref lect this. What happens to the stock
price in the short run is inconsequential.
I N V E S T I N G T H E WA R R E N B U F F E T T WAY
The major goal of this book is to help investors understand and employ
the investment strategies that have made Buffett successful. It is my
hope that, having learned from his past experiences, you will be able to
go forward and apply his methods. Perhaps in the future you may see
examples of “Buffett-like” purchases and will be in a position to prof it
from his teachings.
For instance . . .
• When the stock market forces the price of a good business
downward, as it did to the
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