This article is an excerpt from the Shortform book guide to "The Warren Buffett Way" by Robert G. Hagstrom. Shortform has the world's best summaries and analyses of books you should be reading.
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How did Warren Buffett learn to invest? What criteria does he use to choose his investments? How does he manage his portfolio?
The Warren Buffett Way by Robert G. Hagstrom answers these questions and more. Hagstrom believes that, rather than hiring someone else to manage your investments for you, all you need to do is follow Buffett’s way of investing.
Continue reading for an overview of this practical how-to book.
Overview of The Warren Buffett Way by Robert G. Hagstrom
To the uninitiated, investing can seem daunting and inaccessible, leading many to either hire professionals to manage their investments or forswear investing altogether. But, according to investment professional Robert G. Hagstrom, this mindset can cause you to leave millions on the table. Hagstrom argues that novice investors should emulate the greatest investor in history—Warren Buffett—so that they too can earn above-market returns.
The 2013 book The Warren Buffett Way by Robert G. Hagstrom outlines and explains Buffett’s approach to stock market investing. Hagstrom argues that, rather than simply deferring to financial analysts, investors should follow suit with Buffett and assess companies along four dimensions—their financial prospects, their market value, their business model, and their management—to identify promising companies to invest in. This approach, he suggests, allows investors to find exceptional investment opportunities, leaving them poised to earn exceptional returns.
As the current Chief Investment Officer of EquityCompass, an investment firm that manages over $4 billion in assets, Hagstrom brings years of investing experience into his arguments throughout The Warren Buffett Way. Moreover, having written eight investing books geared toward a general audience, Hagstrom makes accessible even the most complicated aspects of Buffett’s approach to investing.
We’ll first discuss how Buffett quantitatively analyzes companies, explaining Buffett’s specific metrics for evaluating companies’ market value and finances. Next, we’ll examine Buffett’s process for qualitatively assessing companies, outlining the dimensions along which Buffett evaluates companies’ management and business models. To conclude, we’ll examine how Buffett recommends managing your portfolio, including how to allocate your portfolio and avoid psychological pitfalls.
How Buffett Quantitatively Assesses Companies
According to Hagstrom, Buffett recognizes the importance of rigorous quantitative analysis of the companies he considers investing in. In this section, we’ll first outline how Buffett learned to do so from investing legend Benjamin Graham, and then discuss the metrics that Buffett uses to assess a company’s market value and its financial prospects.
The Influence of Benjamin Graham
As Hagstrom relates, Buffett was persuaded by the key arguments of Graham’s investing classic, The Intelligent Investor, when studying under Graham at Columbia Business School. In particular, Hagstrom argues that Graham showed Buffett the merits of value investing, which involves purchasing companies’ stock for less than its true value. Because Graham developed value investing in the wake of the stock market crash of 1929, its key tenets are diametrically opposed to the reckless speculation that drove the stock market crash—a crash that occurred because investors assumed the stock market could only rise, leading to widespread speculative investing.
To understand this approach to investing, we first need to understand the distinction between a company’s share price and its intrinsic value. Share price, quite simply, refers to the actual price of one share of a company’s stock.
Hagstrom notes, however, that intrinsic value is harder to define. Roughly put, the intrinsic value of a company’s stock is the fair value of that stock, assuming all relevant information was known.
For his part, Graham points out that if you buy a stock at a discount to its intrinsic value, you’ve gotten a good deal on the stock. Moreover, he argues that because a company’s share price tracks its intrinsic value over the long term, value investing makes it likely that you’ll profit on your investment as the discounted share price increases to match its intrinsic value.
How Buffett Assesses a Company’s Market Value
While Graham taught Buffett the general principles of value investing, Buffett developed his own approach to calculating intrinsic value to find companies that are undervalued. In this section, we’ll examine how Buffett determines a stock’s intrinsic value by establishing a company’s intrinsic value and then translating this value into a margin of safety when he invests.
Metric #1: Intrinsic Value
As mentioned previously, a stock’s intrinsic value is roughly its fair value. According to Hagstrom, however, Buffett refines this definition by starting with the company’s intrinsic value, which is its expected net income over its lifetime, deducting an appropriate discount rate.
Though Hagstrom doesn’t specify how Buffett calculates a company’s expected net income over its lifetime, he clarifies that Buffett seeks companies that historically have had consistent earnings growth because it’s easier to estimate future earnings for such companies. Next, after estimating a company’s future earnings, he discounts that figure by the long-term government bond rate.
Metric #2: Safety Margin
As Hagstrom relates, Buffett determines a company’s intrinsic value to create a margin of safety when investing, as he seeks companies whose stock is significantly undervalued relative to their intrinsic value. Specifically, he seeks companies whose intrinsic value per share—that is, the company’s intrinsic value divided by its number of outstanding shares—is much higher than their share price on the stock market.
Buffett’s reasoning for seeking a safety margin is twofold. First, because companies’ stock prices over the long term will correspond with their intrinsic value, companies whose stock price is currently undervalued are likely to see their stock rise in the long term. Second, when his investments have a margin of safety, they’re less likely to see their stock prices drop even if their intrinsic value takes a hit since their intrinsic value per share is higher than their share price to begin with.
How Buffett Assesses a Company’s Finances
Hagstrom notes that, although Graham’s influence is most evident in Buffett’s approach to value investing, it also shaped Buffett’s preference for quantitatively analyzing companies’ finances—typically over a five-year time frame since financial data are volatile on a yearly basis. In particular, Hagstrom explains that Buffett seeks companies that have a high return on equity, owner earnings, profit margins, and ratio of retained earnings to share value, metrics that indicate good financial health.
Metric #1: Return on Equity
Hagstrom first explains that Buffett prefers looking at companies’ return on equity (ROE) to assess how efficiently companies generate profits, though he tweaks several aspects of the standard definition of return on equity to isolate financial factors alone.
Generally, ROE equals a company’s operating earnings (its revenue minus operating expenses) divided by its shareholder equity (its assets, such as inventory, minus its liabilities, such as debts).
However, when calculating ROE, Buffett excludes capital gains and losses, since he wants to look solely at the business’s performance rather than how well the company has invested its money. Moreover, Hagstrom notes that Buffett includes the original cost of securities that a company owns when examining its net worth, rather than their current market value, so that net worth isn’t affected by external factors such as the stock market’s performance. After all, if a company’s stock holdings rise dramatically one year, increasing its net worth, this could dwarf impressive operating earnings when looking at return on equity.
Metric #2: Owner Earnings
Next, Hagstrom points out that Buffett assesses companies’ future earnings prospects using owner earnings, a metric he developed as an alternative to the more common cash flow, which tends to overvalue certain companies.
Cash flow, Hagstrom notes, is roughly the amount of cash going into (or out of) a company in a given year. Traditionally, it’s defined as a company’s net income plus its depreciation (how much of its assets’ values have been lost), depletion (how much a company spends extracting natural resources), and amortization (the cost of intangible assets, like patents, spread out across their lifespan).
However, according to Hagstrom, Buffett realized that cash flow fails to include capital expenditures—money used to purchase or repair physical assets, such as heavy machinery in a factory. Because many companies have capital expenditures that at least offset their depreciation, they have cash flows that are misleadingly inflated relative to the actual money going in and out of the company. For this reason, Buffett developed owner earnings, which is simply cash flow minus capital expenditures; this metric, he suggests, is less likely to become overinflated.
Metric #3: Profit Margins
Though Buffett modifies the definition of return on equity, and outright invents the notion of owner earnings, his approach to profit margins is much more mainstream. According to Hagstrom, Buffett prefers investing in companies with high profit margins because high profit margins indicate a willingness to cut unnecessary expenses.
Profit margins are a company’s profit divided by its revenue. Since profit equals revenue minus expenses, Buffett reasons that companies with high profit margins are likely those that cut costs because one natural way to increase profits is to cut extra spending, making these companies ideal investment targets—after all, profitability is closely correlated to shareholder value.
Metric #4: The One-Dollar Test
According to Hagstrom, Buffett’s final method for judging companies is whether they satisfy the “one-dollar test.” These are companies whose market value increases by at least one dollar for every dollar of earnings they retain.
The one-dollar test, Hagstrom notes, shows how effectively companies use their retained earnings—that is, their net income after paying dividends to shareholders. He suggests that companies that savvily re-invest their retained earnings will see their market value increase proportionately. So, companies whose market value increases by at least one dollar for every dollar of retained earnings are likely those that know how best to reinvest their earnings, making them an attractive investment target.
How Buffett Qualitatively Assesses Companies
While Buffett embraced Graham’s numbers-driven approach to evaluating companies, he was also sensitive to the qualitative factors that underlie promising companies. In this section, we’ll first examine how Buffett learned the importance of certain qualitative factors from Philip Fisher before moving on to discuss the metrics that Buffett uses to evaluate companies’ business models and management teams in particular.
The Influence of Philip Fisher
While Graham placed little emphasis on a company’s qualitative aspects, Philip Fisher held that the more subjective aspects of a company could provide valuable investing guidance. According to Hagstrom, Buffett embraced Fisher’s views on the importance of assessing a company’s potential and management when deciding whether to invest.
Hagstrom points out that Buffett was persuaded to embrace Fisher’s views by Charlie Munger, the current vice chairman of Buffett’s company, Berkshire Hathaway, and a longstanding friend. However, because we’re concerned with Buffett’s intellectual influences rather than personal influences, we’ll be focusing on Fisher’s views in particular.
Assessing a Company’s Potential
Hagstrom suggests that Fisher defines a company’s potential as its ability to significantly increase its intrinsic value over the long term. Even if such companies aren’t currently undervalued—as Graham would desire in an investment—Fisher reasons that their share prices are likely to drastically increase over the long term because share price roughly tracks intrinsic value. This prospect makes them attractive investments.
According to Hagstrom, Fisher used two proxies to determine potential: increasing sales and increasing profits. On the one hand, Fisher thought that growth in sales indicated a strong research and development team, as a company’s sales won’t easily increase if it doesn’t continue refining its product. But, Fisher also recognized that increasing sales means nothing without increasing profit since profit most closely correlates with shareholder value. So, he also sought companies that relentlessly cut costs, as cutting costs translates directly to greater profit margins.
Assessing a Company’s Management
Along with potential, Hagstrom notes that Fisher valued honest management since companies with solid business models can nonetheless flounder under shoddy management. After all, self-centered executives are liable to act out of self-interest rather than the interests of the company. Similarly, management teams that mistreat their employees can foster resentment which, ultimately, can make the company less successful.
How Buffett Assesses a Company’s Business Model
Returning to Buffett’s approach to investing, Hagstrom contends that Buffett assesses a company’s business model to identify companies with the potential that Fisher seeks. In particular, Hagstrom relates that Buffett prefers to invest in companies that are simple, predictable, and have a long-term competitive advantage because he can be confident those companies will succeed in the future.
Metric #1: Simplicity
First, Hagstrom explains Buffett’s notion that you should only invest in companies with easily understandable business models. He argues that by investing in simpler companies, you’re more capable of making savvy investment decisions because you’re better poised to understand developments in the company. After all, if you invest in a company far outside your area of expertise, it’ll be difficult to assess any news that’s relevant to the company’s underlying business.
Metric #2: Predictability
Additionally, Hagstrom says, you should prefer investing in companies that are predictable and have consistently produced the same product. As Hagstrom relates, Buffett’s reasoning for preferring predictable companies is twofold. First, Buffett thinks that companies that pivot frequently and often change their primary product are more prone to blunders because there’s a learning curve whenever you shift products. And second, Buffett holds that companies that have delivered success in the past with one main product are likely to do so in the future since past success is a good indicator of future success.
Metric #3: Long-Term Competitive Advantage
In a similar vein, Hagstrom notes that Buffett seeks companies with a long-term competitive advantage as potential investing targets. In short, these competitive advantages are sustainable edges that companies use to remain on top of the competition. Such companies, Buffett argues, are likely to continue delivering impressive returns to shareholders, making them an attractive investment.
By contrast, Hagstrom points out that Buffett avoids investing in companies that primarily sell commodities, which are products that are largely indistinguishable from one another—like gas, gold, and water. Buffett argues that because these companies struggle to develop any advantage over competitors, they’re less likely to deliver the exceptional returns he’s looking for.
How Buffett Assesses a Company’s Management
Though Buffett recognizes the value of companies with promising business models, he also learned from Fisher that such companies can falter under poor management. Consequently, Hagstrom argues that Buffett assesses management in terms of their capital allocation, transparency, and resistance to trends when deciding whether to invest.
Metric #1: Capital Allocation
To begin, Hagstrom explains Buffett’s view that because investors seek companies that will deliver a high return on investment, management should allocate capital in a way that maximizes shareholder value.
Put simply, capital allocation refers to the distribution of company earnings—in other words, what the company does with the money it earns. Broadly speaking, Buffett holds that companies can either reinvest that money within the company, such as by sending additional funding to promising branches, or use it to pay dividends to shareholders. Crucially, while the second option seems like a natural way to maximize shareholder value, Buffett argues that if companies can reinvest that same money within the company to deliver long-term returns that are greater than those dividends, they should do so. Conversely, he recommends that companies pay dividends if they can’t earn shareholders greater returns by investing their earnings internally.
Metric #2: Transparency
Just like capital allocation can show that companies value their shareholders, transparency is also indicative of shareholder-oriented companies. According to Hagstrom, Buffett holds that you should invest in companies that are transparent about their finances rather than those who obscure their failures through convoluted financial reports.
In particular, Hagstrom suggests that deceptive managers are defending their own interests rather than shareholders’, as they prevent shareholders from making well-informed investment decisions. Consequently, you can’t trust managers of those companies to act in your best interests, making them an unappealing investment.
Metric #3: Trend Resistance
According to Hagstrom, Buffett’s final criterion for evaluating management is its resistance to popular industry trends. Hagstrom writes that Buffett prefers companies that don’t readily submit to popular business trends since these trends are often irrational and harm companies’ bottom lines.
As Buffett sees it, management teams often make suboptimal decisions simply because other management teams are doing the same. So, Buffett holds that companies whose management teams don’t blindly adopt industry-wide trends are a better investment because they’re less likely to imitate others’ harmful decisions.
How to Manage Your Portfolio
Having seen how Buffett chooses which individual companies to invest in, we’ll now discuss how he manages his broader investing portfolio. First, we’ll examine the key tenets of focus investing, Buffett’s approach that emphasizes focusing on a select group of stocks. Then, we’ll discuss the psychological pitfalls associated with focus investing and how to avoid them.
The Superiority of Focus Investing
According to Hagstrom, Buffett departs significantly from the mainstream when it comes to portfolio management. He writes that, while most investors diversify their portfolios broadly to minimize volatility, Buffett focuses on a select handful of stocks to maximize his chances of above-market returns.
To see the merits of focus investing, it’ll help to first discuss the main alternative: diversification. Hagstrom notes that investors traditionally prefer diversified portfolios because they supposedly minimize risk—after all, if you have 1,000 stocks represented in your portfolio and one lone stock takes a nosedive, it’s unlikely to cause a catastrophic loss. By contrast, if you only have five stocks in your portfolio, one plummeting stock could cause an outsized loss.
However, Hagstrom points out that Buffett is opposed to diversification for one simple reason—it can only lead to mediocre results relative to the market’s average returns. After all, the more diversified your portfolio is, the more closely its returns will mirror those of the stock market.
Not content with mediocrity, Buffett instead prefers a portfolio consisting of around 10 stocks that he deems exceptional. To show that this approach is most likely to generate above-market returns, Hagstrom cites a statistical simulation showing how hypothetical portfolios of different sizes performed over time. This simulation included 3,000 portfolios of only 15 stocks—the focus group—3,000 portfolios of 50 stocks, 3,000 portfolios of 100 stocks, and 3,000 portfolios of 250 stocks. Hagstrom notes that, of the focus portfolios, over 25% beat the market over a sample 10-year period; by contrast, only 2% of the portfolios with 250 stocks beat the market over that same time span.
Admittedly, Hagstrom concedes that because smaller portfolios are more volatile—meaning they have greater swings in value—they’re also much more likely to deliver below-average returns. However, he suggests that investors can avoid this possibility through Buffett’s savvy stock selection, which he deems far less likely to yield subpar returns.
Focus Investing and Modern Portfolio Theory
It bears mentioning that Buffett’s focus investing is diametrically opposed to the orthodox investing approach in academia–modern portfolio theory. In particular, Buffett rejects portfolio theory’s understanding of market efficiency and risk.
View #1: The Efficient Market Hypothesis
As Hagstrom relates, the cornerstone of the modern portfolio is the efficient market hypothesis (EMH)–the thesis that stock market prices perfectly reflect all available information about a given company, meaning all stocks are fairly priced. Consequently, proponents of EMH reason that investing ultimately boils down to luck since no amount of analysis will reveal insights that aren’t already baked into a company’s stock price.
Buffett rejects EMH, arguing that many investors—himself included—have used focus investing to generate above-market returns, and these returns aren’t just the product of luck. These investors, including Charlie Munger, Bill Ruane, and Lou Simpson, all used similar approaches to investing, centered around Graham’s strategy of finding undervalued stocks. And, rather than claiming that the success of this shared approach is a coincidence, Buffett finds it much more believable that EMH is simply mistaken.
View #2: Defining Risk as Volatility
Because modern portfolio theory holds that investing boils down to luck, it defines risk as volatility, since the more volatile your portfolio is, the more likely that you’ll lose money. Buffett, however, has a different conception of risk when investing: According to Hagstrom, he defines it as the possibility that you’ll be left with less purchasing power than you began with.
Hagstrom explains that, for this reason, Buffett emphasizes the importance of patience to mitigate risk. After all, if you’ve selected an exceptional stock to invest in, it’s highly likely that its stock price will rise given enough time. By contrast, even if you invest in an exceptional company, your risk will be high if you only hold it for one week since the stock market experiences short-term ebbs and flows.
Psychological Pitfalls to Avoid
Because focus investing leads to greater volatility, it can make you more prone to psychological pitfalls. Hagstrom argues that, to maximize success, focus investors must avoid excessive confidence, overreaction bias, and myopic loss aversion.
Pitfall #1: Excessive Confidence
First, Hagstrom argues that investors need to avoid having excessive confidence, which leads directly to shoddy investment decisions. This overconfidence bias, he notes, is a general problem. When it comes to investing in particular, overconfident investors are liable to invest too heavily in stocks they deem exceptional, leaving them susceptible to large losses if these stocks dip.
Pitfall #2: Overreaction Bias
Next, Hagstrom argues that investors must overcome overreaction bias because it leads them to make imprudent, snap decisions on the basis of recent events alone. Put simply, overreaction bias refers to our tendency to assign too much weight to recently discovered information in our decision-making process.
Pitfall #3: Myopic Loss Aversion
Finally, Hagstrom writes that myopic loss aversion is the greatest psychological obstacle to investors’ success. As he relates, myopic loss aversion is the combination of loss aversion—the fact that humans are significantly more sensitive to losses than similar-sized gains—with investors’ tendency to chronically check their portfolios. In other words, it refers to an aversion to short-term losses in particular.
Hagstrom suggests that because the stock market experiences inevitable ebbs and flows, myopic loss aversion can deter us from staying the course and investing for the long term, leading us to sell whenever the market dips. Thus, although this approach might save us from short-term losses, it prevents us from reaping the massive long-term gains that investors like Buffett are after.
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- How to invest like Warren Buffett and earn above-market returns
- How to assess companies to identify which ones to invest in
- Tips for managing your portfolio and avoiding psychological mistakes
