PDF Summary:The Warren Buffett Way, by Robert G. Hagstrom

To the uninitiated, investing can seem daunting and inaccessible. But according to investment professional Robert G. Hagstrom, it doesn’t have to be. Hagstrom argues that novice investors should emulate the greatest investor in history—Warren Buffett—so that they too can earn above-market returns.

In his 2013 book The Warren Buffett Way, Hagstrom outlines and explains Buffett’s approach to stock market investing. Hagstrom argues that, rather than 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.

In this guide, we’ll examine how Buffett quantitatively and qualitatively evaluates companies to decide whether to invest, as well as his recommendations for managing your portfolio and avoiding psychological mistakes. We’ll also consider alternative approaches to investing and discuss updates to Hagstrom’s arguments since publication.

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The Influence of Phil Fisher

While Graham placed little emphasis on a company’s qualitative aspects, Phil 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.

(Shortform note: Fisher is best known for his seminal work Common Stocks and Uncommon Profits, in which he introduced his “scuttlebutt method” of performing due diligence by speaking with as many people associated with the company as possible rather than only poring over financial reports. In so doing, he suggested that you can develop an edge over the average investor who isn’t willing to do that level of analysis.)

Assessing a Company’s Potential

Hagstrom says 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.

(Shortform note: In addition to sales and profits, other experts point out that a company’s potential is partially constrained by its industry. For instance, companies that are in burgeoning industries–like the tech industry in the late twentieth century–are more likely to have high potential, whereas those in languishing industries–like the newspaper industry–will likely have less growth potential.)

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; for instance, they might pay themselves an outsized salary that cuts into company profits. Similarly, management teams that mistreat their employees can foster resentment which, ultimately, can make the company less successful.

(Shortform note: In publicly traded companies, shareholders themselves have the authority to indirectly appoint new management, as they’re allowed to elect a board of directors that can vote to remove the CEO. However, some experts note that this can unfairly target management, as shareholders often take out their frustrations on CEOs whenever the company experiences any turbulence.)

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.

(Shortform note: Though Buffett’s investment advice is geared toward publicly traded stocks, it can apply to other investment decisions as well. For example, other experts argue that preferring simple, understandable investments is a good reason to avoid cryptocurrencies. Cryptocurrencies, they argue, are rife with uncertainty and confusion, making them difficult to understand for all but a select few investors. Consequently, they contend that most investors should steer clear of them.)

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.

The Possible Downside of Predictability

Though Buffett may be correct that consistency is generally desirable for companies, other experts warn that consistency can be dangerous in excess. For example, in Super Thinking: The Big Book of Mental Models, Gabriel Weinberg and Lauren McCann argue that companies must be willing to adapt to ever-changing societal norms and desires. Consequently, they suggest that companies that are too dedicated to their current business model can fail in the face of societal change.

To avoid this pitfall, in The Infinite Game, Simon Sinek offers business advice that differs from Buffett’s. Sinek argues that companies should try to anticipate changing preferences so that they can preemptively pivot rather than consistently sticking with one business model. However, it might be possible to reconcile Sinek’s advice with Buffett’s–because Buffett is offering investment advice, he may nonetheless agree that companies should be willing to pivot, even though frequent pivoting isn’t desirable from an investor’s perspective.

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; for instance, Tesla’s battery supply chain, which is considered superior to competitors’ supply chains, constitutes a competitive advantage. Such companies, Buffett argues, are likely to continue delivering impressive returns to shareholders, making them an attractive investment.

(Shortform note: Elsewhere, Buffett clarifies that a long-term competitive advantage creates a “moat” that shields companies’ profits from potential competitors. Much like a moat protects castles from attackers and thereby stabilizes the castle, he suggests that long-term competitive advantages make companies less susceptible to competition and provide a degree of stability.)

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.

(Shortform note: Although companies that sell commodities generally struggle to differentiate themselves, some have managed to do so with great success. For example, Liquid Death—a company that sells bottles of spring water, sparkling water, and iced tea—has become wildly popular because of its ironic branding and committed customer base.)

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.

(Shortform note: One traditional way that companies reinvest money internally is by funding research and development (R&D) that seeks to learn how to improve existing products and processes while also developing new products. However, experts note that although R&D spending has increased globally, it’s been delivering lower returns since around 2010. These lower returns, they argue, are the result of focusing R&D on short-term gains rather than long-term projects, indicating that companies should instead consider allocating capital to fund long-term R&D.)

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.

(Shortform note: Moreover, a lack of transparency from management can lead to illegal insider trading–the practice of using non-public information to gain an advantage trading a company’s stock. For example, a CEO might inform management of a pending press release that will lead to a significant stock dip, allowing them to sell their shares ahead of time to avoid losing money.)

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. For example, many company executives relentlessly acquire smaller companies to appear growth-oriented, even when these acquisitions aren’t best for shareholders. 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.

(Shortform note: Elsewhere, Buffett clarifies that there’s a close connection between companies that succumb to trends and those with poor capital allocation skills; he notes that companies that submit to institutional trends end up allocating capital poorly because these trends often involve spending inordinately to acquire expensive new companies. By contrast, those that resist these trends can more objectively assess how to allocate their capital.)

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.

How to Diversify Your Portfolio Outside of the Stock Market

Although diversification is typically discussed in the context of stock market investing, experts note that investors can diversify their portfolios beyond the stock market. For example, you can invest in:

• Bonds, which involve loaning money to governments or private corporations in exchange for a modest return down the road.

• Gold, which is generally protected from the volatility of the stock market.

• Real estate, which is simpler and can provide a lower-risk investment than many stocks.

By pursuing these alternative investments, you can better protect yourself in the case of a stock-market crash which can devastate those who have only invested in stocks. For this reason, investing legend John C. Bogle (The Little Book of Common Sense Investing) recommends that even the most aggressive investors keep no more than 80% of their portfolio in stocks.

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.

Diversification and the Merits of “Mediocre” Returns

Though Hagstrom deems market-average returns mediocre when discussing the argument against diversification, it’s worth mentioning that the average investor already earns far below market-average returns. Indeed, expert analysis reveals that between 2000 and 2020, the average equity fund investor earned only 4.25% annually, while the S&P 500 earned 6.06%.

Experts contend that investors earn below-market returns for various reasons. For instance, they tend to buy stocks when the market is high and sell when it’s low, leading to worse returns than if they simply held their stocks indefinitely. But, according to Bogle, one particular reason stands out: Many investors invest in actively managed mutual funds with high portfolio turnover, generating inflated trading costs and fees paid to those mutual funds and reducing investors’ returns.

Consequently, Bogle recommends investing in index funds—funds that track an underlying index, yielding a diversified portfolio—to avoid these costs and enjoy market-average returns. In so doing, you’ll earn more than the vast majority of investors, even though you’ll only be earning the “market average.” So, for investors not yet confident enough to embrace Buffett’s focus investing, index funds are a viable alternative.

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.

(Shortform note: Although Hagstrom and other investors write as if EMH is one simple thesis, economists typically distinguish between several forms of EMH. For instance, only the strong form of EMH states that all information, public or private, is baked into stock prices. By contrast, the weak form of EMH specifies only that all past financial information is baked into stock prices, a more modest claim.)

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.

(Shortform note: While Hagstrom claims that Buffett’s success could only be chalked up to luck if the EMH were true, another explanation exists: EMH wasn’t true when Buffett began investing, but it’s true now. In other words, we might respond that the market was less efficient in the 1980s and 90s, allowing Buffett to find an investing edge through in-depth analysis, but it’s now efficient enough that his analysis is pointless. Indeed, experts argue that the US stock market became significantly more efficient between 1998 and 2010 alone, making it plausible that the market was less efficient when Buffett began investing.)

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.

(Shortform note: Because portfolios with more stocks spread across different industries are less volatile, modern portfolio theory contends that diversified portfolios are also less risky since they minimize volatility. However, it’s worth mentioning that even the most diversified portfolios can be volatile because the market itself is volatile; for instance, the stock market typically experiences at least one 30% annual drop in a given 12-year period.)

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.

(Shortform note: In stark contrast to Buffett’s patient approach to investing, some investors engage in day trading—purchasing and selling securities within a single day in hopes of profiting from daily price fluctuations. But experts warn that day trading is exceedingly risky since these fluctuations can generate quick losses.)

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; for example, a large majority of people consider themselves above-average drivers, even though only half of all drivers are above-average. 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.

(Shortform note: Though Hagstrom cautions against excessive confidence, he doesn’t offer specific actionables for avoiding it. To that end, experts list various strategies for dealing with overconfidence. For example, they recommend specifically asking others to share their views so that you’re exposed to opinions that differ from your own. In a similar vein, they advise seeking out disconfirming information–information that calls your own beliefs into question–so that you don’t hold your views blindly but rather are aware of the counterarguments.)

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.

For example, seniors in high school might decide which college to attend on the basis of a recent shift in college rankings, even though this recent shift is ultimately a small data point. In the case of investing, Hagstrom writes that overreaction bias can lead investors to overemphasize short-term developments—like dips in the stock market, or recent earnings reports—instead of focusing on companies’ long-term prospects. Because savvy investing depends on these long-term prospects, overreaction can lead to suboptimal decisions.

(Shortform note: Overreaction bias is often intertwined with negativity bias–our tendency to weigh negative information far more heavily than positive information when making decisions. In the case of investing, this means that investors are more likely to overreact when presented with negative information, such as a disappointing earnings report, rather than positive information, such as a promising earnings report.)

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.

(Shortform note: It’s natural to think that while myopic loss aversion can harm the average investor’s returns, professionals are less susceptible to it. Yet, one influential analysis suggests that compared to a control group of undergraduate students, professional traders are actually more vulnerable to myopic loss aversion. In turn, these professionals are liable to make irrational decisions that harm their returns in the long run.)