Lessons from Warren Buffett's Investment Strategy and His Mistakes | Toptal® (2024)

Warren Buffett is – most agree – a living legend at this point. His annual shareholder letter is perhaps the most anticipated piece of content in the investment community, generating endless articles and commentary for weeks. Much of what is written about him stinkshagiography: We've all heard about the Oracle of Omaha's thrift, his passion for Coca-Cola, and his childhood entrepreneurial pursuits. It is probably impossible for any individual investor to repeat his success or even get accurate investing tips from himannual letters. However, Warren Buffett's investment strategy and philosophy can be a very useful guide for anyone, as he focuses on long-term financially sustainable results. In this article we analyze his style and philosophy, try to understand his current concerns and spend some time thinking about the mistakes in Warren Buffett's investment history to try to gather some useful and broad recommendations.

Buffett's investment philosophy

Warren Buffett is probably the best-known proponent of value investing: his investment philosophy is deceptively simple. Berkshire HathawaysThe goal isto acquire competently managed companies, in whole or in part, that have favorable and sustainable economic characteristics." Clearly, the economics of the transaction itself must be favorable.

Buffett himself has depicted this philosophy of spotting undervalued companies with the image of a cigar box: a most commonly used cigar that is ignored by others but still has a few risk-free puffs left.

He divides his portfolio into five macro groups, listed below in order of contribution to his operating result in 2018:

1. Operating companies that Berkshire Hathaway (BH) wholly owns (or at least 80%);
2. Publicly traded equity portfolio (in which BH's stake is typically between 5% and 10%;
3. Four companies in which they have a significant interest: approximately between 25% and 50%;
4. Cash and cash equivalents: This is seen as a buffer against mistakes and difficult circ*mstances, almost like insurance;
5. Insurance companies: a source of cheap money used to finance the ownership of the other assets through the 'float' of the insurance companies.

He looks at what he believes is the likelihood of capital being lost on a transaction (due to a deterioration in the overall value of the company or financial instrument), at supporting strong and diligent managers, and at assessing the intrinsic value of a transaction. Hedefinesthis is the discounted value of the cash that can be extracted from the business during its remaining life. The cash amount he uses for this calculation is what he defines as “owner's income."

He also believes in looking at the long-term economic value after deducting all costs, not just those considered accounting costs. He is wary of mark-to-market practices because he believes the volatility of results is a distraction.

To perform acalculationhowever, for intrinsic value, you should only invest in companies that are not too complex to understand.

Formula for owner's income

Over the life of the company, the relationship between intrinsic value and market value will look something like this:

Share intrinsic value

Financially, he is a staunch advocate of limiting debt, retaining profits and buying back shares if those shares are underpriced. Below we outline some key points of Warren Buffett's investment strategy:

1. Why limit leverage? Warren Buffett is known as a very cautious investor: he always starts from the point of view of his shareholders, who clearly do not want to lose money. So he starts watchingpotential downside of all his investments (in terms of capital loss, not in terms of MTM volatility)and uses that criterion for the initial yes/no decision. Although leverage usually leads to superior returns, it exposes investors to large potential losses. Buffett's aversion to this scenario is further clarified by his cash buffer philosophy and his understanding of the importance of underwriting power to insurance companies.
2. Why (and when) should a company retain profits? Berkshire Hathaway includes a retained earnings test in its programManual.The driving idea behind this principle is that companies, if managed well, can use these earnings better than an investor, either by reinvesting them in the company or by buying back their own shares.
3. Why should a company buy back its own shares? The basic idea behind this is that the managers of a well-managed company are able to generate higher returns for shareholders than they could achieve on their own with other investments. Not only this, but they also benefit from an increase in ownership (without additional investment) as the number of floating shares is reduced.

He has long used his interests in property and casualty insurance companies as a way to finance the purchases of other companies: this is due to the business model of the insurance companies, which we illustrate graphically below:

Berkshire Hathaway investeringsmodel

Has Buffett's thinking changed recently? What are his main current concerns?

Warren Buffett is famously modest: he attributes much of his investing success to what he calls “The American Tailwind,” by which he means the continued prosperity the United States has enjoyed since the end of World War II. He points out that simply investing in the stock market at the time he made his first investment would have yielded a return of 5,288 for 1 (minus any fees and taxes).

This economic upturn is expected to continue, he said, which is why he has not recently invested in currencies or much outside the US.

However, he believes that valuations for private companies are currently too high, especially for companies with good financial prospects and longevity. This is a vision I wholeheartedly share, especially for fast-growing technology companies:here is the link to the KKR macro outlook for 2019which I thought was very interesting to read. This view is reflected in Berkshire Hathaway's recent asset allocation across the five pillars we described above: He has prioritized marketable securities and retained additional resources in cash and liquid assets, hoping to find a company with the right value to buy.

An additional risk highlighted by Warren Buffett is a catastrophic insurance event; the ones he mentioned are environmental disasters and cyber attacks.

Where did Buffett go wrong?

Even Warren Buffett has made several mistakes during his long career and he talks about them very openly. We will discuss some of them here to draw some interesting lessons from them.

1. Waumbec Mills:

Waumbec Mills consisted of a group of textile mills in New Hampshire that Berkshire Hathaway acquired in 1975 for less than the value of its working capital. In fact, they took over everything for free except for the excess receivables and inventory – understandably a deal that would be hard to refuse. How did he go so wrong? He was tempted by the low price at which he could secure the transaction and misinterpreted the long-term financial viability of the wind industry. A key lesson he learned from this and other incidents is that a focus on bargain hunting is not necessarily conducive to long-term value. He now prefers to have small interests in better companies than entire companies that are struggling.

2. Berkshire Hathaway:

Clearly, the textile industry hasn't been all that kind to Mr. Buffett. It's also strange to now see Berkshire Hathaway as a company where it has lost a lot of money. This may be a cautionary tale about revenge and acting out of spite. He was already a shareholder in the company in 1962 when he received a verbal offer to buy his shares from the man who ran Berkshire Hathaway at the time, Seabury Stanton. When he received the official offer at a lower price than agreed, he decided not to sell any longer, but instead bought all the BH stock he could get his hands on and fired Stanton. He eventually succeeded in his revenge, but was now also the proud owner of a failed textile company.

3. Dexter-sko:

Dexter Shoes was a shoe company based in Maine that made good quality, durable shoes. Warren Buffett believed this quality and durability gave them a competitive advantage when he purchased Dexter Shoes in 1993. Unfortunately, Dexter Shoes had to close their factories in 2001 due to increased competition from cheaper shoes produced outside the United States. Not only was the investment thesis wrong, but the losses from the transaction were compounded by the fact that the purchase was made entirely in Berkshire Hathaway stock. This meant it hurt shareholder value as he gave away some of their stock for something that was ultimately worthless. He has since become a strong proponent of maintaining even larger cash buffers for acquisitions and using cash only.

4. Salomon Brothers:

In 1987, Warren Buffett acquired a $700 million stake in Salomon Brothers, a prestigious bond trading house and investment bank. It was shortly before major writedowns occurred as a result of the Black Friday stock market crash. This wiped out a third of the value of BH's investment. In subsequent years, the investment bank's financial performance remained extremely volatile and a series of scandals occurred, culminating in 1991 when the trading desk was found to have made bogus bids for government bonds, thereby destroying the Primary Dealership established by the U.S. Treasury. had broken the rules. all with knowledge of management. Warren Buffett was forced to step in at that point and take over the management of the company, letting many people go and enforcing a culture of compliance. This was, in his words, a very "not fun" time and a distraction from his duties in running the business. There were many problems at Salomon, which persisted until it was sold in 1998: an aggressive and lax management and trading culture, excessive debt (at one point the company had reached $37 in assets to $1 in equity, even higher than Lehman, when it collapsed).

5. Tesco:

Tesco is a major British supermarket chain in which Berkshire Hathaway invested in 2006. He became one of the grocer's largest shareholders, despite them issuing several profit warnings. In 2013, BH began selling some of their stake, albeit at a slow pace. When the company was hit by a major accounting scandal in 2014 for overstating its profits, BH was still the third largest shareholder. The lesson Warren Buffett learned from this costly mistake was that he had to be more decisive in recovering this investment because he had lost confidence in management and their practices.

What can an investor learn from Buffett's mistakes and strategy?

It is very difficult to say whether the success of Warren Buffett and Berkshire Hathaway can ever be repeated, even by very talented and smart investors. It was, as Mr. Buffett himself admits, at least partly the product of a prolonged and unprecedented period of economic growth and prosperity. Not only that fact, but also the dynamics of the global macroeconomy are changing; Some of the world's largest and most valuable companies are now in China or other emerging economies, and that can make it harder for global investors to access them as investments and influence management as effectively as the Mr Trump. Buffett was able to do it in his home country, the United States. Finally, Mr. Buffett is known to tend to stay away from technology investments, preferring more traditional business models. However, going forward, it is more likely that this will be the sector most likely to deliver big returns as we witness what Jeremy Rifkin has mentioned:Third industrial revolution.

In my opinion, there are nevertheless some very interesting lessons to be learned from Warren Buffett's investment strategy and his mistakes, even for modest individual investors. For example, his approach to portfolio construction – it's helpful to think of your investments as different sources of money that serve different purposes, and in the same way that Mr. Buffett categorizes them:

1. Long-term assets that will increase in value the most include holdings in private companies. This could be a pension fund, ETFs or angel investments.
2. A more strategic portfolio consisting of shares and bonds when there are interesting buying opportunities on the markets (remember the caveat against bargain hunting).
3. A cash buffer against possible rainy days.
4. And finally, a few sources of passive income that can then be reinvested.

Second, I also share Warren Buffett's belief in the importance of building long-term relationships and working with people he trusts and admires intellectually, but who also largely share his values. This is a good lesson for any business relationship, whether as business partners or, more simply, as bosses or colleagues. Last but not least, another important lesson is that saving and investing are the real keys to wealth creation and that you should start as young as possible, perhaps even as young as 11, like the Oracle of Omaha himself.