Filter One Before Filter Two, Three and Four
The Four Filters invention of Warren E. Buffett and Charles T. Munger helps us eliminate many prospects, and they help us find: “Understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.” In this short article, I will explain the importance of performing the four checklist sequence from the filters instead of starting with quantitative screening similar to filter four.
Warren Buffett has written about the four filters in several ways. This behavioral sequence is always similar: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.” While Charlie Munger has described the process as getting into high quality businesses, Warren Buffett has also phrased the Four Filter process in this slightly different way: “When buying companies or common stocks, we look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.”
After devoting hours of thinking time into their investing ideas and guiding principles , I felt like a man who stumbled upon hidden treasure in the middle of his back yard. I rediscovered a simple sequence called the four filters! They were there all the time.
In the 2003 Berkshire Hathaway annual meeting, a man asked Warren Buffett this question: “Could you just take us thru your filter process when it comes to selecting a company?” Warren Buffett answered, “It’s a question of A) Can I understand it? If it makes it thru that filter, B) does it have some kind of sustainable long-term competitive advantage? If it makes it thru that filter, how do I feel about the management in terms of their ability and honesty? And if it makes it thru that filter, what’s the price? And if it gets it thru all four filters, I sign my name to the check.”
Notice the sequence that Warren Buffett stated. The key phrase may be "If it makes it thru that filter..." These ideas sound so simple. Many people hear them at the Berkshire Hathaway annual meeting in Omaha each year. Yet, few people have stopped to think about the importance and usefulness of each individual filter.
Advantages, Disadvantages and Intimate Knowledge
If we spend a lot of our time with quantitative screening, we rob ourselves of the time available in getting to know and "understand the nature of the business." Filter one is about finding "a business we understand." Then, filter two is about finding a durable competitive advantage and favorable long-term economics. This, by the way, is the topic of my seventh book, "MOATS: Competitive Advantages of 70 Buffett & Munger Businesses."
In developing an "intimate knowledge" of the business, would you rather know its latest numbers well?
I suspect that we should spend our valuable time learning and getting to know the nature, competitive advantage and management of the business in question.
The checklist nature of these four filters serves as a logical and sensible justification mechanism. A checklist can serve to confirm or disconfirm evidence. Like pilots who use a checklist prior to flying, the four filters help us frame a rational investment decision. Charlie Munger believes in using checklist routines to help us avoid a lot of errors. These errors occur because our human brains are wired to find shortcuts, or what Munger calls “shortcut types of approximations.” Charlie Munger said: “The main antidotes to miscues from Availability-Misweighing Tendency often involve procedures, including the use of checklists, which are almost always helpful.”
Charlie Munger described the self-development process this way: “If you're going to be an investor, you're going to make some investments where you don't have all the experience you need. But if you keep trying to get a little better over time, you'll start to make investments that are virtually certain to have a good outcome. The keys are discipline, hard work and practice. It's like playing golf — you have to work on it.”
We should spend our valuable time learning and getting to know the nature, competitive advantage and management of the business in question. If we fail to buy at a great bargain, the wonderful business will still yield happy returns. If you don't believe me, just remember that Warren Buffett said: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Yes, a decision framing sequence does matter!