How do we improve and optimize our investing decision making? How do we develop a better understanding of a company, its products, its present, and its future? Over the years, I have read all of the Letters to Shareholders of Berkshire Hathaway. I have read most of the books and articles about Warren Buffett, his teacher Benjamin Graham, and his business partner Charlie Munger. I have also listened to many hours of audio lectures and interviews. During this time, I have been consistently interested in how Warren Buffett and Charlie Munger "frame" an investment decision, and how they arrive at a winning investment prospect.
I believe that Buffett and Munger invented an amazing formula and process that is underappreciated by the business and academic communities. To be fair, many other great investors used quality checklists. And, many other great investors contributed "Best Practices" to the art of effective investing. Later in this book, I mention several contributors and thought leaders. This book is about the rational four filter process that help Buffett and Munger make better investing decisions. Warren Buffett has talked 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." Buffett has also phrased the Four Filter process in this 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." These ideas sound so simple. Many people hear them at the Berkshire Hathaway annual meeting in Omaha each year. Yet, I suspect that few people have stopped to think about the importance and effectiveness of each individual filter. As a formula, the Four Filters function as a set of "Investing Best Practices." They help us develop better "self-control." They force us to focus on "Wonderful Companies." They function as a smart "Targeting System" that steer us with clear goals. And, using the Four Filters, imposes and promotes investing "self-discipline." This book will also unveil how the Four Filters are a significant intellectual achievement.
This Four Filters Formula first appeared in the 1977 Letter to Shareholders in this form:
"We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. My deepest interest has been focused on the Behavioral Finance area I call "successful practitioner framing." Here is a quick summary about my views on their "framing" process. Framing in behavioral finance is the choosing of particular words to present a given set of facts. And, framing can influence our choices. Tversky and Kahneman described "Prospect Theory" in 1979 using framed questions. Tversky and Kahneman found that contrary to expected utility theory, people placed different weights on gains and losses. Tversky and Kahneman found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some have concluded that investors typically consider the loss of $1 twice as painful as the pleasure received from a $1 gain. Others believe that this work helps to explain patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. An increasing body of literature on framing supports a tendency for people to take more risks when seeking to avoid losses as opposed to securing gains. In 1992, Takemura showed that the effects of framing are likely to be lower when subjects are warned in advance that they will be required to justify their choices, and when more time is allowed for arriving at their choices. Luckily, Buffett and Munger seem to have arrived at the practical use of these optimal framing ideas earlier than most. They make good use of "justification," "elaboration," "elimination," and "time."
CHAPTER ONE OF FIVE: UNDERSTANDING
Filter Number One: Develop an Understanding of a Company and its Products.
Warren Buffett puts it this way: "Seek whatever information will further your understanding of a company's business." My goal in this chapter is to review a tiny bit of history, mention a few concepts, and stimulate a growth in your latticework of understanding businesses and situations. Example number one is a section from the 1960 Buffett Partnership Letter. Example number two shows us that the historical development of Buffett's and Munger's understanding of business.
In developing your understanding of a business, read, study, look, listen, and learn. Charlie Munger advises us to build an idea like a "latticework of mental models" based on facts and accurate and reality based impressions. Look for popular consumer brands. We should begin to build up a mental checklist of factors we like and dislike about a company. I am not sure where the checklist influences came from. However, Phil Carret and Philip Fisher both used quality checklists they developed. Their criteria are illustrated in a table at the end of this chapter. There you can also find Charlie Munger's list of human behavioral tendencies. You will develop a better understanding of a business, its products, and its managers if you can sense it building intrinsic business value on a per-share basis. In addition, the next three filters will add to your "latticework of understanding" the nature of a business.
CHAPTER TWO OF FIVE: SUSTAINABLE COMPETITIVE ADVANTAGE Filter Number Two: Does a Company have a Sustainable Competitive Advantage?
The nature of Capitalism is Competition. A business must have "something special" in order to lead the pack and fend off competitors. What is the nature of the business over the next twenty years? Can we predict it with a high degree of accuracy? Can we imagine an enduring competitive advantage? Is there something special here? Are we being rational and realistic about our assessment? Benjamin Graham urged his students to analyze the business. Warren Buffett is said to be the only student who ever earned an A+ from Ben Graham.
Filter number two is about "sustainable competitive advantage" or "favorable long-term prospects" or "enduring economic advantages." Sustainable Competitive Advantage comes from things that make a company difficult to copy. It is barrier to entry. A protected brand is something unique in the mind of a consumer. A valuable patent or trademark can give a firm a period of protected advantage. There needs to be a strong barrier to entry. Of lesser businesses, Warren Buffett said: "In many industries, differentiation simply can't be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling "commodity" products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability."
Consider why the Coca-Cola Company is such a good business from an investor's point of view. Both Coke and Pepsi make products I enjoy. As an investor, I prefer the Coca-Cola Company. One reason is the amount of Free Cash Flow generated for every sale. Another reason is the amount of Free Cash Flow generated after expenses. Take a look at this chart from Morningstar:
|Coca-Cola Company (KO)||1998||1999||2000||2001||2002||2003||2004||2005||2006||2007||TTM|
|Free Cash Flow/Sales||13.66%||14.21%||13.94%||16.63%||19.89%||22.07%||23.74%||23.91%||18.89%||19.07%||19.07%|
|Free Cash Flow/Net Income||0.73||1.16||1.31||0.84||1.28||1.07||1.07 1.08||1.13||0.9||0.92||91.99|
|PepsiCo, Inc. (PEP)||1998||1999||2000||2001||2002||2003||2004||2005||2006||2007||TTM|
|Free Cash Flow/Sales||8.08%||9.37%||13.92%||10.68%||12.70%||11.06%||12.53%||12.64%||11.43%||11.41%||11.41%|
|Free Cash Flow/Net Income||0.91||0.93||1.30||1.08||0.96||0.84||0.87||1.01||0.71||0.80||79.60|
If you were unaware of the concept of "free cash generating efficiency" prior to now, then I think you are beginning to like my little book.
CHAPTER THREE OF FIVE: ABLE AND TRUSTWORTHY MANAGERS Filter Number Three: Does a Company have Able and Trustworthy Managers?[xiii]
Able but greedy managers will steal from you. As a shareholder, and part owner of a business, do you want a manager taking more money from you than what was agreed upon in his or her contract? The recent past showed us that the non-expensing of stock options was just that. Expensing and Formulating a simple and clear reward plan based on individual performance is clearly more just.
Imagine this scenario. Someday, able but greedy investing managers will try to steal from you, the Berkshire Hathaway Shareholder. The BRK.A "market price" may be sitting calm in the market waters at say "$500,000" for a couple of years. Some enterprising and able corporate raider team, backed by sovereign funds and big complex junk bonds, may arrive at our Berkshire Hathaway castle looking for booty. They will tell a good tale. We are here to break up the kingdom and "unlock value." That will be the telltale sign. What they will really mean is this: "We are here to break up the company into pieces, drive up the market price of each piece and make a bundle of loot for ourselves." In my view, such pirates spread the cancer of fear into good businesses. So, our own managers will need to be able, trustworthy, owner-oriented, forward thinking, and strong of character.
CHAPTER FOUR OF FIVE: BARGAIN PRICE IS A MARGIN OF SAFETY
Filter Number Four: Is the Company available at a Bargain Price?
"Margin of Safety"[xiv] has been called the three most important words in investing by Benjamin Graham and Warren Buffett. This is the final and pivotal filter of the Four Filters Formula.
Think about the Great Depression and the bursting of tech and housing bubbles, and you get the idea. Like we warn our children: "Safety First. Safety First." Purchasing something at a bargain price gives you a "margin of safety." It opens up the opportunity of using our remaining funds to purchase something else. It also helps to protect us from market fluctuations. Warren Buffett and Charlie Munger believe this margin-of-safety principle, strongly emphasized by Ben Graham, is the cornerstone of investment success.[xv]
Later in this chapter, I demonstrate an "intrinsic value" estimation for you. Recall that Warren Buffett warns us that we can easily go wrong in estimating future "coupons." At Berkshire Hathaway, Mr. Buffett attempts to deal with this estimation problem in two ways. Here, I will take the liberty of breaking up his quote into two distinct sections so that you can better visualize the qualitative and quantitative components.[xvi]
CHAPTER FIVE OF FIVE: SUMMARY
As significant as the refinement of the microscope by Antonie van Leeuwenhoek.[xvii]
I believe that Warren Buffett and Charlie Munger invented an investing formula that is underappreciated by the business and academic communities. In my view, the Four Filters developed by Warren E. Buffett and Charles T. Munger is an amazing intellectual achievement in both practical and Behavioral Finance. The Four Filters are a remarkable and important set of steps used by the world's greatest investors. The Four Filters function as an effective time-tested focusing formula for investing success. They serve as a very useful guide for assessing intrinsic value and sensible price.
Behavioral Finance[xviii] and Common Sense have shown us that we all have human tendencies to frame ideas that are affected by our emotions. Ideally, we would use the best of our emotional and intellectual energies in the right way. In my view, the Four Filters reduce the risk of investment failure by helping us steer a better path to a quality bargain.
Charlie Munger has spoken about the merits of having a "pilot's checklist."[xix] This is something I did not appreciate until I studied the Four Filters. These days, Warren Buffett mentions the Four Filters this way: "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."[xx] These Four Filters can enhance the probability of our investment success. I think they will help you in your search for intrinsic value and sensible investment.
In the 1985 Chairman's letter to Shareholders, Warren Buffett wrote that his advantage was attitude. The 2007 annual letter shows Buffett in top form, buying quality bargains. He learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Along the way, he and Charlie Munger got better at picking stocks and whole companies for investment. Their experience and an expanded knowledge base helped them look for understandable first-class businesses with enduring competitive advantages. Philip Fisher and others have influenced their views on evaluating first-class managements and evaluating a business's growth potential.[xxi]
Through the conscientious process of Elaboration and Elimination, the Four Filters illuminate the most important factors for business and investing success. The Four Filters highlight and reveal the good prospects and eliminate the bad prospects for investment. They encompass four clusters that are vitally important to investing success: 1. Products 2. Customers 3. Management 4. Margin of Safety. In each of these four clusters, I can imagine the influence of Ben Graham, Philip Fisher, Charles Munger, and John Burr Williams. Business students can also imagine the ideas of Porter and Greenwald in these filters. In my view, the development of this Four Filters Formula has been an evolutionary process. And, by 1977, the Four Filters were being used like a "checklist" by our pilots, Warren Buffett and Charlie Munger. You can read about many of these influences in Andy Kilpatrick's big comprehensive book, "Of Permanent Value: The Story of Warren Buffett."
If Buffett and Munger had focused solely on the fourth filter, "Margin of Safety" from bargain prices, they would have still done well. However, used as a sequential set of filters, the Four Filters Formula is remarkably effective in preventing loss. It is an elegant algorithm that combines the use of important qualitative and quantitative decision steps. Warren Buffett has also phrased the Four Filter check points in this 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."
From a historical point of view, the record at Berkshire Hathaway under Warren Buffett's tenure speaks for itself. Over the last 43 years, Berkshire Hathaway's book value has grown from $19 to $78,008, a rate of 21.1% compounded annually. Berkshire Hathaway's A share is selling at around $140,000 at the time of this writing (March,2008). It's intrinsic value per share is much higher. And, it's future earning prospects look bright. Future investment managers will do well to practice owner-oriented business principles. I hope Future investment managers understand the effectiveness of this "Four Filter" formula. I practice the Four Filters process.
From a mathematical point of view, think of each stop along the Four Filters as a mutually exclusive and additive event. If a company passes a couple of filters, it is, by the process of elimination, farther to the right on a normal distribution curve. Of course, this filtering is from an "investment prospect" point of view. If this were a field of racing horses, movement along each step of the Four Filters path, the prospect enters a subset of "better than average" horse. In my view, practicing these steps will make you a better investment thinker.
From a practical point of view, business is about taking good care of your customer and arriving at an agreeable trade. Finding the company that has enduring competitive advantage means that you are finding a company that has been tested by time and its customers. Products, Customers, Good Management, and Financial Safety given by a bargain purchase are always important.
Pricing Bubbles, Market excesses, and Government excesses will come and go. Warren Buffett wrote that a different set of major shocks is sure to occur in the future and that he will not try to predict these nor to profit from them. However, if he can identify businesses similar to those he has purchased in the past, external surprises will have little effect on long-term results. Buffett said: "We will stick with the approach that got us here and try not to relax our standards." In my own work, I will continue to use the Four Filters. In talking with students about focus, Warren Buffett often uses this baseball analogy using the story of Ted Williams and his book: "The Story of My Life." Buffett explained: "My argument is, to be a good hitter, you've got to get a good ball to hit. It's the first rule in the book. If I have to bite at stuff that is out of my happy zone, I'm not a .344 hitter. I might only be a .250 hitter." Charlie and I agree and (we) will try to wait for opportunities that are well within our own "happy zone.""
I have lost money foolishly and ignorantly, and I did not like it. I have been an investing "innocent", and I did not like it. This stuff makes better sense. It helps us avoid the biggest risk: "The risk of losing money!" The Four Filters process can help us impose a greater prudence upon our investment decision making.
As significant as the refinement of the microscope, I believe that Warren Buffett and Charlie Munger invented an investing formula that has worked effectively for over 31 years. The Four Filters process incorporates their owner-oriented business principles into an easy to remember "four steps guide." In my view, the Four Filters will help you get closer to your own "happy zone." Used carefully, it will help us avoid losing money. It has helped me greatly in my own investment decision thinking and my own investment decision making. And, I hope it helps you as much as I think it will. As Ben Graham said in the introduction of his book, The Intelligent Investor: "No statement is more true and better applicable to Wall Street than the famous warning of Santayana: "Those who do not remember the past are condemned to repeat it." I hope you find value in my little book.
"An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He or she can earn them only by carefully evaluating facts and continuously exercising discipline."
Warren E. Buffett
 Berkshire Chairman's Letter to Shareholders, 2007, 6.
 Berkshire Chairman's Letter to Shareholders, 1989,(http://www.berkshirehathaway.com/letters/1989.html).
 Berkshire Chairman's Letter to Shareholders, 1989,(http://www.berkshirehathaway.com/letters/1989.html).
 Berkshire Chairman's Letter to Shareholders,1989,(http://www.berkshirehathaway.com/letters/1989.html).
 Daniel Kahneman and Amos Tverksy, "Prospect Theory: An Analysis of Decision Under Risk," Econometrica, 47: 263-291 (1979).
 Takemura, K. (1992) Effect of decision time on framing of decision: A case of risky choice. behavior. Psychologia, 35, 180-185.
Takemura, K. (1994). Influence of elaboration on the framing of decisions. Journal of Psychology, 128, 33-39.
 Berkshire Chairman's Letter to Shareholders, 1993.
 Charlie Munger: USC Business School, 1994 Speech: A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business.
 Fisher and Carret, 0000.
 The Psychology of Human Misjudgment by Charles T. Munger, Kaufman, Peter D., Poor Charlie's Almanack, Virginia Beach, VA: PCA Publication, LLC, 2005.
 Berkshire Chairman's Letter to Shareholders, 1982.
 Morningstar.com, http://quicktake.morningstar.com/stocknet/CashFlowRatios10.aspx?Country=USA&Symbol=KO
[xiii] "Able and honest people", Berkshire Chairman's Letter to Shareholders, 2002.
[xiv] Benjamin Graham Lecture Number Four, These lectures are from the series entitled Current Problems in Security Analysis that Mr. Graham presented at the New York Institute of Finance from September 1946 to February 1947. The book provides an abridged version of this content. The full text of the transcripts are contained within this website. http://www.wiley.com/legacy/products/subject/finance/bgraham/benlec4.html
The Rediscovered Benjamin Graham: Selected Writings of the Wall Street Legend, by Janet Lowe.
[xv] Berkshire Chairman's Letter to Shareholders, 1992.
[xvi] Berkshire Chairman's Letter to Shareholders, 1992.
[xvii] Anton van Leeuwenhoek is generally recognized as an innovator in advancing the microscope, and pioneer of microbiology. ( en.wikipedia.org/wiki/Anton_van_Leeuwenhoek )
[xviii] Behavioral Finance
[xix] Kaufman, Peter D., Poor Charlie's Almanack, Virginia Beach, VA: PCA Publication, LLC, 2005.
[xx] Berkshire Chairman's Letter to Shareholders, 2007.
[xxi] Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett (Birmingham, AL: AKPE, 1998), 683.