How do we improve and optimize our investing decision making? This was the goal of the first edition of this book. Now, about 5 years later, this journey continues with more insights and examples.
We can use the Four Filters Invention of Warren E. Buffett and Charles T. Munger. Their four filters investing process helps us eliminate many inferior investing prospects. This filtering process helps us find high-quality winning investments. Their steps include evaluating a business’ economics, its competitive position, its managers, and its intrinsic value. It provides us a tested and effective toolset.
How and why are these filters effective? Warren Buffett (Trades, Portfolio) said it best: “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.” These four filters focus on the business facts about the Products, Customers, Management, and the Financial Safety given by a bargain purchase.
The Four Filters are a search for: “Understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.”[i]
In my view, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) invented an investing formula that is underappreciated by the business and academic communities. It is an amazing intellectual achievement in both practical and Behavioral Finance. The filters are an important set of steps used by the world’s greatest investors for finding high quality investments.
As a useful guide for assessing intrinsic value and sensible price, the filters function as an effective time-tested focusing process for investing success. They help us frame our investing decision making process correctly, and help us prevent foolish and costly losses. Using this process, you and I will become better investors. We improve the way we think about businesses. This innovation uses qualitative factors as well as quantitative factors to help us find and insure a good stock or whole business for investment. It raises the odds of investing success.
The first edition received some criticism from casual readers stating that it restated many of the writings and talks of Buffett and Munger. Yes, it did. I tried to tell the story from their perspective. So the use of many quotations was necessary, and they were approved for use.
These critical readers did not realize that I was trying to design a book as if Warren or Charlie had written it themselves. Perhaps, I did not explain that clearly enough.
For example, if I insert a passage like this next one by Charlie Munger (Trades, Portfolio), it illustrates his frame of mind: “The way to win is to work, work, work, work and hope to have a few insights…. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.”[ii]
This book is about the intellectual collaboration and experiences of two good friends who smartly changed the world of investing and invented a thoughtful and effective process. They made a lot of money for themselves and their shareholders. There is another treasure hidden in these words: how to improve and optimize our decision making process.
This is also a story about exercising self-discipline. Look to the future and think clearly for yourself. Be open to new ideas from wise people. Study the past, and learn from it. 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.”
History is important to Charlie Munger (Trades, Portfolio) as well. He said this: “Business schools fail by teaching what is easy to teach but less useful. Going back to teaching business history as Harvard used to would be good; there’s a lot to be learned from the rise and fall of GM, or the rise and fall and rise of railroads.”
This book is about one smart way to frame a decision process using sound principles. How do we develop a better understanding of a business, its products, its present, its management, its earnings, and its future? Charlie Munger (Trades, Portfolio) said, “We read a lot. I don’t know anyone who’s wise who doesn’t read a lot. But that’s not enough: You have to have a temperament to grab ideas and do sensible things.”[iii]
This year, 2014, I learned something new from the 2013 annual letter. I learned that retained earnings can be a “powerful competitive advantage.” Warren Buffett (Trades, Portfolio) put it this way: “Here’s a little known fact: Last year MidAmerican retained more dollars of earnings – by far – than any other American electric utility. We and our regulators see this as an important advantage – one almost certain to exist five, ten and twenty years from now.”
Over the years, I have read all of the Letters to Shareholders of Berkshire Hathaway. I have also read most of the books and articles about Warren Buffett (Trades, Portfolio), his teacher Benjamin Graham, and his business partner Charlie Munger (Trades, Portfolio). I also served as the editor of Scott Thompson’s fine textbook: “The Art & Science of Value Investing.”
Having listened to many hours of audio lectures and interviews, I have been consistently interested in how Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) “frame” an investment decision, and how they find a winning investment prospect. This book is a story about their rational filter process. It helps them make better investing decisions. In the words of Charlie Munger (Trades, Portfolio), “You have to understand the odds and have the discipline to bet only when the odds are in your favor.”[iv] And, I hope that this second edition adds more meat (examples) into your decision making process.
Warren Buffett (Trades, Portfolio) 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.”[v] While Charlie Munger (Trades, Portfolio) has described the process as getting into high quality businesses, Warren Buffett (Trades, Portfolio) 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.”[vi]
In 1996, Buffett wrote this about investing in public companies. It is a twist on the Four Filter formula that sets the bar towards realism and conservativism: “The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.”[vii]
After devoting hours of thinking time into their investing ideas and guiding principles[viii], 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 (Trades, Portfolio) this question: “Could you just take us thru your filter process when it comes to, selecting a company?” Warren Buffett (Trades, Portfolio) 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.”
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.
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 Businesses.”[ix] They function as a smart targeting system steering us with clear goals. And, using the Four Filters, promotes investing “self-discipline.” This book unveils how the Four Filters are a significant intellectual achievement in Behavioral Finance.
In addition to the framing aspects to this decision making, the checklist nature of these Four Filters serve as a logical and sensible justification mechanism. A standard checklist serves to confirm or disconfirm evidence. Like pilots who use checklist prior to flying, the Four Filters help us frame a rational investment decision. Charlie Munger (Trades, Portfolio) 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 (Trades, Portfolio) said: “The main antidotes to miscues from Availability-Misweighing Tendency often involve procedures, including the use of checklists, which are almost always helpful.”[x] At the USC Law School Commencement speech in 2007, he said: “You should have all of this elementary wisdom, and you should go through a mental checklist in order to use it. There is no other procedure that will work as well.”[xi] Munger has also said: "You need a different checklist and different mental models for different companies. I can never make it easy by saying, 'Here are three things.' You have to derive it yourself to ingrain it in your head for the rest of your life."
To be fair, other great investors used quality checklists to earn profits. And, other great investors contributed “Best Practices” to the art of effective investing. Later in this book, we see the contributions of several investing thought leaders.
Do you have a “Happy Zone?” The Four Filters serve to increase the probability of investment success by defining “the right ball to hit.” Buffett tells students this Ted Williams baseball analogy: “I put heavy weight on certainty. Use probability in your favor and avoid risk. It’s not risky to buy securities at a fraction of what they are worth. Don’t gamble. You’re dealing with a lot of silly people in the marketplace; it’s like a great big casino, and everyone else is boozing. Watch for unusual circumstances. Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised. In appraising the odds, Ted Williams explained how he increased his probability of hitting: "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.”
This book trims “all the lean beef” into five chapters: “the Four Filter chapters and a summarizing chapter.” The final summary chapter ties the filters together and demonstrate why these filters work to maximize the probability of investing success from both a mathematical and a practical point of view. This second edition adds in more solid examples as well as insights I have learned in the past five years. See the new section on Coca-Cola and their “Yield On Cost” estimation.
So, how were these Four Filters developed? Over the course of their investing experiences, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have had many discussions about the qualities of bad, good, and mediocre businesses they had invested in. Also, keep in mind that Charlie Munger (Trades, Portfolio) believes wisdom acquisition is a moral duty.[xii] So, the Four Filters seem to have evolved from their discussions and their early business and investing experiences.
Interestingly, the 1977 Letter to Shareholders of Berkshire Hathaway is the earliest one listing the Four Filters. It is also the earliest letter posted at the company’s website: ( http://www.berkshirehathaway.com ). This Four Filters Formula was presented 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.”[xiii]
Charlie Munger (Trades, Portfolio) said that once they had gotten over the hurdle of recognizing that a business could be a bargain based on quantitative measures that would have horrified Ben Graham, they started thinking about better businesses. Their results show the bulk of the billions earned at Berkshire Hathaway have come from the better businesses. Munger described their system this way: “We came to this notion of finding a mispriced bet and loading up when we were very confident that we were right. So we're way less diversified. And I think our system is miles better.”[xiv]
For years, Buffett and Munger would site See’s Candies as the best example of a “wonderful business.” See's Candies taught Buffett and Munger much about the evaluation of franchises. Both men admit that they have made significant money because of the lessons they learned at See's. See’s Candies is the wonderful business.
In their talks and writings, they refer to a great business as a “franchise” or a “wonderful business.” Buffett wrote: “An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.”
Buffett and Munger respect able and trustworthy managers. As you read about these great businesses, think about the product or service that: (1) is strongly desired; (2) has no close substitute and; (3) has pricing power. As Buffett said, “A moat that must be continuously rebuilt will eventually be no moat at all. Additionally, this criterion eliminates the business whose success depends on having a great manager.” He summarizes it this way: “We believe that our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success. We expect, therefore, to keep on doing well.”
[i] The Four Filters, Berkshire Chairman’s Letter to Shareholders, 2007.
[ii] From the talk called “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business” by Charles Munger, USC Business School, 1994.
[iii] Berkshire Hathaway Annual Meeting, 2004.
[v] Berkshire Chairman’s Letter to Shareholders, 2007, 6.
[vi] Berkshire Chairman’s Letter to Shareholders, 1989,(http://www.berkshirehathaway.com/letters/1989.html).
[vii] Berkshire Chairman's Letter to Shareholders, 1996.
[viii] Owner-oriented principles, Berkshire Hathaway Owner’s Manual, 1996.
[ix] Berkshire Chairman’s Letter to Shareholders, 1989,(http://www.berkshirehathaway.com/letters/1989.html).
[x] (The Psychology of Human Misjudgment Revised Speech by Charles T. Munger), Kaufman, Peter D., Poor Charlie’s Almanack, Virginia Beach, VA: PCA Publication, LLC, 2005.
[xiii] Berkshire Chairman’s Letter to Shareholders, 1989, (http://www.berkshirehathaway.com/letters/1989.html).
[xiv] A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business”. Charles Munger, USC Business School, 1994.