I recently listened to a podcast where the author of a Warren Buffett (Trades, Portfolio) biography (Roger Lowenstein, "The Making of an American Capitalist") mentioned the “art” part of stock picking in regard to what Warren Buffett (Trades, Portfolio) does. In other words, business analysis as opposed to just looking at the numbers here at GuruFocus or in a Moody’s Manual or something.
I thought this was an important topic to discuss. Because I get a lot of questions – including the recent one about free cash flow yields I answered in an article yesterday – that basically come down to: What’s the “rule” for how best to handle this subject? Should I buy low price-to-book stocks? Magic formula stocks? Low P/E stocks?
Those are questions best left to journal articles and statisticians. They’re questions you can analyze only as group operations. Picking specific stocks is different.
The answer is that when it comes to stock picking – not investing in baskets of stocks, but putting a lot of your eggs in one business basket – it is an art (or at least a craft) and not so much a science.
When buying entire companies for Berkshire, one of the most important decisions Warren Buffett (Trades, Portfolio) has to make is whether a business will continue to earn a good enough return on capital for a long time. So, it is Buffett’s judgment of a company’s “moat” that often matters most. This is especially true in some of his truly long-term investments like the Washington Post (an investment he held for 30+ years), Coca-Cola (KO, Financial), American Express (AXP, Financial) and Wells Fargo (WFC, Financial). The most important question over a holding period of 20 or more years is going to be whether or not you judge a company’s moat correctly.
So, how do you do that? What is this art of stock picking?
One, it’s very selective. Buffett can only pick stocks for the very long-term in a small number of industries and often can only pick businesses that are already in some sense leaders in their field. They can be small. See’s Candies was small when Buffett bought it. But it was already the clear mindshare leader in boxed candies in California. Nebraska Furniture Mart was small when Buffett bought it. But, that single store location already dominated the market for furniture retail in the Omaha, Nebraska market.
Here’s a story about just how “limited” your competitive crystal ball has to be.
I owned a stock many years ago called Village Supermarket (VLGEA, Financial). It operates supermarkets under the Shop-Rite banner (which it doesn’t own, it’s just a member of the co-op that owns that name) in New Jersey. The company has tried expanding into other markets. It entered the Maryland market. I felt pretty comfortable with the company’s “moat” inside the state of New Jersey. But I wasn’t at all comfortable predicting anything about Shop-Rites in Maryland. Likewise, it plans to open a store in the Bronx (New York City). I can’t make predictions about that. Markets really are that local when it comes to groceries. The first step in the art of picking a single stock is usually finding something that is already a leader in its industry, its local area, or its niche.
That’s not always true. Buffett bet on GEICO starting in the 1950s. It wasn’t a market share leader by then. Today, GEICO and Progressive combined are huge leaders in the market for truly new car insurance customers. Market share appears more fragmented than the market for new policies, because people tend not to leave their original insurer. There are a lot of old people who have policies with Allstate and State Farm but whose kids will have policies with GEICO or Progressive. Trust me when I say the big direct sellers – GEICO, Progressive, and USAA (the company GEICO’s business model is a copy of) – have a big tailwind when it comes to gaining market share over insurers who sell through agents (either captive or independent). This has become very obvious since the start of selling car insurance over the internet. But, the advantages of direct selling (then done through the mail) were obvious to Buffett even in the 1950s. GEICO had a better business model. It would gain market share forever.
It’s very hard to bet on the No. 2 or No. 3 in a field. Being able to predict a company’s transition from “good” to “great” is a lot harder than finding a company that was pretty much born great. Buffett usually bets on the status quo. He doesn’t bet on the side of disruption. Instead, he tries to just sidestep industries with a lot of change.
Of course, Buffett makes mistakes even when betting with the leaders. Over in Ireland, he bought shares of Bank of Ireland. And in the U.K., he bought shares of Tesco. Both of those decisions were big mistakes. But, they were still in keeping with betting on a company that seemed to have a “moat.” The supermarket industry in the U.K. was – when Buffett bought into it – especially non-competitive. A small number of companies had a lot of market share all over the country. Margins looked good. The ability to sell store brands instead of name brands also looked good. It would have seemed to Buffett that Tesco had a much better position in the U.K. than a company like Kroger (KR) has in the U.S. It looked like a less competitive market. Of course, that less competitive market was disrupted by discounters that invested heavily in growth in the U.K. and fragmented the market from being one controlled by a few generalists to one where those generalists now had less of the total market. It became a more specialized industry. It ended up getting a lot more competitive – and a lot more like the U.S. market.
Bank of Ireland is another example of a mistake Buffett made that still fits how he usually picks stocks. The Irish banking industry was very, very consolidated. By comparison, the U.S. banking industry is incredibly fragmented by international standards. Ireland is one of the most concentrated markets for banking. There was a housing bubble in Ireland. And there was a financial crisis. Buffett made a mistake. But, he wasn’t betting on a highly competitive industry. He was buying what looked like a cheap bank in an industry with low competition.
We see this again and again with Buffett’s stock picks whether they turn out really well, really badly, or something in between. For example, he bought stock in USG (USG, Financial). It’s a commodity business. The company’s trademark product is SHEETROCK (a brand of drywall) – which is so well-known in the building trade that you may have thought SHEETROCK was itself the generic term for the product. I don’t know if Buffett’s judgment of the cycle was great with USG. But, he was betting on a leader in the field. He knew the company was unlikely to be unseated by a competitor. It had comparative advantages over others. Whether those would translate into a good absolute return on equity or not is another question. But, it would’ve been reasonable for Buffett to expect the economics of USG were better than those of competitors and would stay that way.
This focus on competitive position is the big difference between Buffett and most value investors. It is the “art” part of what he does.
Again, we can see a competitive position reason for even his not so great investment decisions. Buffett’s investment in IBM (IBM) didn’t go well. But, his reasons for buying the stock came down to competitive position. The two things I really remember clearly about why Buffett said he bought the stock were: 1) Corporate IT departments that were already using IBM were unlikely to stop using IBM and 2) The company was likely to keep buying back its own stock. One of those is a capital allocation reason. But, the first one is a competitive position – a “moat” – reason. He felt that once IBM got entangled in a company’s day-to-day operations – the client was unlikely to get rid of them and use a different company. Now, Buffett has said he thinks of IBM differently. So, he may have misjudged the company’s competitive position. But, even when he makes an error – it’s often an error in terms of assessing a business’s competitive position.
One of Buffett’s really good investments that looked like it was going to be a really bad investment for a while there was his purchase of the Buffalo Evening News. This – and his GEICO purchase in the 1970s – is about as close as Buffett gets to a pure “speculation.” The Buffalo Evening News was one newspaper in a two-newspaper city. History – over the last 40 years by that point in the 1980s – had shown that two paper towns eventually became one paper towns. The Buffalo Evening News had the stronger position. In fact, the company’s main competitor mostly survived by publishing a Sunday edition which the Buffalo Evening News did not compete with.
The competing paper did not give in easily. There was a brutal period of competition where the Buffalo Evening News lost money. But, Buffett stuck with it. And when the Buffalo Evening News outlasted its competitor it became a monopoly. It then started earning monopoly profits. Newspapers are one of the businesses that Buffett says are “Survival of the Fattest” industries rather than “Survival of the Fittest” industries. The paper with the most subscribers gets the most advertisers. The paper with the most advertisers is most attractive to subscribers. And subscribers want to read what their neighbors are reading.
This was most obvious back when classified ads were a big part of a newspaper’s profits. It’s hard to imagine such a time now. But, in the 1980s and early 1990s – before people used the internet for these things – classified advertising was a very important profit source for newspapers. These papers were like bulletin boards that connected the people placing ads with the people reading ads. If you were going to read one bulletin board a day – it made sense to read the bulletin board where people were putting the most ads up. And if you were going to post to a bulletin board somewhere – it made sense to post to the bulletin board that everyone read.
A discussion of the competitive position of a leading newspaper in two-paper towns seems quaint now. But a lot of the same competitive pressures are at work on the internet. There are many businesses that tend toward a winner-takes-all outcome. Facebook (FB, Financial) is a lot like a local newspaper. The economics of Facebook are a lot like those of a local newspaper. And much of the world is now a one-newspaper town as far as how you get information on your friends and family. You scroll through Facebook to do it the same way you browsed your local newspaper to see the name of your niece and how many points she scored for the high school basketball team.
Why is Buffett so focused on investing as an “art” of stock picking rather than a “science” of portfolio construction?
Because he’s a very concentrated investor. Buffett doesn’t diversify. That’s the trait that set him apart from other Ben Graham-type investors from the beginning. He was willing to put 50% or more of his net worth into a stock like GEICO when he found it. Graham put much less of his partnership’s funds in GEICO than Buffett put into the same stock. Buffett overweighted the ideas he liked best. And so he quickly outperformed his mentor, Ben Graham, and some of his fellow students of Graham. In his earliest years investing, Buffett seems to have done this not through having better or different ideas than other followers of Graham – but simply through betting very big amounts of his money on the few ideas he liked best. Graham’s partnership often had close to 100 positions. The top 10 stocks would often account for less than 50% of the fund. In other words, Graham’s ideas that didn’t make the top 10 would be half of his portfolio. This waters down your 10 best ideas by 50% each. It’s like halving your bet on every really good idea you have. Graham was a very defensive investor after his experience in the 1929 crash and the few years after that.
It’s worth noting here that Graham’s actual stock picks don’t seem to have been the problem in the early 1930s. It was more that Graham used leverage. That sounds risky to people reading this today. But, Graham probably used a lot less leverage than the vast majority of individual investors in 1929 were using – and yet he was still almost bankrupted by it.
So, Graham diversified widely. He relied on the “science” of picking groups of stocks.
Buffett improved on Graham’s results by focusing on the “art” of picking specific stocks out of those groups and betting big on them.
Charlie Munger (Trades, Portfolio) is often credited with getting Buffett to move in the direction of focusing more on business analysis. But, Buffett had already put most of his net worth into GEICO (in the early 1950s) because he loved that company’s business model – not because it had a low price-book ratio. He had also made his biggest investment ever in American Express during the Salad Oil Scandal. American Express’s value was in its brand name and network effects. It was never a Ben Graham stock. And he also bought a position in Disney that was certainly attractively priced on an asset basis – but which was also bought largely for non-Graham type reasons. Buffett went to the theaters to check out Disney’s latest release. That’s a form of scuttlebutt Phil Fisher would do and Ben Graham wouldn’t do.
So, Buffett was already pretty far along in moving from the “science” of group stock selection that Ben Graham favored to moving to the “art” of individual stock picking that became Buffett’s signature style.
That art of stock picking is largely the art of analyzing a business’s long-term competitive prospects. For the last 40-50 years of his career, that’s how Warren Buffett (Trades, Portfolio) has made his money.
Disclosures: Geoff owns NC, CFR and BWXT.
