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John Huber
John Huber
Articles (105)  | Author's Website |

How Warren Buffett Thinks About Risk

October 18, 2013 | About:
“Rule #1: Don’t Lose Money….”

The best book I’ve ever read on Warren Buffett is Alice Schroeder’s "Snowball." I remember picking up my copy about four years ago and literally not being able to put it down. I read it for hours at a time, all the while marking pages and circling things… and I often reference certain parts of the book when thinking about investments. The book goes much deeper into Buffett’s thought process than most of the other Buffett books.

Schroeder went through pages of Buffett’s scratch notes on many early investments, some of which were heretofore unknown to the public (one in particular is mentioned below). She does a great job at really capturing what Buffett was thinking behind many of his investments, which makes the book a true gem for reverse engineering Buffett’s ideas.

Below is a video of Schroeder that I recently watched. The video below is a clip of her talk at the University of Virginia, which is a great lecture to listen to. But if you have nine minutes, I strongly recommend watching the clip below.

The First Step in Buffett’s Investment Process

One of the most fascinating things about Buffett is his ability to quickly and efficiently filter through many investment ideas. In the video, Schroeder discusses a key question that Buffett asks immdediately before doing any work on a prospective investment. The question is basically: What are the odds that this investment could fail because of catastrophe risk? In other words, what are the major things that could go wrong?

Schroeder goes on to explain that this question was the first step in Buffett’s investment process. He was not interested in putting capital at risk if there was any chance of cat risk. He didn’t care about the potential upside if he perceived there to be a major reason that the business could fail. This is much different than how most investors think. Some investors are willing to take positions in stocks that have significant risk, but even greater upside. Buffett was not. He simply wanted to invest in high probability and low risk situations. This simplified his process.

He missed out on many investments because he wasn’t willing to take the risk. Some members of his family got rich investing in Control Data in the 1960s, even as Buffett urged them not to. He didn’t care about missing opportunity in situations that had catastrophe risk. He wanted high returns, and significant upside – just not at the expense of major risk.

Mid-Continent Tab Card Company[/b]

This brings us to an example that Schroeder discusses in this video clip. The [b]Mid-Continent Tab Card Company is a fascinating case study on Buffett’s investment process

I’ll let Schroeder share the specifics of the investment, but the summary is that Buffett passed on an early stage start-up business that his friends were working on because he thought the business could (not necessarily would) fail due to stiff competition from IBM. So he passed on the idea. However, his friends got the business off the ground, and a year later were hugely profitable, and successfully competing with IBM. They approached Buffett again needing to raise more money. This time he said he would consider it. The cat risk was off the table, and he began doing research on the business.

The case study is also interesting because Schroeder discusses Buffett’s process for evaluating the business, which is also significantly different from how most investors research ideas. He didn’t use DCFs, he didn’t do detailed projections. He used basic analysis with simple common sense logic. And he only did his analysis after first identifying that cat risk was off the table.

The result of the investment is less important than studying his process, but nevertheless, it was fantastic. Buffett ended up making millions from an initial $60,000 investment, compounding his capital in this investment at 33% per year for almost two decades.

Think of Stocks as Businesses[b][/b]

By the way–one more interesting point from the video. Buffett was only 29 when his friends brought him this deal. He had yet to prove himself as a successful investor. His friends knew he was a businessman, and a good investor, but had no idea of how good he really was. I thought this illustrated an interesting point that Buffett was a business owner first and foremost. He truly thought of stocks as businesses, and that’s likely one of the most significant factors in his phenomenal successes as a capital allocator.

Here are some other useful pieces on the Mid-Continent Tab Card Company and Buffett’s filtering process:

Here is the video clip of Schroeder at the Darden School. It’s a great clip to watch:

About the author:

John Huber
I am the portfolio manager of Saber Capital Management LLC, a Registered Investment Advisor (RIA). Saber is an investment firm that manages separate accounts for clients. I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

By using separate accounts, Saber offers its clients complete transparency and liquidity (the funds are held in the name of the client and cannot be accessed by the investment manager). Saber looks to partner with like-minded clients who are interested in a patient, long-term approach to investing that is rooted in the principles of value investing.

I also write at the blog www.basehitinvesting.com.

I can be reached at [email protected]

Visit John Huber's Website

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