Valuing businesses is something Warren Buffett (Trades, Portfolio) has a tremendous amount of experience with, and any comments from the Oracle of Omaha on the topic are always highly informative.
One approach Buffett has advocated in the past is asking questions to build out your valuation process. He spoke about this at the 2010 Berkshire Hathaway annual meeting of shareholders, when one investor asked him if he could give some insight into how his process into valuing businesses has changed and developed over the years.
Valuation model
Buffett began his response by saying that the most significant development in his investment style over the previous few decades was the move away from deep value, the technique taught by his teacher and mentor Benjamin Graham, toward buying quality at a reasonable price.
He went on to say that the "biggest thing" to understand when valuing businesses is not "how big your circle of competence is, but knowing where the perimeter is."
You don't have to understand every single business there is out there on the market. Stretching yourself too thin and trying to understand too much can be detrimental to performance over the long term. If you concentrate on a few companies that you really know and understand well, just as Buffett has done, it becomes easier to make money as it is easier to spot undervalued opportunities. As Buffett explained in his answer back in 2010:
"You don't have to be an expert on 90% of the businesses, or 80%, or 70, or 50. But you do have to know something about the ones that you actually put your money into, and if that's a very small part of the universe, that still is not a killer."
And this is where it pays to start asking questions to extend your knowledge over time. I'll let Buffett explain this fundamental principle:
"And I think if you think about what you would pay for a McDonald's sandwich, you think you would pay for — you know, think about the businesses in your own hometown of Olathe. Which would you like to buy into? Which do you think you could understand their economics? Which do you think will be around 10 or 20 years from now? Which do you think it would be very tough to compete with?
Just keep asking yourself questions about businesses. Talk with other people about them. You will extend your knowledge over time. And always remember that margin of safety. And I think you basically have the right attitude because you recognize your limitations, and that's enormously important in this business. You will find things to do."
The art of investing
I am a firm believer that investing is not a science -- it is an art. And just like all good art, good investing requires lots of practice, patience and continual improvement. Only a handful of artists were good from the very beginning, and the majority have had to practice and develop their art over many years.
The same is true of investors. No one is born a good investor. You have to work at it and develop your skills over many years and decades. One of the best ways to learn and develop your skill set as an investor is to continually be asking questions and developing your circle of competence around certain businesses and industries.
Asking questions is just one of the many ways you can do this, and if you ask the right questions of the right people, they will give you new insights that will be beneficial to your mental models.
It's all about focusing on what you really know and avoiding making any serious mistakes. One of the greatest mistakes you can make is investing in a business you don't really understand. Luckily, you are never under any obligation to invest in any business.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:Â
Warren Buffett: There Will Always Be Opportunities for Value InvestorsÂ
Finding Value the Jean-Marie Eveillard WayÂ
Hedge Funds Roar Back in 2019 but Stock Pickers SufferÂ
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