Reading a company’s financial statements is a crucial exercise for any value investor, as is learning the accounting language they are written in. But are financials sufficient on their own? At the 2008 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting, a shareholder asked Warren Buffett (Trades, Portfolio) whether he would be able to glean enough information from a company’s financials to invest in it, without speaking to management or reading the annual report. Here is Buffett’s response.
Difficult, but often necessary
Buffett said that without knowing the economics of the underlying business, it is exceedingly difficult to value a security. Understanding the fundamental aspects of a market and the types of businesses that operate within them provides the context that informs the reading of the financial statements. For instance, it is very difficult to value a copper mine without knowing what the average price of copper is, or how heavily leveraged other copper mines tend to be.
In some special cases, however, Buffett has acted in exactly the way described by his shareholder:
“But I’ve bought stocks the way you’re describing many times. And they were in businesses that I thought I understood where if I knew enough about the financial past, it would tell me enough about the financial future that I could buy. Now, I couldn’t say the stock was worth X or 105% of X or 95% of X. But if I could buy it at 40% of X, I would feel that I had this margin of safety that Graham talked about, and I could make a decision.”
In other words, if you know the industry well enough, then you don’t necessarily need to see an annual report or talk to management. This isn’t to say you cannot glean useful insights from doing so, but it does pay to remember that management always has an incentive to present results in the best possible light, which is why I like to take management-curated narratives with a pinch of salt. In fact, Buffett and Charlie Munger (Trades, Portfolio) often invest without knowing that much about a management team:
“We’ve bought lots and lots of securities – and in the majority of the securities Charlie and I have bought, we’ve never met or talked to management. We’ve primarily worked off financial statements, our general understanding of the business, and the specific understanding of the industry and the business we’re buying...And there are a lot of things that I wouldn’t buy if I knew the management was the most wonderful in the world – because if there in the wrong business, it really doesn’t make much difference how good the management is”.
The financial news media, like virtually all news media, is in the business of narrative-creation. That’s not a value judgement, just a statement of fact. It’s pretty difficult to keep the digital airwaves busy 24/7 with strictually factual information, which is why there is so much opinion journalism out there today. Some of it may be rooted in fact, but some may be dangerously misleading. A lot of it is also noise.
Focusing on a company’s financials (particularly the cash flow statement, which is harder to game than earnings), allows an investor to cut through a lot of that noise and get down to what is actually important - figuring out whether the business generates money. At the end of the day, that’s the only thing that should matter.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Why Assessing Returns Without Risk Is Pointless
- Charlie Munger: The Lollapalooza Effect and How It Affects the Stock Market
- Warren Buffett: Beware of Long-Duration Bonds
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