Thursday, March 06, 2008


The Four Filters.

What I Learned from Warren Buffett.
By Bud Labitan


Over the years, I have read most of the books about Warren Buffett, his teacher Benjamin Graham, and his business partner Charlie Munger. I have also listened to many hours of audio lectures and interviews. During this time, I have been consistently interested in how Warren Buffett frames an investment decision and how he arrives at a winning investment prospect.

Warren Buffett has talked about the Four Filters in several ways, but the sequence is always the same: “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.” Buffett has also phrased the four filter process in this 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.”

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 effectiveness of each individual filter.

This is a small and valuable book that concentrates on the four sequential filters that will make anyone a better and more skillful investment decision maker. It is dedicated to Janine Rueth and Victoria Labitan. In this book, I squeeze “all the lean beef” into five chapters: “the Four Filter chapters and a summary chapter.” The final summary chapter will tie the filters together and demonstrate, with enthusiastic attitude, why these filters work to maximize the probability of investing success from both a mathematical and a practical point of view.

In developing understanding of a company and its products, Buffett framed the diligent mental process this way: “If I were looking at a company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I worried about? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones.”

Like a detective, he begins by asking himself basic questions. He looks for simple things that he can count. He looks for companies run by able and owner-oriented people.
Said Mr. Buffett, “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.”

I have played with the four filters and twisted them into 4 clusters this way:
1. Products 2. Customers 3. Management 4. Margin of Safety

Why do the filters work? I will give you a hint - Elaboration and Elimination.
In terms of mathematical probabilities, think of each stop along the four filters as a mutually exclusive and additive event. If a company passes a couple of filters, it is, by the process of elimination, farther to the right on a normal distribution curve, from an “investment prospect” point of view. If this were a field of racing horses, movement along each step of the Four Filters path, the prospect or suspect enters a subset of “better than average” horse. In my view, practicing these steps will make you a better thinker.

The majority of Berkshire Haathaway companies have important competitive advantages that will endure over time. For Warren Buffett and his shareholders, it is comforting to be in businesses where some mistakes can be made and yet satisfactory overall performance can be achieved.

How were these four filters developed? Over the course of their investing experiences, Warren Buffett and Charlie Munger have had many discussions about the qualities of both bad and good businesses. Warren Buffett’s advantage is passion and attitude for sensible investing. He learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Sound owner-oriented business principles, along with time, training, and temperment have mabe them even better investors.

So what does Ben Graham add to filter number one, understanding? Graham, according to Buffett, added three basic ideas that can enhance our intellectual investing framework.
Graham’s ideas can help us do reasonably well in stocks.

Buffett on Graham:
His three basic ideas - and none of them are complicated or require any mathematical talent or anything of the sort - are:

1. that you should look at stocks as part ownership of a business,
2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,
3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.

I think those three ideas 100 years from now will still be regarded as the three cornerstones of sound investment.

In developing our understanding of a company and its products, Warren Buffett advises students to “Think for yourself.”

He reads annual reports of the company he is looking at, and he reads the annual reports of the competitors. He has said that annual reports are the main source of the study material needed or understanding. Of course, he also cautions students to focus on their own circle of competence. Notice the filtering process of his statement here: “Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times.”

Just as a good leader has been tested by tough times and has a solid followership, a good company will have a loyal followership or customer base. The wonderful ones will have some sort of pricing power.

Charlie Munger understood the importance of thinking about the “Wonderful Business” early, while Warren Buffett was still buying cheap “Cigar-Butts.” Shortly after purchasing Berkshire, Buffett acquired a Baltimore department store called Hochschild Kohn. That was purchased through a retailing company called Diversified Retailing that later merged with Berkshire Hathaway. They now consider this, as well as the original textile company purchase an investing mistake. But, they both admit that they have learned from their mistakes. Now, when buying companies or common stocks, they look for first-class businesses accompanied by first-class managements. They look to what managements do more than what managements say.

Along with learning about GEICO’s low cost advantage from Lorimer Davidson, Warren Buffett learned some things from studying Phil Fisher, Philip Carret, and Henry Singleton. Buffett met Phil Fisher in the early Sixties, after reading his first book. Phil Fisher was a deep thinker into the nature of managements and their business growth potential. According to Buffett, “His ideas, like those of Ben Graham, were simple but powerful, and I wanted to meet the man whose teachings had such an influence on me…It's been over 40 years since I integrated Phil's thinking into my investment philosophy.”

So, part of developing your “circle of competence” is reading, learning, observing and integrating sound ideas into your investment philosophy. According to Buffett, he and Charlie Munger “just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.”

Buffett and Munger’s Goal at BRK:
Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.

How do we develop a better frame of reference and make better investing decisions? As you now know, Filter One is to “Develop a Better Understanding” of the company and its products. I got interested in looking at how Buffett and Munger frame their decisions when I was in business school at Purdue University Calumet. This is a quick summary about my views on their “framing.”

Framing in behavioral finance is the choosing of particular words to present a given set of facts. And, framing can influence our choices. Tversky and Kahneman described "Prospect Theory" in 1979 using framed questions. Tversky and Kahneman found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They also found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some have concluded that investors typically consider the loss of $1 twice as painful as the pleasure received from a $1 gain. Others believe that this work helps to explain patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. An increasing body of literature on framing supports a tendency for people to take more risks when seeking to avoid losses as opposed to securing gains.

Takemura (1992) showed that the effects of framing are likely to be lower when subjects are warned in advance that they will be required to justify their choices, and when more time is allowed for arriving at their choices. Luckily, Buffett and Munger seem to have arrived at practical use of these optimal framing ideas earlier than most.

They try to keep this simple. Notice this example from the latest 2007 annual report:

The Pritzker family decided to gradually sell or reorganize certain of its holdings, including Marmon, a company operating 125 businesses, managed through nine sectors. Marmon’s largest operation is Union Tank Car, which together with a Canadian counterpart owns 94,000 rail cars that are leased to various shippers. The original cost of this fleet is $5.1 billion. All told, Marmon has $7 billion in sales and about 20,000 employees. We will soon purchase 60% of Marmon and will acquire virtually all of the balance within six years. Our initial outlay will be $4.5 billion, and the price of our later purchases will be based on a formula tied to earnings.

A simple valuation example here will demostrate this bargain purchase in a well run company. For fun, lets do a fair "replacement cost" estimate on the 94,000 railcars alone.
94,000 x what? Made out of steel, the boxcar cost about $45000 a copy in 1980. A buddy of mine, says that $90,000 would be a fair price to pay for a mid-age mid-use rail car which can be depreciated over about 40-50 years. So, 94,000 x $90,000 = 8.46 Billion.... just in railcars alone. Furthermore, consider that the Marmon Group is composed of 125 different companies. And, I may be understating the replacement cost of a mid-age mid-use rail car.

Buffett and Munger have employed the principles taught by Dave Dodd and Ben Graham. In my view, Buffett and Munger overcome the conventional framing effects thru rational and thorough business analysis. They simply avoid getting into judgments in some fields. Warren Buffet has said: "If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter." I call their approach the compounding success theory because I imagined how their sequence of rational decisions push the probability of investment return success into the upper percentiles.

In my masters paper, I must admit that I got too wordy. I have come to realize that the Four Filters encapsulate the most important contributions of John Burr Williams, Benjamin Graham, Phillip Fisher, Warren Buffett, and Charles Munger. Each of the great investors learn from knowledgeable others.

While everyone may take a little different approach to measuring both quantitative and qualitative value; in my view, each of the Four Filters delivers something especially valuable. They help get us closer to the real "intrinsic value" of a good business.

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