How do we improve and optimize our investing decision making? This was the goal of the first edition of this book. Now, about 5 years later, this journey continues with more insights and examples.
We can use the Four Filters Invention of Warren E. Buffett and Charles T. Munger. Their four filters investing process helps us eliminate many inferior investing prospects. This filtering process helps us find high-quality winning investments. Their steps include evaluating a business’ economics, its competitive position, its managers, and its intrinsic value. It provides us a tested and effective toolset.
How and why are these
filters effective? Warren Buffett said it best: “An investor cannot obtain
superior profits from stocks by simply committing to a specific investment
category or style. He or she can earn them only by carefully evaluating
facts and continuously exercising discipline.” These four filters focus on the
business facts about the Products, Customers, Management, and the Financial
Safety given by a bargain purchase.
The Four Filters are
a search for: “Understandable first-class businesses, with enduring competitive
advantages, accompanied by first-class managements, available at a bargain
price.”[i]
In my view, Warren
Buffett and Charlie Munger invented an investing formula that is
underappreciated by the business and academic communities. It is an amazing
intellectual achievement in both practical and Behavioral Finance. The filters are an important set of steps
used by the world’s greatest investors for finding high quality investments.
As a useful guide for
assessing intrinsic value and sensible price, the filters function as an
effective time-tested focusing process for investing success. They help us
frame our investing decision making process correctly, and help us prevent
foolish and costly losses. Using this
process, you and I will become better investors. We improve the way we think about businesses.
This innovation uses qualitative factors as well as quantitative factors to
help us find and insure a good stock or whole business for investment. It raises the odds of investing success.
The first edition
received some criticism from casual readers stating that it restated many of
the writings and talks of Buffett and Munger. Yes, it did. I tried to tell the
story from their perspective. So the use of many quotations was necessary, and
they were approved for use.
These critical
readers did not realize that I was trying to design a book as if Warren or
Charlie had written it themselves. Perhaps, I did not explain that clearly
enough. For example, if I
insert a passage like this next one by Charlie Munger, it illustrates his frame
of mind: “The way to win is to work, work, work, work and hope to have a few
insights…. And you’re probably not going to be smart enough to find thousands
in a lifetime. And when you get a few, you
really load up. It’s just that simple.”[ii]
This book is about the
intellectual collaboration and experiences of two good friends who smartly
changed the world of investing and invented a thoughtful and effective process.
They made a lot of money for themselves and their shareholders. There is another treasure hidden in these
words: how to improve and optimize our decision making process.
This is also a story
about exercising self-discipline. Look
to the future and think clearly for yourself.
Be open to new ideas from wise people. Study the past, and learn from
it. As Ben Graham said in the introduction of his book, The Intelligent Investor: “No statement is more true and better
applicable to Wall Street than the famous warning of Santayana: “Those who do
not remember the past are condemned to repeat it.”
History is important
to Charlie Munger as well. He said this: “Business schools fail by teaching
what is easy to teach but less useful. Going back to teaching business history
as Harvard used to would be good; there’s a lot to be learned from the rise and
fall of GM, or the rise and fall and rise of railroads.”
This book is about
one smart way to frame a decision process using sound principles. How do we
develop a better understanding of a business, its products, its present, its management,
its earnings, and its future? Charlie Munger said, “We read a lot. I don’t know
anyone who’s wise who doesn’t read a lot.
But that’s not enough: You have to have a temperament to grab ideas and
do sensible things.”[iii]
This year, 2014, I
learned something new from the 2013 annual letter. I learned that retained
earnings can be a “powerful competitive advantage.” Warren Buffett put it this
way: “Here’s a little known fact: Last year MidAmerican retained more dollars of
earnings – by far – than any other American electric utility. We and our
regulators see this as an important advantage – one almost certain to exist
five, ten and twenty years from now.”
Over the years, I
have read all of the Letters to Shareholders of Berkshire Hathaway. I have also
read most of the books and articles about Warren Buffett, his teacher Benjamin
Graham, and his business partner Charlie Munger. I also served as the editor of
Scott Thompson’s fine textbook: “The Art & Science of Value Investing.”
Having listened to
many hours of audio lectures and interviews, I have been consistently
interested in how Warren Buffett and Charlie Munger “frame” an investment
decision, and how they find a winning investment prospect. This book is a story about their rational
filter process. It helps them make better investing decisions. In the words of Charlie Munger, “You have to
understand the odds and have the discipline to bet only when the odds are in
your favor.”[iv]
And, I hope that this second edition adds more meat (examples) into your
decision making process.
Warren Buffett has
written about the Four Filters in several ways. This behavioral sequence is
always similar: “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.”[v] While
Charlie Munger has described the process as getting into high quality
businesses, Warren Buffett has also phrased the Four Filter process in this
slightly different 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.”[vi]
In 1996, Buffett
wrote this about investing in public companies. It is a twist on the Four
Filter formula that sets the bar towards realism and conservativism: “The art
of investing in public companies successfully is little different from the art
of successfully acquiring subsidiaries.
In each case you simply want to acquire, at a sensible price, a business
with excellent economics and able, honest management. Thereafter, you need only
monitor whether these qualities are being preserved.”[vii]
After devoting hours
of thinking time into their investing ideas and guiding principles[viii],
I felt like a man who stumbled upon hidden treasure in the middle of his back
yard. I rediscovered a simple sequence called the Four Filters! They were there
all the time.
In the 2003 Berkshire
Hathaway annual meeting, a man asked Warren Buffett this question: “Could you
just take us thru your filter process when it comes to, selecting a company?”
Warren Buffett answered, “It’s a question of a. Can I understand it?...if it
makes it thru that filter…b. Does it have some kind of sustainable long-term
competitive advantage…” If it makes it thru that filter…How do I feel about the
management in terms of, their ability and honesty?.. and if it makes it thru
that filter,…What’s the price?... And if it gets it thru all four filters, I sign
my name to the check.”
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
usefulness of each individual filter.
As a formula, the
Four Filters function as a set of “Investing Best Practices.” They help us
develop better “self-control.” They force us to focus on “Wonderful
Businesses.”[ix] They function as a smart targeting system
steering us with clear goals. And, using the Four Filters, promotes investing
“self-discipline.” This book unveils how the Four Filters are a significant
intellectual achievement in Behavioral Finance.
In addition to the framing
aspects to this decision making, the checklist nature of these Four Filters
serve as a logical and sensible justification mechanism. A standard checklist serves to confirm or
disconfirm evidence. Like pilots who use
checklist prior to flying, the Four Filters help us frame a rational investment
decision. Charlie Munger believes in using checklist routines to help us avoid
a lot of errors. These errors occur
because our human brains are wired to find shortcuts, or what Munger calls
“shortcut types of approximations.”
Charlie Munger said: “The main
antidotes to miscues from Availability-Misweighing Tendency often involve
procedures, including the use of checklists, which are almost always helpful.”[x] At the USC Law School Commencement speech in
2007, he said: “You should have all of this elementary wisdom, and you should
go through a mental checklist in order to use it. There is no other procedure
that will work as well.”[xi] Munger
has also said: "You need a different checklist and different mental models
for different companies. I can never make it easy by saying, 'Here are three
things.' You have to derive it yourself to ingrain it in your head for the rest
of your life."
To be fair, other great investors
used quality checklists to earn profits. And, other great investors contributed
“Best Practices” to the art of effective investing. Later in this book, we see
the contributions of several investing thought leaders.
Do you have a “Happy
Zone?” The Four Filters serve to
increase the probability of investment success by defining “the right ball to
hit.” Buffett tells students this Ted Williams baseball analogy: “I put heavy
weight on certainty. Use probability in your favor and avoid risk. It’s not risky to buy securities at a
fraction of what they are worth. Don’t
gamble. You’re dealing with a lot of
silly people in the marketplace; it’s like a great big casino, and everyone
else is boozing. Watch for unusual
circumstances. Great investment opportunities come around when excellent
companies are surrounded by unusual circumstances that cause the stock to be
misappraised. In appraising the odds, Ted Williams explained how he increased
his probability of hitting: "My
argument is, to be a good hitter, you've got to get a good ball to hit. It's the first rule in the book.”
This book trims “all
the lean beef” into five chapters: “the Four Filter chapters and a summarizing
chapter.” The final summary chapter ties the filters together and demonstrate
why these filters work to maximize the probability of investing success from
both a mathematical and a practical point of view. This second edition adds in
more solid examples as well as insights I have learned in the past five years.
See the new section on Coca-Cola and their “Yield On Cost” estimation.
So, 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
bad, good, and mediocre businesses they had invested in. Also, keep in mind
that Charlie Munger believes wisdom acquisition is a moral duty.[xii] So, the Four Filters seem to have evolved
from their discussions and their early business and investing experiences.
Interestingly, the
1977 Letter to Shareholders of Berkshire Hathaway is the earliest one listing
the Four Filters. It is also the earliest letter posted at the company’s
website: ( http://www.berkshirehathaway.com
). This Four Filters Formula was
presented in this form: “We select our
marketable equity securities
in much the same way we would evaluate a business for acquisition in its
entirety. We want the business to be (1)
one that we can understand, (2) with favorable long-term prospects, (3)
operated by honest and competent people, and (4) available at a very attractive
price.”[xiii]
Charlie Munger said that once
they had gotten over the hurdle of recognizing that a business could be a
bargain based on quantitative measures that would have horrified Ben Graham,
they started thinking about better businesses.
Their results show the bulk of the billions earned at Berkshire Hathaway
have come from the better businesses.
Munger described their system this way: “We came to this notion of
finding a mispriced bet and loading up when we were very confident that we were
right. So we're way less diversified.
And I think our system is miles better.”[xiv]
For years, Buffett
and Munger would site See’s Candies as the best example of a “wonderful
business.” See's
Candies taught Buffett and Munger much about the evaluation of franchises. Both
men admit that they have made significant money because of the lessons they
learned at See's. See’s Candies is the wonderful business.
In their talks and writings, they
refer to a great business as a “franchise” or a “wonderful business.” Buffett
wrote: “An economic franchise arises from a product or service that: (1) is
needed or desired; (2) is thought by its customers to have no close substitute
and; (3) is not subject to price regulation. The existence of all three
conditions will be demonstrated by a company's ability to regularly price its
product or service aggressively and thereby to earn high rates of return on
capital. Moreover, franchises can tolerate mismanagement. Inept managers may
diminish a franchise's profitability, but they cannot inflict mortal damage.”
Buffett and Munger respect able and
trustworthy managers. As you read about these great businesses, think about the
product or service that: (1) is strongly desired; (2) has no close substitute
and; (3) has pricing power. As Buffett said, “A moat that must be continuously
rebuilt will eventually be no moat at all. Additionally, this criterion
eliminates the business whose success depends on having a great manager.” He
summarizes it this way: “We believe that our formula - the purchase at sensible
prices of businesses that have good underlying economics and are run by honest
and able people - is certain to produce reasonable success. We expect,
therefore, to keep on doing well.”
[i]
The Four Filters, Berkshire Chairman’s Letter to Shareholders, 2007.
[ii]
From the talk called “A Lesson on Elementary, Worldly Wisdom As It Relates To
Investment Management & Business” by Charles Munger, USC Business
School
[v]
Berkshire Chairman’s Letter to Shareholders, 2007, 6.
[vi]
Berkshire Chairman’s Letter to Shareholders,
1989,(http://www.berkshirehathaway.com/letters/1989.html).
[viii]
Owner-oriented principles, Berkshire Hathaway Owner’s Manual, 1996.
[ix]
Berkshire Chairman’s Letter to Shareholders,
1989,(http://www.berkshirehathaway.com/letters/1989.html).
[x]
(The Psychology of Human Misjudgment Revised Speech by Charles T. Munger),
Kaufman, Peter D., Poor Charlie’s Almanack, Virginia Beach , VA
[xi]
Charlie Munger’s speech at USC Law School Commencement, 2007.
[xii]
Charlie Munger’s speech at USC Law School Commencement, 2007.
[xiii]
Berkshire Chairman’s Letter to Shareholders, 1989, (http://www.berkshirehathaway.com/letters/1989.html).
[xiv]
A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management
& Business”. Charles Munger, USC
Business School
