Buffett and Understandable Businesses

In a previous post we discussed the Four filters of Invention of Warren Buffet and Charlie Munger by Bud Labitan. I felt that some of the material needed a more thorough description than I could provide in my overview so I would like to look exclusively at the first of the four filters, namely finding understandable companies and contribute some of my own thoughts.

What is an Understandable Business?

Buffett is a student of Graham and as such approaches investing in companies as if he were purchasing the company outright. This approach demands a clear picture of how the company makes money before any investment can be made.  To understand how the company makes money you have to have a clear understanding of the products that the company creates, how much profit it makes by selling the products, what the company’s greatest competitors are etc.

Seek whatever information will further your understanding of a company’s business.
Berkshire Letter to Investors 1993

Having an understanding of the business is key, but getting it is no small feat. Too often, in my opinion, this process gets reduced to examining only the financial statements of a company and little else. There are a multitude of other places though that investors such as Buffett look at before buying a stock. Here are a few of my recommendations:

Talk to the consumers

The people who are most familiar with a product are those who regularly consume it.  When I was researching Sun Microsystems (JAVA) I went to our office’s server room and talked to our IT staff. When I researched Caterpillar (CAT) I stopped off at a few local construction yards and talked to the workers.  These field experts know what tools work and which ones don’t, they know how to get past the marketing and can tell you about quality, cost, reliability, service, and the consistency of the brand.

Read the financial statements

To understand a business, figure out what results it is achieving, why it is getting those results, and what could happen to change what is causing those results.
Charlie Munger

Almost every value investor says they do this but many perform only superficial analysis.  It is more than just reading the numbers, read the text, see what they are saying about there own company or what they are not saying.  Omissions are just as good an indication as any. Listen to the investor calls they are usually very easy to access and can yield a wealth of information beyond the sculpted language of a press package.  Things to look for on the financial side are what does it cost to run this company, how much does it cost to produce the products, does the business depend on complex systems to make money or is the business model very simple.

Call the company

I’ve spoken about this before, but I can’t underscore it enough. If you want to know about a company phone them and talk candidly to one of their staff you will be amazed what you can learn from people who are prepared to speak honestly to you.

Look at the competitors

Finding a winning horse in a race is also about making sure the other horses in the race have 3 legs.  You may have found a great company after all of your hard work but it may also be going up against an even better competitor.  Look around at the competition, find their strengths and weaknesses and try to get a sense of where your company sits in relative strength.

What an Understandable Company Is Not

Sometimes an understandable company can be categorized as simply a company that does not fall into any of these bins:

• Vague in its communication with investors.
• Undecipherable or overly complex in how it is making money.
• Shady.

At the end of the day if you understand the company you are going to invest in you are going to be able to make an informed choice about your investment dollars which time has shown leads to much stronger and consistent returns.

Other Articles In The Series:

1. The Four Filters of Warren Buffett and Charlie Munger
2. Buffett and sustainable and competitive Advantage
3. Buffett and Able and Trustworthy Managers