Buffett’s Analytical Framework
Berkshire Hathaway released its annual letter to shareholders last Saturday, and as usual Warren Buffett used an extended section of the letter to teach a general lesson on investing. In this year’s lesson, entitled “Some Thoughts on Investing,” Buffett discussed two non-stock investments he made years ago and continues to hold: a farm in Nebraska, and an interest in a retail property in New York City.
Most of the media’s attention has focused on the “think long-term” moral of Buffett’s lesson, and rightly so. But for me, the main takeaway was its reminder that the world’s most sophisticated investor uses an extremely simple analytical framework when evaluating investments. He starts with the purchase price of the asset in question, and then compares that price to the near-term income that the asset will earn and distribute to him as owner. Dividing the latter by the former produces a ratio he calls the current yield, which in the case of both the farm and the property was about 10 percent. He then tries to estimate the rate at which this distributed income will grow over time.
And that’s it. It’s certainly true that many interesting things follow from this framework. For instance, it can be shown arithmetically that an asset’s total annualized return is roughly the sum of its current yield and the annualized growth rate of distributed income.* And you can take a future stream of distributions and bring them forward into something called a terminal value. But the basic framework is still current yield and growth rate of distributions out to infinity as the sole determinant of your total return over time. There are many “rules” attributed to Buffett by his more dogmatic acolytes, and having followed him for nearly 20 years I’m convinced that he’s happy to break nearly all of them. If you believe for instance that “Buffett only invests in good businesses,” then consider Daehan Flour. If you think “Buffett avoids technology companies and companies without a demonstrated history of earnings,” then consider Mid-Continent Tab Card Company. If it warms your cold heart to know that “Buffett avoids leverage,” then read up on the real estate investment in New York City. But if I had to engage in mind-reading, I would say that the two “rules” Buffett always follows are a) he always thinks in terms of a margin of safety, and b) he always thinks in terms of the “fundamental return” framework outlined above.
This framework is so simple that without realizing it, we all use it when evaluating the simplest of investments, like a savings account or savings bond. The words we use change—”purchase price” becomes “deposit” or “principal”, and “distributed income” becomes “interest not reinvested”, but those are different words for the same ideas. And of course, the distributed income of a business is less certain than that of a savings account. But again, the framework is the same. It’s the basic framework behind all of capitalism—in fact, it’s the reason capitalism is called capitalism in the first place. Capital can be transformed into assets that are productive—i.e. that produce income, and the decision of the capitalist comes down to comparing the income produced by an asset with the capital investment required to earn the right to receive that income.
One of the happy paradoxes of investment life is that the more you discipline yourself to stay within the simple frameworks, the more sophisticated and complex your thinking can become. Staying within Buffett’s framework allows you to compare every investment to every other investment by reducing them all to their common underlying ideas, income and capital required to produce the income, both now and over time. It prevents you from making common analytical mistakes, such as neglecting to “penalize” a fast-growing enterprise for the capital required to produce that growth, or neglecting to reward an enterprise that can grow without additional capital (Buffett’s farm and property fall into this category). It forces you to ask yourself “where might future growth in distributed income come from?”, which is perhaps the most useful question a professional investor can ask on a day-to-day basis.
And finally, Buffett’s framework is the only framework that is both theoretically and intuitively “true.” It’s difficult to explain, but once the basic intuition behind all of this clicks in your head (true confession: it didn’t click for me until I was in my 30s, and even now I often have to remind myself of it), you can see all kinds of things more clearly. You can see how seemingly different things are really just different names for the same thing, which allows you to read things like “a stock is just like a bond with a magic coupon that grows” and feel less rather than more confused. Or you can use this intuitive understanding to see when the normal rules don’t apply: An insurance business, for instance, can be seen as an enterprise in which the basic framework of capitalism—”capital is transformed into assets that produce income” is inverted to become “income produces assets that can be used as capital.”
The ability to work hard to see things clearly and simply is perhaps the ultimate competitive advantage that one investor has over another. This ability is obviously good for allocators, but it’s also good for the investor himself/herself, because it’s probably the purest source of joy in investing or any other kind of analytical work. Wall Street has many dirty secrets, and one of them is how few professional investors think as Buffett does. The price they pay is not only worse performance, but less joy too.
*To be more precise, it can be shown that for an investment that pays a coupon that grows at some rate over time, the internal rate of return of the investment is roughly equal to the sum of the initial yield and the annual growth rate of the yield. A given internal rate of return does not mean the investor will earn exactly that rate of return—that’s only true if the return on all reinvested distributions turns out to be exactly the same as the return on the initial capital outlay, which almost never happens. But the IRR is useful as an indifference point: If your rate of return on reinvested distributions ends up being lower than your IRR, then you’re still better off having made the capital outlay. If on the other hand you end up earning a higher rate of return on reinvested dividends, then your capital outlay was a “mistake,” but the idea is that your IRR is high enough that it’s a high-class mistake.