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Woo! My first book review. A while back, I stopped in my local used book store and saw that they had the 1999 classic: Buffettology. This book was a quick and enjoyable read, much like the Warren Buffett and the Interpretation of Financial Statements from the same authors. As a hardcore Buffett fan, most of the concepts in this book were not new for me. However, I believe this book provides an excellent foundation for new investors or those who have only participated in the speculative side of the market. While the book has a lot of good information, in this Buffettology book review I wanted to highlight my two big takeaways: thinking about stocks as a business owner and owning quality businesses.
Business Mindset
One of the key takeaways from Buffettology is that stocks are a fractional share of a business. When you own a stock, you are a partial owner of that enterprise. For example, if a company had 1 million shares outstanding, and you owned 10,000 shares, then you would own 1% of that company.
Realizing that you are a business owner when you own stock helps create a long term mindset. This is opposed to the short term, constant buying and selling commonly associated with the stock market. With a business owner mindset, would you rather own a great business that compounds at 10% a year for decades or sell a stock after six months to make a 20% profit quickly?
Another aspect of thinking of stock as owning a business is that the share price by itself is meaningless. A stock trading at $1,500 a share may be cheap, while a stock trading at $2 a share could be expensive. That is because stock prices are more than just some numbers that fluctuate on a screen. A stock price is telling you what the market currently thinks the business is worth, but that is only useful when you compare it to the profits generated by the company. The $1,500 a share company could have profits of $500 a year, while the $2 company might only generate a penny of earnings. The $2 company is not a bargain.
Since looking at giant corporations can be confusing, I like to think about this concept using a simple example. Imagine your friend is trying to sell you their ice cream stand. Probably before you even looked at the selling price, you would look at its financials. Is this ice cream stand profitable, by how much, and are the profits stable? If the ice cream stand makes $10,000 a year in profit, what would be a reasonable price to pay?
Buffettology explains that the price you pay for a business determines your rate of return. Let’s say you paid $100,000 for this ice cream stand, which would generate a 10% return. Not bad. Alternatively, if you paid $1 million for this ice cream stand because they have this new flavor that is the best thing since Rocky Road, well, you would likely earn about 1% a year. When you can see how much earnings the business has, you can determine the price you are willing to pay for that stock by determining your desired rate of return (there is more to business valuation than this, but it’s a good basic concept).
Thinking about stocks as partial ownership in a business is a key aspect of my investing philosophy. One of my favorite Buffett quotes is, “Investing is most intelligent when it is most business like.” I think for someone new to investing, or someone who trades the market in a speculative manner, Buffettology does a good job introducing investing from a business owner perspective.
Quality Companies
Now that Buffettology has laid down the foundation for how Warren Buffett thinks about stocks, the book spends some time defining what a good business is. Most businesses are mediocre, or just plain bad. Searching for quality companies is like a process of elimination. It can make your life easier because you filter out all the mediocre businesses in order to focus on researching the gems.
The book introduces the concept of “consumer monopolies”. These are businesses that have a popular brand name, patents, or secret formula. Think of companies like Coke-Cola or Nike that have products that are “must have” for some people. Another example was when newspapers existed, a city with a single newspaper had a monopoly on all newspaper ad revenue.
A thought experiment described in Buffettology used to test if a company has a consumer monopoly is to think about what it would take to create a better competitor from scratch. If you had access to billions of dollars and top managers, could you overtake Coke? Probably not.
There are many benefits to consumer monopolies that attract Buffett’s interest. These businesses are typically very profitable. Even better, these profits are consistently increasing. Poor quality businesses have erratic earnings that make it difficult to predict your rate of return. Consumer monopolies are often low tech, and often have products that are easy to make. This differs from companies that must constantly invest in R&D or build complex factories to stay competitive. Finally, consumer monopolies typically have low debt, since they’re business grows just fine without it. Low debt is a major factor I look at when analyzing companies. It’s hard for a company to go bankrupt with no debt.
Warren Buffett often talks about business having a “wide moat” to defend itself from competitors. These moats are the consumer monopolies as described in Buffettology. For my discretionary stock picks like Capital One, or Emerson Electric, I am definitely thinking about whether these are quality companies with consumer monopoly.
Conclusion
Buffettology is now my go-to book recommendation for anyone who wants to be introduced to the value investing philosophy. As a value investing nerd, I have a few nit picks such as the valuation method used, and the implications of low interest rates (the book is talking about 5-7% rates!). Towards the back of the book, there is a list of companies the authors believed are consumer monopolies. One of these days I want to go through this list to see how these consumer monopolies did 20 years after the book was published! Hope you enjoyed my Buffettology book review
For more value investing content check out:
The Many Flavors of Value Investing