Buffett’s investing process is grounded in common sense and uncommon wisdom.
Buffett argues that the approach you should take to investing in public companies through fractional ownership via the stock market is precisely the process you would use if you were looking to purchase a private business in a small town, for example, a gas station or a lawn care business. You would first examine the business and its competitive position to reach a judgment about how stable the business was, whether it could be expected to prosper and grow or decline under the weight of increased competition, changing demographics, or whatever other factors would impact the business’s prospects. This is the certainty factor.
You would then try to estimate how much cash the business would generate over its lifetime, taking fully into account the capital expenditures you would need to make to maintain and grow the business. You would then estimate the timing of the free cash and discount it back by the risk free rate of return to arrive at an estimate of (maximum) value of the business – what Buffett’s call intrinsic value. The final step would be to compare this value to the asking price and make a decision.
Most investors would intuitively do these steps if buying a private business, yet, when many of these same investors consider buying a stock, they spend their time looking a host of factors that having little or nothing to do with the value of the business. They forget that a stock is not a piece of paper but fractional ownership in a business. Over time, the economic success – or failure – of the business will govern the results they achieve.
Finally, unlike many valuation practitioners, Buffett does not use a higher interest rate to compensate for uncertainty in a prospective investment. To him, the thought process is binary: either an investment has the required level of certainty of it does not. This assessment starts with a judgment of whether the business is within your circle of competence and if you can make a reasonably sure assessment of the business’s future prospects after consideration of the facts. Buffett does not think it makes sense to compensate for uncertainty by raising the discount rate in your calculation of intrinsic value.
Buffett’s investing framework can be used to value all assets including the general stock market. The long term driver of the stock market’s total return is corporate profits. Certainly there are other factors at play such as investor sentiment and interest rates, but in the long-term it is the underlying performance of the businesses that make up the stock market that will determine the long-term performance of the stock market. In the long-run, you cannot expect the stock market to return in aggregate results that are greater than those of these underlying businesses.
Buffett’s approach to beating the market is a combination of buying stocks that are cheaper than the general market and that are growing intrinsic value faster the general market. In both cases, Buffett looks to get more value for his investments than he could get by investing those same dollars in an index fund. Wash, rinse, repeat. Buffett has been using this same playbook to consistently trounce the market for over fifty years.