In the last post, we looked at the influence of Ben Graham’s on Warren Buffett. Today, we look at the other three major influences on Buffett’s financial education:
Whereas Graham’s influence was quantitative in nature, Fisher’s was qualitative. Fisher taught Buffett two things: Invest in companies with above-average potential, and align yourself with the most capable management. Each of these now form core principles of Buffett’s investment philosophy.
In assessing above-average potential, Fisher meant to look for the ability to grow sales at a rate greater than the industry average while maintaining consistent (or growing!) profit margins.
The previous two teachers gave Buffett the skills necessary to determine if the company was something he wanted to buy. Williams gave Buffett the tool to assess the intrinsic values of the companies he wants to buy. That tool is the Discounted Cash Flow (DCF) Model, and Williams developed it in his PhD thesis, The Theory of Investment Value.
The basis for the DCF model is that you can find what a security is worth today by estimating all the cash the company will earn over its lifetime and then discount that back to the present value and determine it on a per-share basis. As Buffett says, “Just like a cow for her milk, or a hen for her eggs, so is a company for its earnings”.
Never forget that a share is a mere representation of a company, and you are buying the company rather than a share. On a technical note, Buffett uses the long-term (10 year) US bond rate as his discount rate. Where this rate is very low, Buffett uses 10%. He uses the risk-free government rate because he believes the risk is covered in the transaction itself (by factoring in the margin of safety).
Munger is the Vice-Chairman of Berkshire Hathaway. He was a successful investor in his own right prior to associating with Buffett, generating compound annual returns of 19.8% from 1962-75 vs. 5% for the Dow. His long-standing friendship and work association with Buffett has had a profound effect on Buffett, as evidenced by the number of times Buffett writes “Charlie and I” in the Berkshire annual reports.
Munger’s greatest contribution is perhaps helping Buffett get away from a strict value philosophy to consider those companies that don’t perfectly fit Graham’s quantitative rules. He taught “it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, which is precisely the case in some of Berkshire’s greatest investments.