The New Buffettology

1. Warren Buffett's Contrarian Edge: Exploit Market Foolishness

Warren Buffett got superrich not by playing the stock market but by playing the people and institutions who play the stock market.

Exploiting Short-Sightedness. Buffett's success stems from capitalizing on the emotional and often irrational behavior of other investors. He understands that most market participants are driven by short-term gains, reacting to immediate news rather than focusing on the long-term value of a business. This creates opportunities for Buffett to acquire undervalued companies when others are selling out of fear or impatience.

Contrarian Investing. Buffett thrives on pessimism. He actively seeks out companies that are temporarily out of favor, recognizing that negative news often leads to overselling and depressed stock prices. This allows him to buy into fundamentally sound businesses at bargain prices, knowing that their true value will eventually be recognized by the market.

Long-Term Vision. Unlike short-term traders, Buffett focuses on the intrinsic value of a business, not its current stock price. He understands that the market's perception of a company can fluctuate wildly, but the underlying economics of a strong business will ultimately prevail. This long-term perspective allows him to ignore short-term market noise and make rational investment decisions.

2. Selective Contrarianism: Buy Exceptional Businesses, Not Just Beaten-Down Stocks

To be like Warren one has to know what to buy and when to buy it. What to buy? An exceptional business with a durable competitive advantage working in its favor. When? When the stock market's pessimistic shortsightedness has driven the price of its shares into the dumps.

Beyond Traditional Contrarianism. Buffett's approach goes beyond simply buying stocks that have performed poorly. He emphasizes the importance of investing in exceptional businesses with strong underlying economics and a "durable competitive advantage." This ensures that the company has the resilience to weather temporary setbacks and generate long-term profits.

Durable Competitive Advantage. This is the cornerstone of Buffett's investment philosophy. He seeks out companies that possess a unique and sustainable advantage over their competitors, such as a strong brand name, a proprietary technology, or a dominant market position. This advantage allows them to generate consistent profits and maintain their market share over time.

Patience and Discipline. Buffett's selective contrarian strategy requires patience and discipline. He is willing to wait for the right opportunity to arise, even if it means sitting on cash for extended periods. He avoids the temptation to chase quick profits and remains focused on acquiring exceptional businesses at attractive prices.

3. Durable Competitive Advantage: The Key to Long-Term Wealth

It is the competitive advantage of a company that allows it to earn monopolylike profits. It is the durability of the competitive advantage—the company's ability to withstand competitive attacks—that determines whether it will be able to maintain its competitive advantage and earn monopoly-like profits well into the future.

The Moat Analogy. Buffett uses the analogy of a castle and a moat to explain the concept of competitive advantage. The castle represents the business, and the moat represents the barriers that protect it from competitors. A wide and deep moat makes it difficult for rivals to attack and erode the company's profitability.

Sources of Competitive Advantage. A durable competitive advantage can arise from various sources, including:

• Strong brand recognition (e.g., Coca-Cola, H&R Block)
• Proprietary technology or patents (e.g., patented prescription drugs)
• Dominant market share (e.g., fast-food restaurants)
• Unique service offerings (e.g., Dun & Bradstreet)

Durability is Paramount. The key to long-term success is not just having a competitive advantage, but ensuring that it is durable and sustainable over time. Buffett favors businesses that have been selling the same product or service for decades, as this indicates a proven ability to withstand competitive pressures and changing market conditions.

4. Profit Margins and Inventory Turnover: Understanding Business Economics

Businesses make money in two ways: by having the highest profit margins possible and/or by having the highest inventory turnover possible.

Two Engines of Profitability. Buffett understands that businesses generate wealth through two primary mechanisms: high profit margins and high inventory turnover. Profit margin refers to the difference between a company's costs and its selling price, while inventory turnover measures how quickly a company sells its products.

The Lemonade Stand Analogy. The book uses a lemonade stand analogy to illustrate these concepts. A lemonade stand with high profit margins can make a lot of money even if it doesn't sell many glasses, while a stand with low profit margins needs to sell a high volume of lemonade to be profitable.

Ideal Business Characteristics. Buffett seeks to own businesses that possess either high profit margins or high inventory turnover, or ideally both. He avoids companies with low profit margins and low inventory turnover, as these businesses are unlikely to generate significant wealth over the long term.

5. Avoiding Losers: The Perils of Price-Competitive Businesses

The selective contrarian investment philosophy that Warren practices dictates that he give price-competitive businesses a pass regardless of how great the buying opportunity looks.

Commodity Businesses. Buffett shies away from businesses that operate in price-competitive industries, where products or services are largely undifferentiated and customers primarily make decisions based on price. These businesses often lack pricing power and are vulnerable to margin compression.

Examples of Price-Competitive Industries:

• Airlines
• Commodity producers (e.g., steel, oil)
• Internet service providers

The Burlington Industries Example. The book cites Burlington Industries, a textile manufacturer, as an example of a price-competitive business that failed to generate significant returns for shareholders despite significant capital expenditures. This illustrates the difficulty of creating lasting value in industries where competition is fierce and pricing power is limited.

6. Mr. Market: Friend, Not Foe

You should be interested only in the price that Mr. Market is quoting you, not in his thoughts on what the business is worth.

Benjamin Graham's Parable. The book revisits Benjamin Graham's parable of Mr. Market, an imaginary business partner who offers to buy or sell his stake in the business every day. Mr. Market's moods fluctuate wildly, leading him to offer prices that are sometimes irrationally high and sometimes irrationally low.

Exploiting Mr. Market's Moods. Buffett uses Mr. Market's erratic behavior to his advantage. He buys when Mr. Market is feeling pessimistic and offering bargain prices, and he sells when Mr. Market is feeling euphoric and offering inflated prices.

Ignoring Mr. Market's Opinions. Buffett emphasizes the importance of ignoring Mr. Market's opinions about the value of the business. Instead, he focuses on his own independent assessment of the company's intrinsic value and acts accordingly, regardless of Mr. Market's current mood.

7. Interest Rates and Stock Prices: A Delicate Dance

Lower interest rates make businesses' earnings worth more to an investor and will drive stock prices up.

The Inverse Relationship. The book explains the inverse relationship between interest rates and stock prices. When interest rates rise, the value of businesses decreases, as investors can earn higher returns from bonds and other fixed-income investments. Conversely, when interest rates fall, the value of businesses increases, as stocks become more attractive relative to bonds.

The Fed's Influence. The Federal Reserve's monetary policy decisions play a significant role in shaping the stock market. By raising or lowering interest rates, the Fed can influence the overall economy and the attractiveness of different investment options.

Capitalizing on Interest Rate Changes. Buffett understands the impact of interest rates on stock prices and uses this knowledge to his advantage. He may be more inclined to buy stocks when interest rates are high, as this can create buying opportunities in undervalued businesses.

8. The Bear/Bull Market Cycle: A Roadmap for Buying Opportunities

During a bear market it is possible to find some spectacular buys. Companies with durable competitive advantages are selling for a fraction of their long-term worth.

Identifying Market Stages. The book outlines the different stages of the bear/bull market cycle, from the depths of a bear market to the euphoria of a bull market bubble. Each stage presents unique opportunities and challenges for investors.

Bear Market Bargains. Bear markets offer the best opportunities for selective contrarian investing. During these periods of widespread pessimism, even the strongest companies can see their stock prices plummet, creating attractive buying opportunities for patient investors.

Corrections and Panics. Stock market corrections and panic selling events can also create temporary buying opportunities during bull markets. These events are often driven by fear and emotion, leading to overselling and depressed stock prices.

9. Beyond Market Cycles: Identifying Other Buying Opportunities

Bad-news situations come in five basic flavors: stock market correction or panic, industry recession, individual business calamity, structural changes, and war.

Industry Recessions. An industry-wide recession can create buying opportunities in strong companies that are temporarily affected by the downturn.

Individual Calamities. A company-specific crisis, such as a product recall or a management scandal, can depress its stock price and create a buying opportunity.

Structural Changes. Corporate restructurings, mergers, or spin-offs can create temporary dislocations in the market, leading to undervalued stocks.

The War Phenomenon. The uncertainty and fear associated with war can cause a broad market sell-off, creating buying opportunities in fundamentally sound businesses.

10. Financial Due Diligence: Uncovering Hidden Value

The Internet has given everyone with a connection access to all the information they need to employ Warren Buffett's selective contrarian investment strategies.

The Power of Information. The book emphasizes the importance of conducting thorough financial due diligence before making any investment decision. This involves gathering and analyzing financial data, reading industry reports, and understanding the company's competitive landscape.

Utilizing Online Resources. The Internet has made it easier than ever for individual investors to access financial information. The book recommends several online resources, including Bloomberg, Value Line, and the SEC's EDGAR database.

The Scuttlebutt Approach. The book also highlights the importance of the "scuttlebutt" approach, which involves talking to customers, competitors, and industry experts to gain a deeper understanding of the business.

11. Mathematical Equations: Projecting Future Value

Warren is not calculating a specific value for a stock. Warren is instead asking, if I pay X per share for Gannett stock, given the economic realities for the company, what is my expected annual compounding rate of return going to be in ten years?

Projecting Future Earnings. The book presents several mathematical equations that Buffett uses to project the future value of a business. These equations involve estimating future earnings growth, discounting future cash flows, and assessing the company's ability to generate returns on equity.

The Importance of Discount Rates. The discount rate used in these calculations plays a significant role in determining the projected value of the business. Buffett typically uses the yield on treasury bonds as a benchmark for the discount rate.

Focus on Long-Term Returns. The goal of these calculations is to estimate the long-term annual compounding rate of return that an investment is likely to generate. Buffett seeks to invest in businesses that offer the potential for high long-term returns, even if it means paying a premium in the short term.

12. Stock Arbitrage: Warren's Secret Weapon

With arbitrage, Warren was able to produce positive results for his investment partnership even in down years.

Exploiting Market Inefficiencies. Stock arbitrage involves capitalizing on temporary price discrepancies that arise from corporate events such as mergers, acquisitions, and spin-offs.

Cash Payments on Sale or Liquidation. Buffett prefers to focus on arbitrage situations involving cash payments on sale or liquidation, as these are typically less risky than deals involving stock or other complex considerations.

The Importance of Timing. The key to successful stock arbitrage is to accurately assess the likelihood of the deal closing and to estimate the time it will take for the transaction to be completed.

Last updated: March 14, 2025