|I don’t understand why business schools don’t teach the Warren Buffett model of investing. Or the Ben Graham model. Or the Peter Lynch model. Or the Martin Whitman model. (I could go on.)
In English, you study great writers; in physics and biology, you study great scientists; in philosophy and math, you study great thinkers; but in most business school investment classes, you study modern finance theory, which is grounded in one basic premise–that markets are efficient because investors are always rational. It’s just one point of view. A good English professor couldn’t get away with teaching Melville as the backbone of English literature. How is it that business schools get away with teaching modern finance theory as the backbone of investing? Especially given that it’s only a theory that, as far as I know, hasn’t made many investors particularly rich.
Meanwhile, Berkshire Hathaway, under the stewardship of Buffett and vice chairman Charlie Munger, has made thousands of people rich over the past 30-odd years. And it has done so with integrity and a system of principles that is every bit as rigorous, if not more so, as anything modern finance theory can dish up.
On Monday, 11,000 Berkshire shareholders showed up at Aksarben Stadium in Omaha to hear Buffett and Munger talk about this set of principles. Together these principles form a model for investing to which any well-informed business-school student should be exposed–if not for the sake of the principles themselves, then at least to generate the kind of healthy debate that’s common in other academic fields.
Whereas modern finance theory is built around the price behavior of stocks, the Buffett model is centered around buying businesses as if one were going to operate them. It’s like the process of buying a house. You wouldn’t buy a house on a tip from a friend or sight unseen from a description in a newspaper. And you surely wouldn’t consider the volatility of the house’s price in your consideration of risk. Indeed, regularly updated price quotes aren’t available in the real estate market, because property doesn’t trade the way common stocks do. Instead, you’d study the fundamentals–the neighborhood, comparable home sales, the condition of the house, and how much you think you could rent it for–to get an idea of its intrinsic value.
The same basic idea applies to buying a business that you’d operate yourself or to being a passive investor in the common stock of a company. Who cares about the price history of the stock? What bearing does it have on how the company conducts business? What’s important is whether you can purchase at a reasonable price a business that generates good returns on capital (Buffett likes returns on equity in the neighborhood of 15% or better) without a lot of debt (which makes returns on capital less dependable). In the best of all worlds, the company will have a competitive advantage that allows it to sustain its above-average ROE for years, so you can hang on to it for a long time–just as you would live in your house–and reap the power of compounding.
Buffett further advocates investing in businesses that are easy to understand–Munger calls it “clearing one-foot hurdles”–so you can come up with more reliable estimates of their long-term economics. Coca-Cola‘s basic business is pretty staid, for example. Unit case sales and ROE determine the company’s future earnings. Companies like Microsoftand Intel–good as they are–require clearing much higher hurdles of understanding because their business models are so dependent on the rapidly evolving world of high tech. Today it’s a matter of selling the most word-processing programs; tomorrow it’s the Internet presence; after that, who knows. For Coke, the challenge is always to sell more cases of beverage.
Buying a business or a stock just because it’s cheap is a surefire way to lose money, according to the Buffett model. You get what you pay for. But if you’re evaluating investments as businesses to begin with, you probably wouldn’t make this mistake, because you’d recognize that a good business is worth buying at a fair price.
Finally, if you follow the Buffett model, you don’t trade your investments just because our liquid stock markets invite you to do so. Activity for the sake of activity begets high transaction costs, high tax bills, and poor investment decisions (“if I make a mistake I can sell it in a minute”). Less is more.
I’m not trying to pick a fight with modern finance theory enthusiasts. I just find it unsettling that basic business-school curricula don’t even consider models other than modern finance theory, even though those models are in the marketplace proving themselves every day.