👑 How Warren Buffett has built his empire

Preparing for the Berkshire Hathaway weekend

This week Compounding Quality is in Omaha to attend the Berkshire Hathaway weekend.

As a way to prepare, I reread every annual letter of Warren Buffett.

In this article you’ll learn the key principles on which Warren Buffett has built his empire.

1. Think like an owner

The entire philosophy of Berkshire Hathaway is built on the fact that Warren and Charlie think like owners.

They try to acquire entire businesses, and when they buy just a part of a company, they act like they would own it completely.

“Charlie Munger and I think of our shareholders as owner‐partners, and of ourselves as managing partners. We do not view the company itself as the ultimate owner of our business assets but, instead, view the company as a conduit through which our shareholders own the assets.” - Warren Buffett

This means Charlie and Warren aren’t stock pickers, but business pickers. This is a fundamental difference as you can see here:

2. Capital allocation is key

Allocating capital is the key task of Charlie Munger and Warren Buffett at Berkshire Hathaway.

Both gentlemen aren’t involved in the daily operations of the companies they own. Instead, they direct capital at their subsidiaries and select the CEOs who make day-to-day decisions.

As an investor you should invest in companies which are led by managers who are experts in allocating capital efficiently. Berkshire Hathaway as well as Constellation Software are two great examples.

“Berkshire directs capital allocation at these subsidiaries and selects the CEOs who make day-by-day operating decisions. My job is to allocate the capital within Berkshire Hathaway the way I would do it for my sister.” - Warren Buffett

3. Skin in the game matters

More than 99% of Warren Buffett’s net worth is invested in Berkshire Hathaway. This means that Warren will do everything he possible can to maximize the value for shareholders and himself.

Academic research has proven that companies with skin in the game outperform the market by 3.7% per year on average.

“In line with this owner‐orientation, our directors are all major shareholders of Berkshire Hathaway. In the case of at least four of the five, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking.” - Warren Buffett

4. Focus on intrinsic value

While in the short term the market is a voting machine, in the long term it’s a weighting machine.

In the long term, it’s all about the growth of the intrinsic value of the companies you own.

You can calculate it as follows:

Growth in intrinsic value = free cash flow per share growth + dividend yield

“Our long‐term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per‐share basis.” - Warren Buffett

5. Return on invested capital matters

A high and consistent Return On Invested Capital (ROIC) is a must for quality investors.

Warren Buffett already stressed this in his annual letters of the 70s.

A company’s ROIC must be higher than its cost of capital because otherwise the company will destroy shareholder value when they invest for growth.

If you want to learn more, take a look here: What you need to know about Return On Invested Capital

“Our preference would be to reach this goal by directly owning a diversified group of businesses that generate cash and consistently earn above‐average returns on capital.“ - Warren Buffett

6. Cash is like oxygen

Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent.

At the end of the year, Berkshire had almost $128 billion in cash. Warren Buffett stated that Berkshire will always hold a boatload of cash and U.S. Treasury bills.

Why? Because Warren Buffett’s entire empire is built on the principle that they will always avoid behavior that could result in uncomfortable cash needs at inconvenient times.

“We rarely use much debt and, when we do, we attempt to structure it on a long‐term fixed rate basis. We will reject interesting opportunities rather than over‐leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.” - Warren Buffett

7. Good businesses are rare

It’s a misconception that Warren Buffett is a value investor.

Over the years, Warren Buffett has evolved from a pure value investor to a quality investor thanks to the influence of Charlie Munger.

The fact that Berkshire Hathaway has owned great companies like Geico, Coca-Cola and See’s Candies for decades confirms this.

Good businesses are very rare. That’s why once you’ve found them, the right time to sell is almost never.

"It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” - Warren Buffett

8. Never make economic forecasts

Making economic forecasts and trying to predict the stock market in the short term is a fools game.

In the world of making economic forecasts, there are only 2 kinds of people: those who don’t know and those who don’t know they don’t know.

Economic and market forecast are worse than useless.

"I would say that I’ve been in business, running Berkshire for 58 years, and I’ve never opined an economic forecast of any use to the company. If I depended on economic forecasts, I don't think we'd make any money." - Warren Buffett

9. Let your winners run

Peter Lynch once said that selling your winners and holding your losers is like cutting the flowers and watering the weeds.

If you invest $1.000 in a stock, all you can lose is $1.000 but you stand to gain $10.000 or even $50.000 over time if you’re patient.

"In August 1994 Berkshire completed its purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion. The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million." - Warren Buffett

10. The acquisition criteria of Warren Buffett

Warren Buffett uses a strict approach to acquire entire businesses.

The acquisition criteria can be found in his annual letters:

1. The company must have demonstrated consistent earnings power

2. The business must earn good returns on equity while employing little or no debt

3. Management should be in place (Berkshire won’t supply it)

4. The business should be simple (only invest within your circle of competence)

5. A fair price

As you probably already noticed, a lot of quality criteria can be found in this list.

If even Warren Buffett focuses on quality companies, shouldn’t you?

Charlie and I are simply not smart enough to get great results by adroitly buying and selling portions of far-from-great businesses." - Warren Buffett

Berkshire Hathaway weekend

Currently I am in Omaha to attend the Berkshire Hathaway weekend.

My schedule looks as follows:

• Friday: breakfast with Vitaly Katsenelson, ValueXConference with among others Mohnish Pabrai, William Green and Guy Spier and in the evening I’ll have dinner with Gautam Baid (Author of The Joys of Compounding)

• Saturday: Berkshire Hathaway meeting and an YPO Event afterwards with among others Tom Gayner and Thomas Russo

• Sunday: lunch Markel (Tom Gayner), meet the guys behind Investing By The Books (podcast) and Clay Finck (The Investors Podcast - We Study Billionaires)

If you are also in Omaha and want to connect, just let me know so we can try to meet each other.

I am really looking forward to keep you updated about the Berkshire Weekend via Twitter and this newsletter. Love you all and talk to you soon!

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About the author

Compounding Quality is a professional investor which manages a worldwide equity fund with more than $150 million in Assets Under Management. We have read over 500 investment books and spend more than 50 hours per week researching stocks.