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How Warren Buffett Thinks About Risk

“Rule #1: Don’t Lose Money….”

The best book I’ve ever read on Buffett is Alice Schroeder’s Snowball. I remember picking up my copy about four years ago and literally not being able to put it down. I read it for hours at a time, all the while marking pages and circling things… and I often reference certain parts of the book when thinking about investments. The book goes much deeper into Buffett’s thought process than most of the other Buffett books.

Schroeder went through pages of Buffett’s scratch notes on many early investments, some of which were heretofore unknown to the public (one in particular is mentioned below). She does a great job at really capturing what Buffett was thinking behind many of his investments, which makes the book a true gem for reverse engineering Buffett’s ideas.

Below is a video of Schroeder that I recently watched. The video below is a clip of her talk at the University of Virginia, which is a great lecture to listen to. But if you have 9 minutes, I strongly recommend watching the clip below.

The First Step in Buffett’s Investment Process

One of the most fascinating things about Buffett is his ability to quickly and efficiently filter through many investment ideas. In the video, Schroeder discusses a key question that Buffett asks immdediately before doing any work on a prospective investment. The question is basically: What are the odds that this investment could fail because of catastrophe risk? In other words, what are the major things that could go wrong?

Schroeder goes on to explain that this question was the first step in Buffett’s investment process. He was not interested in putting capital at risk if there was any chance of cat risk. He didn’t care about the potential upside if he perceived there to be a major reason that the business could fail. This is much different than how most investors think. Some investors are willing to take positions in stocks that have significant risk, but even greater upside. Buffett was not. He simply wanted to invest in high probability and low risk situations. This simplified his process.

He missed out on many investments because he wasn’t willing to take the risk. Some members of his family got rich investing in Control Data in the 1960’s, even as Buffett urged them not to. He didn’t care about missing opportunity in situations that had catastrophe risk. He wanted high returns, and significant upside–just not at the expense of major risk.

Mid-Continent Tab Card Company

This brings us to an example that Schroeder discusses in this video clip. The Mid-Continent Tab Card Company is a fascinating case study on Buffett’s investment process.

I’ll let Schroeder share the specifics of the investment, but the summary is that Buffett passed on an early stage start-up business that his friends were working on because he thought the business could (not necessarily would) fail due to stiff competition from IBM. So he passed on the idea. However, his friends got the business off the ground, and a year later were hugely profitable, and successfully competing with IBM. They approached Buffett again needing to raise more money. This time he said he would consider it. The cat risk was off the table, and he began doing research on the business.

The case study is also interesting because Schroeder discusses Buffett’s process for evaluating the business, which is also significantly different from how most investors research ideas. He didn’t use DCF’s, he didn’t do detailed projections… he used basic analysis with simple common sense logic. And he only did his analysis after first identifying that cat risk was off the table.

The result of the investment is less important than studying his process, but nevertheless, it was fantastic. Buffett ended up making millions from an initial $60,000 investment, compounding his capital in this investment at 33% per year for almost 2 decades.

Think of Stocks as Businesses

By the way–one more interesting point from the video. Buffett was only 29 when his friends brought him this deal. He had yet to prove himself as a successful investor. His friends knew he was a businessman, and a good investor, but had no idea of how good he really was. I thought this illustrated an interesting point that Buffett was a business owner first and foremost. He truly thought of stocks as businesses, and that’s likely one of the most significant factors in his phenomenal successes as a capital allocator.

Here are some other useful pieces on the Mid-Continent Tab Card Company and Buffett’s filtering process:

Here is the video clip of Schroeder at the Darden School. It’s a great clip to watch:

Have a great weekend.

27 thoughts on “How Warren Buffett Thinks About Risk

    1. Well it’s always been quite simple from what I can gather. Schroeder talks a little bit more about what his process was like in the late 50’s in that video. And you can watch the extended lecture on Youtube. But the best thing is to check out Snowball if you get a chance. You’ll learn a lot about Buffett’s process.

      But she describes it as quite simple. No projections… just take some notes of what they’ve done over the past couple years. What are the earnings? What is each plant doing? What are the margins? Can they continue to hold these margins? What happens if margins get cut in half? What will they earn then? He asks some simple questions and makes very conservative assumptions and then simply decides if he can get his 15% return. If so, he’ll buy it.

      Many of his early investments were obvious… a bank selling at a P/E of 5 at half of book value for example. There were a number of other investments like that. But very early on he began looking at great businesses thanks to Munger. He owned Amex, Disney, and others that were all high quality businesses. Even Geico in the early 50’s was a great business that was growing.

      He really wanted to own value… he wanted low risk ideas with big margins of safety. He asked simple questions and had simple models in his head.

  1. Love your site. Very informative. Very curious as to how all your accumulated knowledge has or has not affected your investment performance. What sort of returns have you actually been getting over the last several years? There is one very important writer/thinker you do not mention in your site but whom you might want to pay attention to–the Nobel prize winner Daniel Kahneman. After reading him, you will recognize and appreciate the role of luck, the unpredictability of stocks/markets, and that very few people, if any, can beat the market over the long term. Sure you can point to Schloss, but if his methods were so easy to emulate, there would be tons of managers following suit and racking up his 20% returns year in and year out over long time periods. But this clearly isn’t the case. Instead, as Kahneman argues, we are overly optimistic and operate under an illusion of stock-picking skill that we can PERSISTENTLY outperform the market when the odds of doing so are extremely slim.

    1. Hi Dave… great questions… It’s a topic I often enjoy discussing with other value investors (and other non-value investors and efficient market believers)… I’ll write some general thoughts I have on the topic in a post or two over the next couple days…

    2. There are a lot of investment managers beating the market for long periods. Guys like Chris Mittleman, Sahm Adrangi, Glenn Surowiec, James East, Mohnish Pabrai, James Zimmerman, etc. Also, there are many individual investors killing the market for the last 10 years. Size is a huge disadvantage for many funds, which is why you might see some funds that don’t outperform (like Longleaf). But if this weren’t possible, people wouldn’t be value investing. I don’t think the market will ever be efficient with so many irrational participants and high-speed traders.

      1. Thanks for the comment Jack. Yes those are some guys with long term records, and as you say, there are many small investors we’ve never heard of quietly putting together outstanding long term records. Greenblatt talks about guys that he’s seeded who were making 40% annual returns in their own small accounts over a period of quite a few years. Small capital size is a big tailwind for returns.

  2. The question that springs right to my mind is this– how was he so sure that if Mid-American could come in and do this to compete, others couldn’t? What would he today describe as the moat around Mid-American?

    1. That’s a great question and I thought about that as well. I don’t know. Buffett has an incredible business sense, and a lot of it is intangible. So I don’t know if we could figure that out unless we could ask him directly. But one thing Buffett has said regarding margins is that a 40% gross margin is often a sign that the business possesses a moat. And that’s gross margin. I think in this case, Schroeder said the business was producing 40% net margins… and it was one of the most profitable businesses Buffett had ever looked at.

      I had a similar question but it pertained more to durability. I think the business clearly had a moat, because it was producing huge margins–I have no idea of how durable the moat was (although apparently it was durable because the business continued to grow value for many years after Buffett bought it).

      It’s a great question-and one I thought of also. I think Buffett probably became interested once he eliminated the “cat-risk”, or the risk that IBM would crush the business. Once that was off the table and he realized Mid-Continental could compete with IBM, he became very interested in the profitability the company had, and he made his assumptions extremely conservatively. He only assumed they’d be able to sustain half the margins. So he gave himself and the business a lot of room for error. The company was minting money at the time, so his margin of safety came from the current profitability (i.e. even if margins got cut in half, the investment would still pass his hurdle rate). As it turned out, the margins held up for the most part and his investment averaged 33% per year, doubling his self imposed hurdle…

      At the right price, businesses like this can provide a huge margin of safety thanks to their profitability because the business is producing cash at such a rapid rate. Usually in the public markets, these types of businesses are priced at a level where the margin of safety isn’t there (i.e. they will be great investments if they continue operating at the same high level, but if they don’t, then the investment becomes mediocre or worse… I think in this case, Buffett was able to get a great business at a great price, and thus had a huge margin of safety that would only get larger as time went on).

      1. (going through some more old posts here – I know my reply is years too late!)

        Interesting about the comparison to IBM. I saw one of the presentations with Warren, Bill Gates, and Charlie Rose that they did in the past year or two. Warren asked Bill Gates, back in the day, how he was able to compete with IBM.

        I guess Warren must be looking at whatever he considers to be the big market leader, and then trying to figure out if the smaller business really has any chance to permanently (and profitably) gain market share.

        That’s not really terribly insightful. I think, in general, the US has moved towards bigger business, and away from smaller ones. It just looks like our landscape has gravitated towards larger businesses, so this is probably a good question to ask.

  3. Does he derive his 15% return from the margins though? What confused me was that say the company has 50% margins, and what buffett would decide that he wanted 15% of that. Is that where he gets his return from?

    I think he unknowingly used ROC and EV/EBITDA metrics in his analysis..

  4. Thanks for sharing this video. I have only briefly read about this company (as an investment that wasn’t in the partnership). Would love to find more information about it.

    The discussion by Schroeder about catastrophic risk is somewhat forced in my opinion. She is trying to go back and figure out what he did (with his help), but I think that process is difficult and subject to a lot of bias errors. We describe our past actions in a much better light than they actually occurred. This is a great example because in talking about catastrophic risk of an investment, especially one in technology, the biggest risk being that your technology becomes obsolete. I am no computer history expert, but isn’t that precisely what happened here? In this case, it appears that this company sold out before that technological change came to fruition, but it would appear that luck, not smart decision making regarding the initial catastrophic risk was what made this investment successful. In other words, Buffett judged the competition with IBM correctly, but completely failed to see that computers eventually would no longer need tabs to process information.

    1. True, but he failed to see the internet coming in and trashing World Book and The Washington Post, too. He has never pretended to be clairvoyant. My guess is that for him, if the company had continued to exist into the PC age, he would have seen this coming and sold, or he wouldn’t have seen it and this would have been like Blue Chip Stamps– something that threw off so much cash that it was worth it just for the span of time it was around.

    2. Yeah it’s a good point. It would be very interesting to ask Buffett himself about this at one of his events… maybe I’ll put it on my list at the annual meeting if I happen to be lucky enough to get the chance to ask a question.

      But I think Schroeder’s right about the concept of cat risk. I think Buffett considers that first, and I think he’s discussed that previously. Not sure if he used the term cat risk, but he basically describes his process the same way. No interest in taking risk of permanent loss.

      Of course he’s made investments that have turned out bad over time, but I think he thinks about risk first.

      And regarding the tech, I thought the same thing… there is no way Buffett could have seen it. One thing I did think about was this… while we don’t know what valuation Buffett paid for his share of Mid-Continental, we know the net margins were extremely high and the ROE was extremely high. I think Schroeder mentioned something about asset turnover being extremely high, which would drive higher ROA. Not sure of the leverage, but overall, we can assume this was a very high margin, high return on capital type business.

      My guess is Buffett thought about this very simply… something like this: If the business continues to achieve margins that are even half the current margins, it will produce cash flow (owner earnings) of X. He probably discussed capital allocation with his friends (the management) so he probably felt comfortable there. Who knows, he could have put a very short life on this thing and estimated the cash flow for the next few years at a very conservative number. My guess is he thought the probability was very high that the business would produce enough cash in a very short period of time to cover his initial investment. My guess is he knew not a lot about the business itself, and probably didn’t envision what the investment would look like in 20 years. It turned out to be a home run, but my guess is that he made the investment because he had little downside in a business that was growing rapidly and extremely profitable. He clearly wasn’t convinced the business would maintain its level of profitability as he assumed margins would get cut in half. But however he sliced it, he probably saw a low risk investment opportunity (huge margin of safety because of high margins and high cash flow) with potential asymmetric upside if things went well.

      Note: I don’t know what the cash flow looked like… but I assume that if Buffett invested, it produced a lot of free cash flow even after the growth capex requirements… whatever they happened to be.

  5. Yes, I’m aware that his hurdle rate is 15%. How was he so sure that he would get 15% though? Did he just look at the margins and said “Oh, there’s 50% margins and I want 15% of that.” Or.. “Oh look there’s 50% ROC. Hmm, can they sustain this within the next 10 years? Okay, great I want 15% of that.”

    Is that how he operates?

    1. My impression is that he looked at the various scenarios that were at all likely, and that even in the worse-case scenario, in which the margins get chopped in half due to competition, or something, he saw that he’d get a 15% return based on their probable earnings and on the price he could get the shares at. And if things turned out better than that, as they often do (and did, here), that would be gravy.

      1. Yes this is the same general interpretation I had… he really made a simple decision. Major risk off the table… business is minting money… can it continue? What does my return look like if margins get chopped (so even after he took cat-risk off the table, he still was very conservative with his assumptions). The odds pointed to a large margin of safety… and as you say, things worked out better than his conservative approximations.

        That’s the key. He wanted 1 foot hurdles… I really don’t think he was concerned about 10-15 years in this investment. He figured he could get his cash back in a few years because it was doing so well. Any upside was just icing on the cake. He probably couldn’t really envision how well it could do, but he probably felt he had a huge margin for error because it was printing so much money now.

        The interesting thing is we don’t know the valuation… but my guess he got good terms, and thus wasn’t really relying on great prospects long term to make his investment work (which is what we’re always after with investments… we don’t want to rely on growth, we want upside for free and low downside 🙂

    2. No the margins and ROC were whatever they were… the 15% is the return he wanted on his own invested capital. His ultimate decision to buy (according to Schroeder) hinged on the probability of his achieving that hurdle rate. He “handicapped” these odds based on his experience and the facts. And that probability was approximated due to a variety of things (presumably including the high margins, high asset turnover–i.e. high ROA, etc…)

      So it’s really simple… he looked at the fundamentals, looked at the cash the business was generating, and the margins it had, and somehow came to the conclusion that he could get the 15% returns he desired.

      That’s really all we know regarding Mid-Continental. But it’s the philosophy of the importance of looking at risk and focusing on simple fundamentals are what I took away…

  6. The point I want to make is that looking back 50 years and trying to determine what someone was thinking is fraught with hindsight bias. A better example would be Buffett’s investment $2B debt investment in Energy Future Holdings (which he has written down by about $1.4B at my last check). The reason for the write-down is the decrease in natural gas prices, which in 2007 may have seemed unlikely, but given you are investing in a commodity, not uncommon to think that prices to fall to the point where your investment could suffer catastrophic loss.

    In other words, the risk of cat loss was there and obvious, so under Alice’s theory, why would he do it?

    I really admire Buffett and I find his thinking complex and nuanced at times and when others try to simplify it, you lose a lot of the nuance that makes it worthwhile. We should ask Alice to write an article about Mid-Continent Tab Company and let us draw our own conclusions…

    1. The degree and– especially– the durability of price drop that occurred in gas and to a lesser extent oil isn’t one that ordinarily occurs even with commodities; it came around because a new technology, fracking, became established and popular. To anyone except an oil specialist it was unforeseeable.

      It was much more predictable that the internet would grow to the point of ruining business models in the information field, and he either didn’t see that or decided it would be worse for his reputation among potential business sellers if he started engaging in “gin rummy” business-trading, as he calls it (discarding your least promising business at each turn).

    2. The biggest two takeaways for me (this is really fundamental but it was still important)… 1) he thought of risk first and foremost 2) he didn’t rely on projections… Schroeder said in thousands of pages she never saw what resembled a typical model projecting out margins, earnings, etc…

      I thought that was interesting. But you’re right regarding the difficulty in reverse engineering this specific case.

  7. Sorry, I am trying to reverse engineer this. But using the numbers she is quoting, he bought 16% of the company for $60k, which values the total equity at $375k. Even if we look at the prior year’s sales ($1mn) and attach the 36% profit margin AND cut it in half (so profit of $360k), he was buying the firm at about 1x earnings. Why would the company sell him a private share for 1x earnings if they are growing at 70% a year? I feel like something has to be off here with those figures, maybe he put in $600k, unless someone understands the math a bit better?

    1. That’s exactly what I thought,

      i) company can deliver faster than IBM (competitive advantage) and has proven it can compete successfully with them
      ii) company growing at a great clip per annum and you’ll do well even if margins fall
      iii) pe of 1 ( + he also got some subordinated notes)

      How can you not make money on that? In our stock market of today, companies like this would be trading on a pe of 20 or so.

      Opportunities like this can occur but they are rare, like rarer than GFC’s. But examples like this don’t help much to show investors what to do in more normal stock valuations.

    2. I think it should be 600,000 instead. Alice mentioned that investment was 20% of Warren’t total net worth at that time. His partnership letters in 1965 or something said his total net worth was more than 3 million. So 600,000 would be more reasonable. That would lead to 15% return on investment (as Buffett also bought some notes with that money).

      Hope this helps, though it’s three years after your question 🙂

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