Books : The Buffettology Workbook : Excerpts

Chapter Two: Identifying the Economic Engine Warren Wants to Own

What are the characteristics of the businesses that Warren Buffett wants to invest in? After more than forty-five years of actively investing in common stocks, Warren has discovered that if you want to take advantage of the stock market's short-sightedness, coupled with the bad news phenomenon, you must invest in companies with economics that will let them survive and prosper beyond the negative news that created the original buying situation.

Remember, Warren is an exploiter of the investors and mutual funds that sell their shares on bad news. To do this he has to make sure that the company he is investing in is not only an intrinsically sound enterprise, but also has the economic ability to excel and earn fantastic profits. Warren isn't only interested in bottom picking. He's interested in using the market's mistakes to become the owner of some of America's greatest business enterprises at bargain prices. By picking only the cream of the crop, he is able to ensure that over a period of time the share price will not only fully recover, but will continue its upward trajectory. It is nothing for Warren to see a dramatic increase in the value of one of these great business after he buys in. In the case of Geico he saw a 5,230% increase in value. And with The Washington Post he did even better, clocking in with a 7,930% increase in value. It's mind-blowing, isn't it? He bought into these companies at a time when all of Wall Street was running from them as if they had the plague. He held on to them, because they were fantastic businesses that had the kind of economics working in their favor that over time would make him tremendously wealthy.

Think of it this way. You have two racehorses. One, called Healthy, has a great track record with lots of wins. The other, Sickly, has a less than average track record. Both manage to catch the flu and are out of action for a year. The value on both shrinks because neither is going to win any money this racing season. So their owners, intending to cut their losses, offer them up for sale. Which would you want to invest your money in? Healthy or Sickly?

It's not hard to see that Healthy is the best bet. First of all, you know that Healthy is fundamentally a strong horse. Not only does Healthy have a better chance of recovering from the flu than Sickly does, but afterward Healthy will be winning lots of races and make you tons of money!

Even if Sickly recovers, the horse will more than likely remain true to its name and get sick again and again. The return on your investment will be like Sickly's health -- poor.

Warren has separated the world of business into two different categories. The first one is the sickly kind; these are companies that have poor economics working in their favor. He refers to these as "commodity" type businesses. A commodity type of business manufactures or sells a generic product that a lot of other businesses also make or sell. The second type of business is the healthy kind, which has terrific business economics working in its favor. Think of Coca-Cola, Geico, and The Washington Post. He calls these companies "consumer monopolies." A consumer monopoly is the kind of business that sells a brand name product or has a unique position in the stream of commerce that allows it to act like a monopoly. Thus, if you want that particular product or to use a company's specific service, you have to purchase it from that company and no one else. This gives the company the freedom to raise prices and have higher earnings. These companies also have the greatest potential for long-term economic growth. They experience fewer ups and downs in business and they possess the wherewithal to weather the storms that a short-sighted stock market invariably overreacts to.

First things first. Warren believes that unless you can identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market. You have to know what a commodity type business is and be able to identify its characteristics. If you don't, you just may end up owning one. You also have to be able to identify what a consumer monopoly type business is and be able to identify its characteristics, because this is the type of business that will make you a pot of gold.

Let's take a deeper look into both these kinds of businesses, so you will be able to determine which is which, and which one is going to make you rich. As Warren says: "A stock well bought never has to be sold."

KEY POINTS
FROM THIS CHAPTER

Warren has separated the world of business into two different categories: the healthy consumer monopoly type business and the sick commodity type business.

A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly.

A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell.

Warren believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market.

Study Questions

Why has Warren divided the world of business into two categories?

Can you think of a company that has a consumer monopoly?

Can you think of a company that sells a commodity type of product?

True or False

1. T or F Warren is interested in buying the sick commodity type of business.

2. T or F Warren is interested in buying the healthy consumer monopoly type business.

3. T or F A commodity type of business is the kind that manufactures a brand name product.

4. T or F A consumer monopoly type of business is the kind that manufactures a generic type of product.

Answers: 1. False 2. True 3. False 4. False