Note # 1 – Four Filters

Note # 1 – Four Filters
Buffett and Munger look for businesses
1) that they can understand
2) with sustainable competitive advantage
3) operated by able and honest people; and
4) available at a very attractive price

Because of both market conditions and Berkshire’s size, they now substitute ‘an attractive price’ for ‘a very attractive price.’

An experienced analyst can easily go wrong in estimating the attractive price. At Berkshire, they attempt to deal with this problem in two ways.
1) They try to stick to relatively simple and stable businesses. If a business is complex or subject to constant change, it is impossible to predict future cash flows. The most important thing for investors is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.
2) They insist on a margin of safety in their purchase price. They are not interested in buying a common stock if the calculated value is slightly higher than the market price. In many instances, shares worth x in business value have sold in the market for 1/2x or less.

Sustainable competitive advantage:
They look for consumer monopolies that offer products or services where there is little or no competition. This could be either due to a brand name or patent that makes the product or service unique.

A moat is a sustainable competitive advantage that allows a company to earn good profits over time. They look for companies that have one of the following moats.
a) Low Cost Producer
b) High Switching Costs
c) The Network Effect
d) Intangible Assets (brands or patents)

Able and honest management:
The ability of the management can dramatically affect the equity future earnings.

– From 2010 Buffett’s Annual Letter

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