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Norbert Lou

March 6, 2014
The Private Investment Brief
Buffetts Analytical Framework publishes live investment case
studies taken from the portfolios
Berkshire Hathaway released its annual letter to shareholders last Saturday, and as
of small, value-oriented
usual Warren Buffett used an extended section of the letter to teach a general lesson
investment managers.
on investing. In this years lesson, entitled Some Thoughts on Investing, Buffett
discussed two non-stock investments he made years ago and continues to hold: a
farm in Nebraska, and an interest in a retail property in New York City. SUBSCRIBE
Most of the medias attention has focused on the think long-term moral of Buffetts
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lesson, and rightly so. But for me, the main takeaway was its reminder that the
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worlds most sophisticated investor uses an extremely simple analytical framework
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when evaluating investments. He starts with the purchase price of the asset in
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question, and then compares that price to the near-term income that the asset will
earn and distribute to him as owner. Dividing the latter by the former produces a
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ratio he calls the current yield, which in the case of both the farm and the property
was about 10 percent. He then tries to estimate the rate at which this distributed
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income will grow over time.

And thats it. Its certainly true that many interesting things follow from this RECENT POSTS

framework. For instance, it can be shown arithmetically that an assets total

The Quality Brand Mittelstand
annualized return is roughly the sum of its current yield and the annualized growth
On Mark Leonards IRR Thought
rate of distributed income.* And you can take a future stream of distributions and
Experiment
bring them forward into something called a terminal value. But the basic framework
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is still current yield and growth rate of distributions out to infinity as the sole
account
determinant of your total return over time. There are many rules attributed to
Success Secrets of the Kardashians
Buffett by his more dogmatic acolytes, and having followed him for nearly 20 years
The Mystery of the Middleman
Im convinced that hes happy to break nearly all of them. If you believe for instance
that Buffett only invests in good businesses, then consider Daehan Flour. If you
think Buffett avoids technology companies and companies without a demonstrated RECENT ESSAYS

history of earnings, then consider Mid-Continent Tab Card Company. If it warms

The Quality Brand Mittelstand
your cold heart to know that Buffett avoids leverage, then read up on the real estate
On Mark Leonards IRR Thought
investment in New York City. But if I had to engage in mind-reading, I would say
Experiment
that the two rules Buffett always follows are a) he always thinks in terms of a
Success Secrets of the Kardashians
margin of safety, and b) he always thinks in terms of the fundamental return
The Mystery of the Middleman
framework outlined above.
Alpha in Real Estate

Amazon.com, Economic Efficiency, and

This framework is so simple that without realizing it, we all use it when evaluating
the Play in Five Acts
the simplest of investments, like a savings account or savings bond. The words we
On Deferred Income
use changepurchase price becomes deposit or principal, and distributed
Buffetts Analytical Framework
income becomes interest not reinvested, but those are different words for the
Aggregator Economics
same ideas. And of course, the distributed income of a business is less certain than
Southwestern Energy: Value Investing
that of a savings account. But again, the framework is the same. Its the basic
framework behind all of capitalismin fact, its the reason capitalism is called in Real Life

capitalism in the first place. Capital can be transformed into assets that are
productivei.e. that produce income, and the decision of the capitalist comes down ARCHIVES
to comparing the income produced by an asset with the capital investment required
to earn the right to receive that income. August 2016

July 2016

One of the happy paradoxes of investment life is that the more you discipline April 2016

yourself to stay within the simple frameworks, the more sophisticated and complex February 2016

your thinking can become. Staying within Buffetts framework allows you to compare December 2015

every investment to every other investment by reducing them all to their common August 2014

underlying ideas, income and capital required to produce the income, both now and March 2014

over time. It prevents you from making common analytical mistakes, such as September 2013

neglecting to penalize a fast-growing enterprise for the capital required to produce August 2013

that growth, or neglecting to reward an enterprise that can grow without additional July 2013

capital (Buffetts farm and property fall into this category). It forces you to ask June 2013

yourself where might future growth in distributed income come from?, which is May 2013

perhaps the most useful question a professional investor can ask on a day-to-day March 2013

basis.

And finally, Buffetts framework is the only framework that is both theoretically and
intuitively true. Its difficult to explain, but once the basic intuition behind all of
this clicks in your head (true confession: it didnt click for me until I was in my 30s,
and even now I often have to remind myself of it), you can see all kinds of things
more clearly. You can see how seemingly different things are really just different
names for the same thing, which allows you to read things like a stock is just like a
bond with a magic coupon that grows and feel less rather than more confused. Or
you can use this intuitive understanding to see when the normal rules dont apply:
An insurance business, for instance, can be seen as an enterprise in which the basic
framework of capitalismcapital is transformed into assets that produce income is
inverted to become income produces assets that can be used as capital.

The ability to work hard to see things clearly and simply is perhaps the ultimate
competitive advantage that one investor has over another. This ability is obviously
good for allocators, but its also good for the investor himself/herself, because its
probably the purest source of joy in investing or any other kind of analytical work.
Wall Street has many dirty secrets, and one of them is how few professional investors
think as Buffett does. The price they pay is not only worse performance, but less joy
too.

*To be more precise, it can be shown that for an investment that pays a coupon that
grows at some rate over time, the internal rate of return of the investment is roughly
equal to the sum of the initial yield and the annual growth rate of the yield. A given
internal rate of return does not mean the investor will earn exactly that rate of return
thats only true if the return on all reinvested distributions turns out to be exactly
the same as the return on the initial capital outlay, which almost never happens. But
the IRR is useful as an indifference point: If your rate of return on reinvested
distributions ends up being lower than your IRR, then youre still better off having
made the capital outlay. If on the other hand you end up earning a higher rate of
return on reinvested dividends, then your capital outlay was a mistake, but the idea
is that your IRR is high enough that its a high-class mistake.
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