Berkshire Hathaway: A Study Guide

Short Answer Quiz

* Why was the textile business that Buffett acquired an ideal vehicle for making investments?

* Explain how insurance companies provide Berkshire Hathaway with a "float," and why this is advantageous.

* According to Buffett and Munger, what two "super-contagious diseases" affect the investment community and how do they attempt to approach them?

* What type of businesses do Buffett and Munger believe will cope well with inflation?

* Describe the difference between the two basic themes in value investing that are mentioned in the text.

* What is the "cigar butt" approach to investing, and why does Michaelis not prefer it?

* Why does Buffett believe that diversification makes no sense for someone who knows what they are doing?

* What criteria does Buffett use for evaluating the performance of management?

* How does Buffett describe an ideal business?

* Explain the concept of the "moat" in relation to a business.

Answer Key

* The textile company, Berkshire Hathaway, was ideal because its stock provided a publicly traded corporation with captive capital, which allowed Berkshire to make investments without shareholder redemptions directly impacting available funds.

* Insurance companies collect premiums, a portion of which is held as reserves to cover future claims; this reserve, the "float", can be invested by Berkshire, generating returns while waiting to pay out claims.

* The two diseases are fear and greed. Buffett and Munger aim to be fearful when others are greedy, and greedy only when others are fearful, attempting to profit from market overreactions.

* Businesses that employ relatively little capital, generate lots of cash, and possess pricing flexibility will navigate inflation successfully as they can increase prices in line with inflation without significant capital investment.

* The two themes are 1) buying assets at a discount and 2) buying companies with high earnings power. The first focuses on undervalued assets, while the second focuses on sustained high returns.

* The "cigar butt" approach involves buying cheap assets, hoping for a final "puff" of profit. Michaelis dislikes it because it requires a catalyst and may involve waiting a long time for returns and is not sustainable.

* Buffett argues that diversification is a safety net for those who do not understand the businesses they own. He believes knowing the business deeply enough makes diversification unnecessary and a waste of opportunity.

* Buffett evaluates management on two key aspects: their ability to effectively run the business and how well they treat the company’s owners.

* An ideal business, according to Buffett, is one that costs a penny to produce, sells for a pound and is habit forming, implying high margins, high demand, and low costs.

* A business "moat" refers to a barrier to competition that protects the company's earnings, which can be derived from things such as low production costs, strong trademarks, or advantages of scale or technology.

Essay Questions

* Discuss the evolution of Warren Buffett's investment philosophy, as described in the text, contrasting the "cigar butt" approach with a focus on earnings power and “idiot-proof” businesses. How has this shift shaped Berkshire Hathaway’s portfolio?

* Analyze the significance of "float" generated by Berkshire Hathaway’s insurance businesses. How does this unique funding model contribute to their long-term investment strategies, and what are its limitations?

* Assess the key characteristics of a "wonderful business" according to Buffett and Munger, and explain why they believe such businesses are the best protection against inflation. Provide examples from the text or your own research to support your analysis.

* Explore the psychological factors that affect market behavior, focusing on the "super-contagious diseases" of fear and greed. How do Buffett and Munger attempt to leverage these tendencies for their investment advantage, and what role does "enlightened common sense" play?

* Considering the various principles of business and investing discussed in the text, outline a personal strategy for wealth creation. How would you incorporate Buffett and Munger's lessons into your approach to building a business or investment portfolio?

Glossary of Key Terms

* Float: In the context of insurance, it refers to the premiums collected that are held in reserve to pay future claims. This money can be invested and earns money for the insurance company, and thus, Berkshire Hathaway.

* Value Investing: An investment strategy that focuses on buying assets or businesses for less than their intrinsic worth.

* Earnings Power: A business's ability to generate profits consistently over time.

* Cigar Butt Approach: A value investing strategy that focuses on buying deeply discounted assets for a potentially quick gain, similar to finding a used cigar with one puff left.

* Moat: A competitive advantage that protects a company's profitability from competitors. Examples include strong brand names, high switching costs, or unique technology.

* Margin of Safety: The difference between a business’s perceived value and its market price. An investor should always have a margin of safety in the case of unforeseen events.

* Circle of Competence: The range of industries and business types a person understands well enough to invest in.

* Book Value: A company's net asset value. It represents the amount of money shareholders would receive if the business was liquidated.

* Intrinsic Value: The actual or perceived worth of a company, which may differ from its current market price.

* LBO (Leveraged Buyout): Acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition.

* Arbitrage: The practice of simultaneously buying and selling an asset to profit from a price difference in different markets.

* Modern Portfolio Theory (MPT): A theory that tries to create a well-diversified portfolio of assets with an aim to maximize returns for a given level of risk.

* Beta: A measure of the volatility or systematic risk of a security or a portfolio compared to the market as a whole.

* Capital Allocation: The process of deciding how a company will spend its financial resources (e.g., reinvesting in the business, making acquisitions, paying dividends).

* Habit-Forming: A product or service that has low production costs, sells at a high premium, and generates repeat customers.

* Institutional Blindness: Refers to when an institution or its members are so set on a particular way of viewing the world that they are unable to see other possibilities.

* Trade Deficit: When the value of a country's imports exceeds the value of its exports.

* Program Trading: Automated trading based on computer algorithms, often involving large volumes and often used in arbitrage situations.

* Diversification: The practice of spreading investments across different assets to reduce risk.

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