Steve talks with Bud Labitan, physician, investor, and author whose books about the decision-making strategies of Warren Buffett and Charlie Munger provided material for Steve’s recent presentation at the Money Show in Orlando.
Bud’s latest book Four Filters Invention synthesizes the investing philosophy behind the phenomenal success of Warren Buffet and Charlie Munger, which on the surface sounds simple but actually requires a deep level of understanding and thoughtfulness.
Filter #1: Understanding the business. Charlie Munger talks about examining a business from the inside out, that is, knowing the underpinnings of a business, which Munger refers to as the latticework, and comparing that to others that have gone under and failed. You want to buy a first-class business that can endure economic storms and that can mutate, if necessary. Berkshire Hathaway, for instance, was a textile business that because of competition from overseas manufacturers and other factors, eventually had to redefine and redirect itself into other companies.
Filter #2: Finding a business with an economic mote. By nature, business is competitive, so Buffet looks for those companies that are protected from competition. This often involves brand loyalty, such as with Coca-Cola or Gillette.
Filter#3: Able and trustworthy management. You want a company managed by passion and drive but also with integrity. Cost control and not over-spending have to be considered along with commitment on the part of management.
Filter #4: Buying at the right price. Probably the most difficult of all the criteria is knowing how to value a company. Bud says he employs a formula that allows him to tell whether something is overvalued or undervalued similar to what Buffett and Munger do, which is probably the most difficult part of the assessment process.
Steve ends the interview by stating that successful long-term investing is so much more than just trading the good markets and avoiding the bad or being lured by the hot tips of the week. Deep understanding of a company and a cool, somewhat clinical determination of when or even if to buy, are critical.
Steve Pomeranz: Some years ago, I was introduced to a number of terrific books written by my next guest. He is a physician and investor who has written books describing the special decision making of Warren Buffett and Charlie Munger, all within light of understanding that human behavior needs some reforming when it comes to making good investment decisions. Creating checklists and parameters within which to work go a long distance in helping us. My next guest has done that very well. His name is Bud Labitan. As a matter of fact, I used his books as the source of my talk at the Money Show in Orlando recently. Welcome to the show, Bud.
Bud Labitan: Oh, thank you, Steve.
Steve Pomeranz: One book that I want to discuss today is the Four Filters Invention. Describe what those four filters are.
Bud Labitan: Sure. The four filters, let me give you just a little bit of background. I became interested in their decision-making process, and I came across a phrase that Mr. Buffett uses in a couple different ways. He says, “We look for a business that we can understand.” That’s number one, and he means economic understanding. Number two, “A business that has a sustainable, competitive advantage.” Sometimes he uses the words, “durable, competitive advantage.” He wants them with able and trustworthy managers, so that’s filter number three. Finally, is Ben Graham’s margin of safety, which is purchasing at a bargain price.
Steve Pomeranz: They sound so simple on the face of it.
Bud Labitan: Yes.
Steve Pomeranz: Let’s delve underneath each one and see what they really mean. Once again, the first filter is basically understanding what you own. Tell us about that.
Bud Labitan: Yes. Understanding what you own was also influenced by his partner, Mr. Charlie Munger, who’s now about ninety-two or ninety-three years old. Charlie Munger has always said, “Let’s look at a business like a latticework of mental models, and let’s collect mental facts about each business. Then, let’s take a look at it and see if it’s a first-class business and whether it can endure economic storms.”
Steve Pomeranz: What is a latticework of mental models?
Bud Labitan: A latticework of mental models is something like building your experience just by looking at numerous businesses. Your audience will appreciate the fact that as we go through our life, over time, we start to get a sense of which businesses are good and can endure. As we get a little bit older, we can see businesses that have gone under and failed. Little by little, we build up our latticework of mental models every day.
Steve Pomeranz: Yeah, I understand. We operate in a world full of big companies and brand names and smaller companies with good products or bad products. We start to get a feel for what the true underpinning story is behind a particular company. Now, did Buffet and Munger invest in small companies or were they mostly interested in buying established companies?
Bud Labitan: Well, the answer to that question, in my view, is that they have evolved over time. You may be familiar with some of their early purchases, way back when they bought a department store. In fact, Berkshire Hathaway was a textile business that was slowly losing business to southern manufacturers and overseas textile manufacturers. At the time they purchased it, it was still producing free cash. At that moment in time, it was kind of a cash cow, but, over time, competition diminished that business. Luckily, they transferred some of their funds into insurance companies and other fine businesses.
Steve Pomeranz: They were able to manage that money. Also, if I remember, he bought a map company way back when, when that was important stuff to do. The thing about that map company is it had a lot of stocks on its balance sheet, and he liked the stock portfolio. Forget the map company, it wasn’t that important. Understanding a company is of paramount importance. What is the second filter that you believe that Warren Buffet and Charlie Munger use?
Bud Labitan: The second filter is sustainable competitive advantage, and sometimes he’ll label it durable competitive advantage. Basically, that means he wants a business that has an economic mote, or some type of protection around that company so that it’s difficult for other businesses to get into that line of business.
Steve Pomeranz: Well, business is competitive, and it’s the nature of capitalism for competitive. As a matter of fact, the more successful a business is, the more people want to compete in that business because there’s a lot of money to be made. That dilutes the competitiveness of a particular business. The Buffett method is to try to find businesses that are protected from competition. That sounds easy, but I think that’s a pretty hard thing to do. What do you think?
Bud Labitan: Yes. That’s something that you kind of build with experience. You look for brands or brand identity because that means customer loyalty. Also, having a sustainable competitive advantage means that you have repeat customers, and they develop a loyalty like Coca-Cola and Gillette and some of the other brands. I think most recently, they acquired the Duracell unit from Proctor and Gamble.
Steve Pomeranz: Yeah, right. That makes sense. The Gillette model is basically you give away the razor for free, but you’re continuing to have to buy the blades all the time. That’s a wonderful business. You know what always struck me was that Coca-Cola seems like a business that would not be able to create and maintain a durable competitive advantage. How have they been able to do that?
Bud Labitan: The amazing thing about Coca-Cola is that if you look at the numbers of Coca-Cola versus Pepsi, Coca-Cola—which has been around over a hundred and ten years—has built a worldwide distribution system and a cost advantage. If you look at the ratio of free cash produced per unit, it actually beats Pepsi and many of the competitors just because of its scale, its size, and its distribution. Then, of course, it also has that loyalty brand that some people just prefer Coke over Pepsi.
Steve Pomeranz: Well, I was wondering if Amazon, with the way it’s been able to grow, is developing a durable competitive advantage?
Bud Lapitan: That’s a good point, Steve. I think you may be on to something there. Amazon, I prefer shopping on Amazon online, but I did look at their estimated intrinsic value. If you model that traditionally, right now it looks slightly expensive. You could be right. If you put a longer tail on your valuation, then you could argue that it’s fairly valued.
Steve Pomeranz: Okay, so let’s go to the next filter. What is that?
Bud Lapitan: Okay, the third filter is able and trustworthy management. He always has this joke, when you listen to Warren Buffett. He says, “If they’re able but not trustworthy, you may end up losing money.” Just like those guys that used to run Enron. They were certainly able, doing business, and operating the energy part of their company. However, as facts have proven, they weren’t very trustworthy.
Steve Pomeranz: Right, right. You have to have both of those combined. Also these managers, I’m thinking about the companies that Berkshire Hathaway purchases. These managers have plenty of money. They’re not really doing it for the money solely anymore. There’s got to be this extra drive they are exhibiting. You have any comments on that?
Bud Labitan: Yes. You’re exactly correct. He looks for the passion that they have … excuse me… he looks for the passion that they have for their individual businesses. They do have a drive to build their businesses rationally and not overspend and control the costs.
Steve Pomeranz: Then, the fourth filter is this idea of buying at the right price. In a sense, I think this one of the more difficult of the four filters because trying to capture a valuation of a company is very, very difficult. Even Warren Buffett says it’s very hard to know how to value a company. Do you do it based on book value or cash flow? Then you’ve got to project certain amounts of growth in upcoming years, which can be very variable. How do you determine how to pay a price that contains a margin of safety?
Bud Labitan: You’re right again there. The estimation of the intrinsic value per share can be done several ways. The one that I use, and the one that Warren has talked about in his writings, is the estimation of free cash flow that the company will produce over its lifetime. Now, I don’t stretch it out that long, but I use a fifteen-year model, where I try to use a conservative growth rate on the first ten years. Then, I just flatten in out from year eleven to year fifteen. Then take the sum and discount the sum using the formula called net present value. Bring that back to present value and then divide by the number of shares.
Steve Pomeranz: Then you get a price per share. You compare that to the current price per share, and you can tell whether something is overvalued or undervalued based upon its current price.
Bud Lapitan: Right. At least to get you in the ballpark area.
Steve Pomeranz: Exactly.
Bud Labitan: Warren always says that he and Charlie could sit down and do these numbers, and they wouldn’t come up with the same figure, but as long as you come close, then you know whether you’re buying at a bargain or you’re overpaying.
Steve Pomeranz: Folks, this is what it takes to understand and to successfully invest for the long term in stocks if you’re going to invest in stocks on your own and individual stocks yourself. It’s not a question of just trading and trading the good markets and trying to keep away from the bad markets or day trading. It’s understanding what you own. It’s understanding the value of owning something that’s going to be compounding its earnings year after year, building its intrinsic value, and then waiting for the market to come to a price where you’ve indicated, or you’ve figured out, is a price which is a fair price to pay, and will offer you a good rate of return. Bud Labitan has been my guest. He is the author of the Four Filters Invention. He also has authored other books, one entitled, Moats: The Competitive Advantages of Buffett and Munger. Then finally, on my list here, A Fistful of Valuations. Bud Labitan, thank you so much for joining us.
Bud Labitan: Oh, thank you very much, Steve.
Steve Pomeranz: All right, that was fun.