This article is an excerpt from the Shortform book guide to "The Warren Buffett Way" by Robert G. Hagstrom. Shortform has the world's best summaries and analyses of books you should be reading.
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How should companies allocate capital? How important is it for businesses to resist trends?
If you’re looking at a company as a potential investment, you need to assess its leadership. Warren Buffett looks for three things: how they allocate capital, how transparent they are with their finances, and how resistant they are to trends.
Continue reading to discover how to evaluate management in the same way that Warren Buffett does.
How to Evaluate Management
Buffett learned how to evaluate management from Philip Arthur Fisher, who taught him that companies with viable business models can falter under poor leadership. Consequently, Buffett looks at capital allocation, transparency, and resistance to trends when deciding whether to invest.
Metric #1: Capital Allocation
To begin, Hagstrom explains Buffett’s view that, because investors seek companies that will deliver a high return on investment, management should allocate capital in a way that maximizes shareholder value.
Put simply, capital allocation refers to the distribution of company earnings—in other words, what the company does with the money it earns. Broadly speaking, Buffett holds that companies can either reinvest that money within the company, such as by sending additional funding to promising branches, or use it to pay dividends to shareholders. Crucially, while the second option seems like a natural way to maximize shareholder value, Buffett argues that if companies can reinvest that same money within the company to deliver long-term returns that are greater than those dividends, they should do so. Conversely, he recommends that companies pay dividends if they can’t earn shareholders greater returns by investing their earnings internally.
(Shortform note: One traditional way that companies reinvest money internally is by funding research and development (R&D) that seeks to learn how to improve existing products and processes while also developing new products. However, experts note that although R&D spending has increased globally, it’s been delivering lower returns since around 2010. These lower returns, they argue, are the result of focusing R&D on short-term gains rather than long-term projects, indicating that companies should instead consider allocating capital to fund long-term R&D.)
Metric #2: Transparency
Just like capital allocation can show that companies value their shareholders, transparency is also indicative of shareholder-oriented companies. According to Hagstrom, Buffett holds that you should invest in companies that are transparent about their finances rather than those who obscure their failures through convoluted financial reports.
In particular, Hagstrom suggests that deceptive managers are defending their own interests rather than shareholders’, as they prevent shareholders from making well-informed investment decisions. Consequently, you can’t trust managers of those companies to act in your best interests, making them an unappealing investment.
(Shortform note: Moreover, a lack of transparency from management can lead to illegal insider trading–the practice of using non-public information to gain an advantage trading a company’s stock. For example, a CEO might inform management of a pending press release that will lead to a significant stock dip, allowing them to sell their shares ahead of time to avoid losing money.)
Metric #3: Trend Resistance
According to Hagstrom, Buffett’s final criterion for evaluating management is its resistance to popular industry trends. Hagstrom writes that Buffett prefers companies that don’t readily submit to popular business trends since these trends are often irrational and harm companies’ bottom lines.
As Buffett sees it, management teams often make suboptimal decisions simply because other management teams are doing the same. For example, many company executives relentlessly acquire smaller companies to appear growth-oriented, even when these acquisitions aren’t best for shareholders. So, Buffett holds that companies whose management teams don’t blindly adopt industry-wide trends are a better investment because they’re less likely to imitate others’ harmful decisions.
(Shortform note: Elsewhere, Buffett clarifies that there’s a close connection between companies that succumb to trends and those with poor capital allocation skills; he notes that companies that submit to institutional trends end up allocating capital poorly because these trends often involve spending inordinately to acquire expensive new companies. By contrast, those that resist these trends can more objectively assess how to allocate their capital.)
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- How to invest like Warren Buffett and earn above-market returns
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