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Opportunity Cost: Buffett & Munger’s Powerful Investing Filter

Aug. 04, 2010

In the past year there has been a lot of discussion within the value investing community about the use of checklists. The idea has been around for awhile. For example, Poor Charlies’s Almanac, which is a compendium of Munger’s teachings and speeches, contains a copy of Munger’s investing checklist. Munger got the idea from pilots who religiously use checklists to avoid errors.

Also, for years Buffett and Munger have discussed their basic investing filters or checklist:

   1. Is it a good business?
   2. Does it have a durable competitive advantage?
   3. Does it have capable, honest management?
   4. Is it available at a good price?

The idea of investing checklists took on renewed interest as a result of the recent financial crisis as bloodied investors did post-mortems on their dismal performance and searched for tools and insights that might help them do better going forward. One source of insight was an article by Atul Gawande in The New Yorker, “The Checklist”, that showed how a simple checklist could make an enormous impact on outcomes in both simple and complex life-threatening medical procedures. Gawande went on to develop the article into a book, The Checklist Manifesto: How To Get Things Right, that expands his ideas and includes a discussion of how checklists are used by investors Monish Pabrai and Guy Spier.

At the 1998 Berkshire Hathaway annual shareholders meeting, Buffett and Munger discussed another of their basic investment filters - opportunity cost – and how they use it. (1)

Munger explained that if you have the opportunity to purchase an investment that is better than 98% of all businesses, then you can use it as a filter to automatically eliminate the other 98%. Munger conceded that it’s a simple idea and wondered aloud why it has not been more widely imitated because 1) Berkshire Hathaway was proof that it worked, 2) if practiced it tends to lead to a concentrated portfolio (which Buffett and Munger believe is the rational way to invest), and 3) it saves you a lot of time because you can quickly eliminate investment ideas that aren’t in the top 2%.

Buffett went on to explain it this way. Whenever they look at a possible investment, they immediately compare it to Coke, which Buffett views as about as perfect an investment as you will ever find. Coke not only has superior economics and growth prospects far into the future, but also its future prospects are highly certain.

Buffett puts a high premium on certainty. According to Buffett, when you invest you are trying to peer into the future. With many, if not most businesses, it’s either impossible or fraught with uncertainty. With a few businesses, however, if you do your homework, you can develop real and rational conviction about their future prospects.

If a prospective investment does not pass Buffett’s “Coke” or “Gillette” (Gillette was purchased by P&G in 2005) test, he’s unlikely to buy. Buffett went on to say that CEO’s should apply the same filter when sizing up an acquisition. If it doesn’t pass the “Coke” test, Buffett asks why not buy stock in Coke or repurchase shares in their own business? According to Buffett this would have prevented a lot of unsound deals.

This is a simple, yet powerful, filter that you can put to use immediately.

(1) Berkshire Hathaway annual meeting, 1997, Outstanding Investor Digest, August 8, 1997, p. 15.

Gregory Speicher is an Ohio-based investor. His career has primarily been in technology start-ups and small growth companies, including an Inc. 500 Company which he cofounded. He also holds several patents. He received his bachelor's degree in philosophy Magna Cum Laude from the University of St. Thomas in Rome, Italy, and attended the MBA Program at the Wharton School of the University of Pennsylvania. He has attended Professor Bruce Greenwald's Value Investing Executive Education Course at Columbia University and continues to read and study widely in the field of value investing. Visit his website: GregSpeicher.com

From gurufocus.com published on Aug. 04, 2010