Warren Buffett: Why You Should Never Look At PE Ratios

Key Concepts

• Intrinsic Value vs. Price: The fundamental worth of a business compared to its market price.
• Qualitative Analysis: Evaluating a company based on non-numerical factors like management quality, competitive position, industry trends, and brand strength.
• Competitive Advantage (Moat): A sustainable structural advantage that allows a business to protect its long-term profits and market share.
• Business-centric Investing: Approaching stock purchases as if acquiring an entire private business, focusing on its long-term prospects and operational realities.
• Cumulative Knowledge: The accumulated understanding of various industries and companies gained over decades of observation and experience.
• Skepticism of Macro Forecasts: A deliberate disregard for broad economic or market predictions when making investment decisions.
• "New Normal": A term referring to a potentially altered economic environment with different growth rates or returns compared to historical averages.
• Replacement Value: The cost to replace an existing asset or business, often used to assess the underlying value of infrastructure-heavy companies.

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Investment Philosophy: Beyond Financial Ratios

Warren Buffett and Charlie Munger emphasize that their investment decisions are not based on precise financial ratios like Price-to-Earnings (PE) or Price-to-Book Value (PB). Instead, their primary focus is on forming a confident judgment about "what the company might look like in five or 10 years" and identifying a significant disparity between its intrinsic value and market price.

Charlie Munger explicitly states that they "don't know how to buy stocks just by looking at financial figures and making judgments based on ratios." While some data might influence them, a deeper understanding of "how the company actually functions" is paramount. They do not use computer screens to filter for low PE or low PB stocks. Their approach is to evaluate businesses "exactly like we'd look at them if somebody came in and offered us the entire business."

This qualitative approach acknowledges the difficulty in predicting the future for many companies. For instance, after observing the auto business for 50 years, they admit they "don't know how to foresee the future well enough" to confidently pick long-term winners. Conversely, they express a "high degree of competence" in predicting the competitive advantage of companies like Burlington Northern 15 years from now, but would "never have that degree of competence about Apple no matter what their financial statement showed," due to the inherent difficulty and rapid changes in such industries. Similarly, they are "virtually 100% confident about a Burlington Northern or a Geico" but not about an oil company's prospects a decade out.

The Primacy of Qualitative Understanding and Cumulative Knowledge

The speakers argue against the common tendency, especially among mathematically inclined individuals, to seek a system based purely on numbers. Buffett asserts, "It's not that easy. You really have to understand the company and its competitive position and the reasons why its competitive position is what it is. And that is often not disclosed by the math." While acknowledging the foundational principles learned from Ben Graham—viewing stocks as businesses and maintaining a sound attitude toward the market—Buffett states he would manage money "poorly" if solely relying on numbers.

Their investment mindset is crucial: "We are buying businesses," whether it's 100 shares or the entire company. This perspective is supported by their "cumulative knowledge of a good many industries and a good many companies." They highlight that the importance of various financial numbers differs depending on the type of business. For example, a basketball coach would have a "prejudice" against a 5'4" player, even if skilled, because certain physical attributes (like height, "seven-footers") are generally more critical for that sport.

They also recognize their limitations, concluding that they "can't make an intelligent analysis out of about all kinds of businesses." Investment ideas often emerge from "some little fact" that causes them to rethink something. Buffett recounts the Bank of America preferred stock offer, clarifying that it wasn't a sudden "bathtub idea" but the culmination of over 50 years of following banks, reading books like "Biography of a Bank," and prior experience buying banks in the late 1960s. This illustrates that there is "not one size-fits-all" approach; different considerations apply when buying a bank versus an insurance company or a brand-dependent company like Coca-Cola (a "terrific example" of a brand that "travels very well").

Disregard for Macro Forecasts and "New Normal" Discussions

Buffett and Munger explicitly state that they "don't pay any attention to macro forecasts," such as predictions about future market returns. Over their 54 years of working together, they cannot recall a single investment decision based on a macro discussion. They believe that if they don't know what the future holds in a precise way, "nobody else knows" either, and spending time on such unknowable topics is "not very productive."

While Buffett maintains a general feeling that "America will continue to work well," he dismisses the constant stream of opinions about short-term economic outcomes, stating, "nobody knows." He contrasts this with what they do know with "a very high degree of certainty": that Burlington Northern Santa Fe (BNSF) will carry more carloads in 10 or 20 years, that there will be "no substitute" for their service, that there will be two important railroads in the West and two in the East, and that these railroads possess assets with "incredible replacement value" for which they will be "paid fairly." To "ignore what you know because of predictions about what you don't know" is, in their view, "just plain plain silly."

They find discussions about a "new normal" or "old normal" meaningless for their investment strategy. Buffett advises that "people will do very well owning good businesses if they don't pay too much for them," holding them for long periods (10, 20, or 30 years). Attempting to "time their purchases in some way by listening to forecasts" will primarily benefit their broker, "not so well for themselves."

Munger's Nuance on "New Normal" and Capital Deployment

Charlie Munger adds a nuanced perspective, acknowledging that Berkshire Hathaway, with its "lot of money," "have to do something with it," and will continue to invest "no matter what the external climate is." However, he suggests that for individuals, macro forecasts might hold more relevance. For example, a "busy surgeon" contemplating retirement might "rationally" be interested in the "new normal" to inform their decision to work "an extra couple of years."

Regarding his own view on the "new normal," Munger believes future returns will be "less than we've enjoyed in our lifetimes," and it's "quite a conceivable outcome" that they could be "worse than the average in the last 10 years."

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Synthesis and Conclusion

The core message from Warren Buffett and Charlie Munger is a powerful endorsement of deep, qualitative, business-centric investing over purely quantitative screening or reliance on macro-economic forecasts. They advocate for understanding a company's long-term competitive position and intrinsic value, leveraging extensive cumulative industry knowledge, and focusing on what is knowable about a business rather than speculating on broader economic trends. While they dismiss macro predictions as unproductive for investment decisions, Munger acknowledges their potential relevance for individual life planning and offers a more conservative outlook for future market returns compared to historical averages. Their philosophy underscores patience, a long-term horizon, and a profound understanding of the underlying businesses being acquired.