Bud Labitan just shared with me part of his new book, The Four Filters: What I learned from the Invention of Warren Buffett and Charlie Munger. He describes his book as a short read that can easily be read on a quick plane ride. The book goes into the “amazing invention” that Warren Buffett and Charlie Munger created to guide their investment decisions. I could go into describing the book more thoroughly, but Bud was kind enough to allow me to reprint the final chapter of this book. Here it is for your own review.
CHAPTER FIVE OF FIVE: SUMMARY
As significant as the refinement of the microscope by Antonie van Leeuwenhoek, I believe that Warren Buffett and Charlie Munger invented an investing formula that is underappreciated by the business and academic communities. In my view, the Four Filters developed by Warren E. Buffett and Charles T. Munger is an amazing intellectual achievement in both practical and Behavioral Finance. The Four Filters are a remarkable and important set of steps used by the world’s greatest investors. The Four Filters function as an effective time-tested focusing formula for investing success. They serve as a very useful guide for assessing intrinsic value and sensible price.
Behavioral Finance and Common Sense have shown us that we all have human tendencies to frame ideas that are affected by our emotions. Ideally, we would use the best of our emotional and intellectual energies in the right way. In my view, the Four Filters reduce the risk of investment failure by helping us steer a better path to a quality bargain.
Charlie Munger has spoken about the merits of having a “pilot’s checklist.” This is something I did not appreciate until I studied the Four Filters. These days, Warren Buffett mentions the Four Filters this way: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.” These Four Filters can enhance the probability of our investment success. I think they will help you in your search for intrinsic value and sensible investment.
In the 1985 Chairman’s letter to Shareholders, Warren Buffett wrote that his advantage was attitude. The 2007 annual letter shows Buffett in top form, buying quality bargains. He learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Along the way, he and Charlie Munger got better at picking stocks and whole companies for investment. Their experience and an expanded knowledge base helped them look for understandable first-class businesses with enduring competitive advantages. Philip Fisher and others have influenced their views on evaluating first-class managements and evaluating a business’s growth potential.
Note however, that growth is only one component in assessing value. Through the conscientious process of Elaboration and Elimination, the Four Filters illuminate the most important factors for business and investing success. The Four Filters highlight and reveal the good prospects and eliminate the bad prospects for investment. They encompass four clusters that are vitally important to investing success: 1. Products 2. Customers 3. Management 4. Margin of Safety. In each of the four clusters, I can imagine the influence of Ben Graham, Philip Fisher, Charles Munger, and John Burr Williams. Business students can also imagine the ideas of Porter and Greenwald in these filters. In my view, the development of this Four Filters Formula has been an evolutionary process. And, by 1977, the Four Filters were being used like a “checklist” by our pilots, Warren Buffett and Charlie Munger. You can read about many of these influences in Andy Kilpatrick’s big comprehensive book, “Of Permanent Value: The Story of Warren Buffett.”
If Buffett and Munger had focused solely on the fourth filter, “Margin of Safety” from bargain prices, they would have still done well. However, used as a sequential set of filters, the Four Filters Formula is remarkably effective. It is an elegant algorithm that combines the use of important qualitative and quantitative decision steps. Warren Buffett has also phrased the Four Filter check points in this way: “When buying companies or common stocks, we look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price.”
From a historical point of view, the record at Berkshire Hathaway under Warren Buffett’s tenure speaks for itself. Over the last 43 years, Berkshire Hathaway’s book value has grown from $19 to $78,008, a rate of 21.1% compounded annually. Berkshire Hathaway A share is selling at around $140,000 at the time of this writing (March,2008). It’s intrinsic value per share is much higher. And, it’s future earning prospects look bright. Future investment managers will do well to practice owner-oriented business principles. I hope Future investment managers understand the effectiveness of this “Four Filter” Formula. If I was privileged to serve on this team, I would practice the Four Filters.
From a mathematical point of view, think of each stop along the Four Filters as a mutually exclusive and additive event. If a company passes a couple of filters, it is, by the process of elimination, farther to the right on a normal distribution curve. Of course, this filtering is from an “investment prospect” point of view. If this were a field of racing horses, movement along each step of the Four Filters path, the prospect enters a subset of “better than average” horse. In my view, practicing these steps will make you a better investment thinker.
From a practical point of view, business is about taking good care of your customer and arriving at an agreeable trade. Finding the company that has enduring competitive advantage means that you are finding a company that has been tested by time and its customers. Products, Customers, Good Management, and Financial Safety given by a bargain purchase are always important.
Working together, Buffett and Munger have produced a remarkable and effective Behavioral Finance formula. Within that Fourth Filter, Bargain Price, we see Ben Graham’s three most important words in investing, “Margin of Safety.” “Investing Safety” is practically insured by purchasing at a bargain price.
Pricing Bubbles, Market excesses, and Government excesses will come and go. Warren Buffett wrote that a different set of major shocks is sure to occur in the future and that he will not try to predict these nor to profit from them. However, if he can identify businesses similar to those he has purchased in the past, external surprises will have little effect on long-term results. Buffett said: “We will stick with the approach that got us here and try not to relax our standards.” In my own work, I will continue to use the Four Filters. In talking with students, Warren Buffett often uses this baseball analogy using the story of Ted Williams and his book: “The Story of My Life.” Buffett explained: “My argument is, to be a good hitter, you’ve got to get a good ball to hit. It’s the first rule in the book. If I have to bite at stuff that is out of my happy zone, I’m not a .344 hitter. I might only be a .250 hitter.” Charlie and I agree and (we) will try to wait for opportunities that are well within our own “happy zone.””
The Four Filters Formula helps to impose a greater prudence in our investment decision making. As significant as the refinement of the microscope, I believe that Warren Buffett and Charlie Munger invented an investing formula that has worked effectively over the last 31 years. The Four Filters will help you get closer to your own “happy zone.” It has helped me greatly in my own investment decision thinking and my own investment decision making. And, I hope it helps you as much as I think it will.
My first impression of this book is that it holds a lot of promise. I’ve never really looked at Buffett’s investment criteria as filters, but Bud’s take makes sense to me. I look forward to reading the whole book in the near future. Hopefully, it will be published soon. What are your thoughts on this future book?