Yesterday, we learned Warren Buffett is to make another acquisition for Berkshire Hathaway. According to reports, he agreed a deal to acquire insurance company Alleghany for $11.6bn in cash. In my view, the Berkshire CEO’s latest buy perfectly illustrates his approach to investing for those like me who want to copy it.
Circle of competence
The most important part of Buffett’s strategy involves sticking to what he knows. Alleghany’s insurance operations are closely connected to Berkshire’s existing operations (and Buffett claims to have been following the company for about 60 years) so the business is one that is within what the Oracle of Omaha calls his ‘circle of competence’.
For me too, investing like Warren Buffett means only buying shares in companies whose economics I can understand. For example, if I want to buy Rolls-Royce shares, I need to know that about 41%of its revenues come from civil aviation. I also need to understand what the costs of switching away from Rolls-Royce engines are for a manufacturer. And I need some idea of how the company’s exposure to titanium imported from Russia matters in the current political climate. That is staying within my circle of competence
Intrinsic value
Buying a company below what the Oracle of Omaha calls intrinsic business value is also important. The deal to buy Alleghany represents a price per share of $848. This is significantly higher than the company’s previous price of $677 a share. But Buffett takes the view that the price of the Alleghany deal represents a discount to the company’s intrinsic value. Importantly, the fact that the market was pricing Alleghany shares lower doesn’t influence his view of the company’s intrinsic value. Markets reflect what people are prepared to pay for a company, according to Buffet, not what the company is worth.
Figuring out the intrinsic value of a company is a matter of working out how much cash the company will produce over time. Exactly how to do this varies from business to business. But let’s take BP as an example. Establishing BP’s intrinsic value involves working out how much oil the company will produce, how much it will be able to sell that oil for, and what it will cost to extract it. Having figured this out, I can buy it when the company’s shares trade at a price below this valuation.
Patience
Lastly, Buffett’s Alleghany investment highlights the importance of being patient and waiting for opportunities. The last major Berkshire Hathaway acquisition was around six years ago. To the frustration of some, the company’s cash pile had grown to around $140bn before recent investments in Occidental Petroleum and Alleghany. But patience is an important part of Buffett’s approach to investing.
Being selective is an important part of echoing his approach. This means only taking the best opportunities that are available. If a suitably attractive opportunity isn’t available, then the Oracle of Omaha waits until it is. There will always be another opportunity, but it’s important to be prepared to take it when it comes around.
