In the 2008 shareholder meeting of Berkshire Hathaway, a shareholder asked Warren Buffett and Charlie Munger –

“If you could not talk with management, could not read the annual report, and did not know the stock price of the company, but were only allowed to look at its financial statements, what metric would you look at to help you determine whether you should buy the company?”

They replied –

Buffett: Well, what we’re doing in investment – and what everybody does – is we’re laying out money now to get more money back later on.

Now, let’s leave the market aspect of the asset out of it. When you buy a farm, you really aren’t thinking about what the market on it is going to be tomorrow, next week, or next month. You’re thinking about how many bushels of beans or corn per acre you can get, and what the price is likely to be. You’re looking to the asset itself.

And in the case you lay out, the first question you have to ask is, do I understand enough about thus business so that the financial statements can tell me the information that is useful to me to make a judgement about what the future financial statements are going to look like? And in a great majority of cases, the answer would probably be no.

But I’ve bought stocks the way you’re describing many times. And they were in businesses that I thought I understood where if I knew enough about the financial past, it would tell me enough about the financial future that I could buy. Now, I couldn’t say the stock was worth X or 105% of X or 95% of X. But if I could buy it at 40% of X, I would feel that I had this margin of safety that Graham talked about, and I could make a decision.

Most times, I wouldn’t be able to make it. If you hand me a bunch of financial statements and don’t tell me what the business is, there’s no way I can make a judgement as to what’s going to happen.

So unless I know the nature of business, the financial statements aren’t going to tell me much. But if I knew something about the business – or the product – and I just see the financial statements, I may be able to make that judgement.

But we’ve bought lots and lots of securities – and in the majority of the securities Charlie and I have bought, we’ve never met or talked to management. We’ve primarily worked off financial statements, our general understanding of the business, and the specific understanding the industry and the business we’re buying. Charlie?

Munger: I think there’s one metric we use that others should use more. We tend to prefer the business that makes so much money, that it drowns in cash. One of the main reasons for owning it is you have all of this cash coming in.

Buffett: It’s a lot easier to understand a business that’s bringing you a check every month…But I bought a lot of things off of financial statements. And there are a lot of things that I wouldn’t buy if I knew the management was the most wonderful in the world – because if there in the wrong business, it really doesn’t make much difference how good the management is.

This thought from Maugham holds a great relevance when it comes to picking up businesses for investment.

If you refuse to accept anything but a good/great business, you very often get it. That’s the reason so many investors around you, who just refused to do the hard work of picking up the best available businesses (at the right prices, of course!) are now stuck with several duds in their portfolios.

• Pick up a business with good economics and at good margin of safety, and the probability of making money in the long run is high.
• Pick up a business with poor economics with any margin of safety, and the probability of losing your shirt, and entire wardrobe, in the long run is very high!

Understanding a business also adds significantly to your margin of safety, which is a great tool to protect yourself against losing a lot of money.

Here is what Buffett wrote in his 1997 letter to shareholders…

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need.

If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.

In short, focus on the quality of the business you are looking to buy. Don’t over-stress on getting its financial picture and valuations right to three decimal places.

In fact, if you don’t understand a business and/or something looks difficult/problematic to you in the first few minutes of looking through it, you may completely ignore looking through its financial performance or valuations.

As Munger advises, it is better to remember the obvious than to grasp the esoteric.