Buffett's Five Risk Factors
In his 1993 Chairman's letter, Warren Buffett outlined five risk factors which should be evaluated with any investment:

  1. The certainty with which the long-term economic characteristics of the business can be evaluated;
  2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;
  3. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
  4. The purchase price of the business;
  5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.

#1 begs the question: why does the business have good economics**?** To answer this question, one must understand the industry structure, as well as the company's competitive advantage (i.e., why will it continue to generate excess returns over time?).
#2 points to the importance of capital allocation, a necessary input in any evaluation of management.
#3 addresses management's alignment and incentive structure, an often-overlooked aspect of investing. Humans naturally respond to incentives, so it's important that management be aligned with shareholders in this department.
#4 reminds investors of the number one rule of investing: don't lose money. One of the easiest ways to lose money is to overpay for an investment, particularly if one's emotional makeup is not conducive to holding through drawdowns.
#5 is interesting to think about, particularly in today's environment. Historically, the inputs in this area don't change frequently. A company's tax rate largely stays the same, and at least for the entirety of my life, we've experienced ~2% inflation. As inflation rises, however, investors' uncertainty about purchasing-power returns grows, contributing to the volatility we've seen in the market.

My solution to this problem? Focus on #1-4, and #5 should take care of itself. Good managers running good businesses for the long-term generally prove resilient through periods when #5 becomes the focus of investor attention.
Joshua Simka's avatar
Points 2 and 3, in their focus on management, are interesting to me. Didn't WEB at some point say that he prefers to buy a company so simple that a monkey could run it--because at some point, that probably will be the case? 1993 was almost 30 years ago and WEB has shifted his approach throughout his career. Wondering if what I'm recalling would have reflected his thought prior to this letter? Or more recently?
Invested Thought's avatar
@tomato I’m no Buffett expert in all honesty but I vaguely recall what you’re saying. I think his thoughts on a monkey running it may apply more to the simplicity of the business model, but again, I’m no expert on how his philosophy has changed. Thanks for reading!

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