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Buffett's Five Risk Factors
In his 1993 Chairman's letter, Warren Buffett outlined five risk factors which should be evaluated with any investment:
- The certainty with which the long-term economic characteristics of the business can be evaluated;
- 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;
- The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;
- The purchase price of the business;
- 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.
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