The Physics of Warren Buffett’s Investment Strategy

 Takeaways

• Warren Buffett’s investment strategy is presented through the framework of physics

• Buffett’s First Principle of Investing: Buy Businesses

• Buffett’s First Law: Buy Wonderful Businesses at Fair Prices

• Buffett’s Second Law: Ensure an Enduring Moat and Long-Term Growth

• Buffett’s Third Law: Maintain Mental Stability

Warren Buffett, widely regarded as the greatest investor of all time, has generated exceptional returns over an unmatched period of 70-plus years. Like physical laws of nature, Buffett’s investment strategy has stood the test of time, as well as a multitude of major events including World War II, deep recessions and market crashes, and long-running bull markets and frothy bubbles.

In his Berkshire Hathaway annual shareholder letters, Buffett wrote extensively about his investment principles, laying the foundation of modern investing — buying long-term growth companies at reasonable prices. In this article, I will attempt to present Buffett’s principles through the framework of physical laws, starting with the first or foundational principle, followed by three laws of investing.

Buffett's First Principle of Investing: BUY BUSINESSES

If you Google "Warren Buffett's Investment Principles," you will find many different answers. Some articles give you three principles and others give you seven. ChatGPT presents a long list of 12 items. Several common ones are listed below:

• Invest for the long term

• Look for a quality business with a wide moat

• Invest in what you understand

• Have a margin of safety

• Don't worry about the economy

Reciting all of these when deciding whether a company is worth investing in is too complex a thought process. Is there one principle that stands out from the rest and is the most important one?

In Berkshire Hathaway's 2022 letter to shareholders, Buffett wrote: "Charlie and I are not stock-pickers; we are business-pickers." Reading this line was an epiphany for me. I believe this is the First Principle of Buffett's investment strategy. When I say it is the First Principle, I am not indicating that it is the first of many principles or even the most important one. What I mean is that, like a first principle of physics, "Buy Businesses" is the foundational principle that defines Buffett's investment framework.

In physics, a first principle is a basic law or proposition that cannot be deduced from any other proposition; all other laws can be derived from it. Newton's laws of motion, for example, are the first principles of classical mechanics. All other laws and formulas—such as the equations governing Earth's orbit around the Sun—are derived from them.

I am arguing that in Buffett's investment framework, all other "principles" can be derived from a single first principle: "Buy Businesses." Let's analyze each of the “principles” listed above.

Invest for the Long Term

If you are focused on buying businesses—whether owning the whole business or a significant stake—you will naturally orient yourself toward the business’s long-term prospects. You will ponder whether the business will thrive in 5, 10, or even 20 years. You will consider whether its products will remain in demand for the foreseeable future, and whether its business model will generate sufficient returns for your investment.

Will you buy a business and then sell it in three months with the goal of making a quick profit? As a business owner, the answer is definitely no.

Look for a Quality Business with a Wide Moat

To buy a business, you would certainly look for a quality one with good potential for future growth and profits, and a strong competitive advantage (or a “moat”) that protects it. You would prefer a business with a wide moat, creating a high barrier to entry for competitors.

Invest in What You Understand

When you are investing a large chunk of your net worth to buy a business, you would certainly want to understand it as thoroughly as possible—including its market, products, competitors, management, and financials. To buy a whole business, you would most likely be a seasoned participant in the same industry, with a deep understanding of the target company.

If you are working in the biotech industry, can you imagine investing 20% of your net worth into a semiconductor company you do not fully understand, even if its stock has been soaring and everyone around you is bullish on it? A thorough understanding of the company and proper due diligence are essential in any business transaction.

Have a Margin of Safety

Imagine you have $1 billion and can only invest it in one company. You would spend a great deal of time analyzing the company's financials, and you would want to negotiate the lowest price possible. You probably would also ask yourself: "If my analysis is off by 20%, will my investment be safe?" In other words, you would naturally seek as wide a margin of safety as possible.

Don't Worry About the Economy

As a business owner, if you think that your industry has a bright future and have a chance to buy out your main competitor in the same town at a bargain price, would you go for it, even when the economy is in poor condition? In this case, you would probably worry more about finding the funds than about economic conditions. You will likely only find this opportunity at a bargain price when the economy is struggling.

When you adopt the mentality of a business owner rather than a stock trader, you will have a fundamentally different perspective when making investment decisions. All you need to remember is Buffett's first principle of investing—"Buy Businesses"—and you should be well on your way to a rewarding investment journey.

Now that we know investors should focus on buying businesses, the question is “what businesses should we buy?”

Buffett's First Law: BUY WONDERFUL BUSINESSES AT FAIR PRICES

Early in Buffett’s career, he followed his mentor Ben Graham and focused on deep value stocks whose prices were below or near their book values. Buffett later called these stocks “cigar butts” — cheap but with only one last puff of profit left. With the influence of Charlie Munger, his long-time business partner, Buffett later shifted his strategy to buy long-term growth companies, even when the stocks were not cheap in Graham’s traditional system. With the purchase of growth companies like American Express, Coca-Cola, and more recently Apple, Buffett was able to achieve exceptional returns over decades, even after the size of his investment increased exponentially which made the “cigar butt” approach untenable.

In Berkshire Hathaway's 1989 letter to shareholders, Buffett wrote: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” The question now is: “What are wonderful businesses, and what are their fair prices?”

Buffett's Second Law: ENSURE AN ENDURING MOAT AND LONG-TERM GROWTH

In his 2007 letter, Buffett defined a wonderful company as having “an enduring ‘moat’ that protects excellent returns on invested capital.” As the main purpose of investing a company’s capital is to create growth and profits, I’d like to think that a wonderful business is one with a competitive edge that sustains above-average and profitable growth. Buffett’s long-time holdings — Coca-Cola, American Express, GEICO, and Apple — are examples of wonderful businesses. Each of these companies has its distinctive competitive advantage, including strong brand recognition, cost advantage (GEICO), and a user ecosystem (Apple), and each has demonstrated above-average and profitable growth for decades. Other successful businesses in this category include Microsoft, Amazon, Google, and Meta, among others. Research has shown that long-term shareholder returns correlate strongly with a company’s revenue growth. Buying and holding profitable high-growth companies has proven to be a winning strategy.

With wonderful businesses in our focus, the next question is what is a fair price?  Buffett did not provide a simple answer. He used the Discounted Cash Flow (or “DCF”) analysis but stated that he did not rely on any formula. First and foremost, Buffett wanted to make sure that the companies he invested in would thrive in the following 10 to 20 years.

In my opinion, having a simple quantitative analysis to determine whether a growth company is worth investing in is highly desirable for ordinary investors. There are thousands of publicly traded companies. Even when limited to those in one’s familiar industries, there are dozens if not hundreds. For investors who do not have the time to go through annual reports of each of these companies, a simple filtering tool is extremely useful to narrow the list down to just a handful before conducting deep qualitative analysis. Unfortunately, it remains a missing piece in Buffett’s investing framework.

The DCF analysis is too complex for ordinary investors to use. Research has also shown that DCF is very sensitive to input parameters such as future interest rates and terminal value. Other measures, such as the PE ratio and the PEG ratio, also have their limitations. The PE ratio, either the trailing ratio or the forward ratio, does not take into account the long-term growth prospects of a company. The PEG ratio, perhaps the most relevant measure, tends to be volatile as it relies on earnings projections. My own research based on mathematical analysis shows that profitable revenue growth is the most important factor affecting long-term shareholder returns. I will share my analysis in future research papers and blog posts.

Getting the fair price is only the starting point of determining whether you should invest in a company. As stated by Buffett, determining whether a company will sustain above-average and profitable growth in the next 10 years is the most critical factor. Buffett achieved this by staying in his circle of competence and thoroughly researching companies by reading annual reports. I believe investors should ONLY invest in companies they have a deep understanding of. In-depth and ongoing qualitative research is imperative to stay informed of where a company is heading. In addition, a thorough understanding of a company gives an investor confidence to hold onto its stock when facing price fluctuations and negative narratives.

Phil Fisher was a proponent of comprehensive qualitative research of companies. He called his approach “Scuttlebutt,” which involves talking directly to people at the company and its customers, suppliers, and competitors, among others. Nowadays, you can find most of the information online. While information is more easily available, qualitative research is time-consuming and includes reading quarterly earnings reports, listening to earnings conference calls, and keeping up with company news. I will share my thoughts on qualitative research in a future blog post.

Through quantitative and qualitative analysis of companies you understand, you can find long-term growth companies with a wide moat at fair prices.

Buffett's Third Law: MAINTAIN MENTAL STABILITY

After you have done the quantitative and qualitative research and bought shares in your target company, the real challenge has just begun. In order to reap the benefits of long-term compounding growth, you need to hold the stock for several years at the minimum. Holding a stock purchased based on value instead of price momentum requires extraordinary emotional control. Buffett said: “Investing is simple but not easy.” He also said: “It is a game where you are bombarded by minute-by-minute opinions. You do have to have sort of an emotional stability that will take you through almost anything. And then you'll make good investment decisions over time." During the holding period, you will encounter countless media articles, analyst reports, rumors, and family and friend discussions, many of which will be negative and disconcerting. Price declines and negative headlines, even when the business is strong and growing, can easily create self-doubt and give you an urge to sell the stock.

Holding a value stock whose price is stagnant or declining for a prolonged period can also be a lonely experience. You may become reluctant to share your holdings with others. You may be doubted, second-guessed, and maybe even laughed at for holding “losers.” You may be pressured by peers, online followers, or perhaps even your spouse to sell the losers. On the other hand, trading stocks with rising prices can make you feel good and more popular, as people agree with you and admire your “smart” judgments.

Jeff Bezos, the founder of Amazon, once asked Buffett: “… your investment thesis is so simple. Why doesn’t anyone copy you?” Buffett’s answer was: “Because no one wants to get rich slow.” Most people intellectually understand the logic of holding great businesses that produce compounding returns over decades, but emotionally they have trouble enduring the slowness of the process and the price volatility along the way. Buffett's answer essentially meant that the real barrier isn't intellectual — it's psychological. Holding stocks and adding to a position amid persistent price declines and negative headlines is extremely difficult and, in my opinion, contrary to human nature. Investing based on value is much more difficult than trading based on price charts, as it is a practice requiring not only a deep understanding of business and finance, but also exceptional independent thinking and mental stability.

Summary

Warren Buffett’s investment strategy is presented here through the framework of physical laws, with his first principle: Buy Businesses, and his three laws of investing: Buy Wonderful Businesses at Fair Prices, Ensure an Enduring Moat and Long-Term Growth, and Maintain Mental Stability. Instead of picking stocks, investors should focus on companies with competitive advantages that sustain above-average and profitable growth, buying them when prices are reasonable, and holding them for the long run. It is critical to stay in your circle of competence and thoroughly research companies to develop a deep understanding. The real challenge is to hold your investments, not being swayed by daily price fluctuations or other people’s opinions. Independent thinking and emotional stability are the most critical traits in achieving compounding returns from long-term growth companies.

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