Buffett’s 2-Step Stock Market Strategy

02Step One: Hunting for Truly Exceptional Businesses

Finding a stock to buy is incredibly easy, but finding a truly exceptional business is an entirely different endeavor. Step one of Buffett’s strategy is elegantly simple in theory but requires a sharp eye in practice: you must find a wonderful business. In his early years, Buffett actually practiced a different style of investing known as the "cigar-butt" method. He would look for terrible, failing companies that were selling so cheaply that buying them was like finding a discarded cigar on the sidewalk—it might be gross, but it had one good, free puff left in it. While this method made him some money early on, it was exhausting and ultimately unscalable. It was his brilliant business partner, Charlie Munger, who convinced him to change his philosophy to the one that would eventually build his massive fortune. Munger advised him to forget about buying fair businesses at wonderful prices, and instead focus purely on buying wonderful businesses at fair prices. What exactly makes a business wonderful? A wonderful business is one that essentially runs itself, generates massive amounts of cash, and does not require constant, massive infusions of capital just to stay afloat. Consider the story of See's Candies, one of Buffett’s most famous acquisitions. When Buffett bought See's Candies in the early 1970s, it was a beloved West Coast chocolate maker. The beauty of See's Candies was not just that the chocolate tasted good; it was the financial mechanics of the operation. People loved the brand so much that they were willing to pay a premium price for it every single Valentine's Day and Christmas. The company did not need to invent new, expensive technology every year, nor did it need to build massive new factories constantly. It simply kept making the same delicious chocolates, raising prices slightly every year to match inflation, and sending mountains of cash back to Omaha. When you are hunting for an exceptional business, you want to look for simplicity. If a company’s business model is so complex that it takes a PhD in advanced robotics or biotechnology to understand how they make money, Buffett suggests putting it in the "too hard" pile and moving on. You want businesses that are easy to comprehend. Think about a company that sells razor blades, carbonated beverages, or chewing gum. You know exactly how they make money, and you can reasonably predict that ten years from now, people will still be shaving, drinking sodas, and chewing gum. This predictability is the holy grail of step one. Furthermore, an exceptional business must have competent and honest management in place. As an investor, you are handing your hard-earned money over to a group of executives you have likely never met. You want to ensure these people treat the company’s money as if it were their own. Danial Jiwani points out that you can often gauge the integrity of management by reading their annual letters to shareholders. Do they admit their mistakes openly, or do they bury their failures under layers of corporate double-speak? Do they explain their business decisions in plain, simple English, or do they hide behind confusing jargon? Honest managers who love their business are a crucial ingredient in the recipe for a wonderful company. Another hallmark of a wonderful business is pricing power. This is a concept that truly separates the mediocre from the magnificent. If a company can raise its prices without losing its customers to a competitor, it holds an incredibly powerful position in the market. Think about your favorite brand of smartphone. If the company raises the price of the newest model by fifty dollars, are you going to abandon the entire ecosystem and switch to a competitor? Probably not. You will grumble, but you will pay the premium. That is pricing power. On the other hand, if a company that makes generic white t-shirts raises its prices by a few dollars, you will instantly buy a different brand because a white t-shirt is fundamentally a commodity. You want to own the businesses that dictate the prices, not the ones that are at the mercy of them. Ultimately, hunting for an exceptional business is like looking for a strong, sturdy castle. You want a castle built on a solid foundation, governed by a wise king, and capable of withstanding the inevitable storms of economic recessions, changing consumer trends, and aggressive competitors. But simply having a strong castle is not quite enough in the brutal world of corporate warfare. To truly ensure that your exceptional business survives and thrives for decades to come, that castle needs a defense system. It needs something to keep the invading armies at bay while the business continues to generate wealth. This critical defensive mechanism is the secret sauce of long-term investing success, and understanding how it works will completely change the way you look at the companies around you.

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