Warren Buffet – The Snowball

Learn how the world’s most successful investor did it (and how you can too).

Warren Buffett is arguably the most successful investor of all time. He has been averaging approximately a 20% growth of his capital per year, which has turned his small fortune of a thousand bucks in the early 1940s, into quite an outstanding one of 86 billion as of 2018.

His complete focus on investing can't be overstated.

He always tried to save a buck in order to grow his capital faster, not interested in real estate, art, cars, or any other tokens of wealth.

In this summary, we will cover the top 5 takeaways of The Snowball: Warren Buffett and the Business of Life, written by Alice Schroeder.

Takeaway 1: The power of compounding income

Imagine that you recently started a new job.

During your first day, you work for 8 hours and at the end of the day your manager gives you $100.

The next day, you go back and you get ready for another 8 hours of labor. After 7 hours and 50 minutes, your manager goes over to you, gives you $100 and asks you to leave for the day.

You're slightly confused, but don't complain about being able to quit 10 minutes earlier.

On day 3, the procedure is repeated – only this time your manager gives you a hundred bucks after 7 hours and 40 minutes.

On day seven, when your manager hands over your salary after only 7 hours, you feel that you must ask what all this is about.

Why do you keep earning the same amount, but with less effort?

Your manager simply gives you the following explanation: "Because you worked yesterday!"

This example illustrates the power of compounding income.

Money comes easier and easier the more you have of it, or as in our example, the more that you've worked previously.

Warren Buffett understood the importance of this at an early age when he was presented with the book "1000 Ways to Make a Thousand Dollars".

He was fascinated by one of the business ideas of the book, which was to buy weighing machines.

You get paid by taking out a small fee every time someone wanted to use the machines.

Once you've gained enough money from weighing people with the first scale, you can now buy a second one, and earning money for the third one will go twice as fast!

Warren Buffett used this approach early in his life, but the business consisted of pinball machines, not weighing machines.

In this, he also discovered the miracle of capital – money that works for its owner.

He used the power of compounding income to his advantage in forming his first investing partnership – Buffett Associates.

The deal was that he would gain half the upside, above a 4% gain, but pay a quarter of the downside to his partners.

By turning his company Berkshire Hathaway into an insurance company, Buffett has been using compounding to his advantage for many years now. You see, insurance premiums are always paid before the actual claims might come, which gives Buffett plenty of time to compound the money before an eventual payout.

According to the saying: If someone dropped a dollar, the average billionaire wouldn't bother picking it up, because the money gained from doing so is less than what he usually earns during such a timeframe.

Warren on the other hand, would gladly pick it up and state: "This is the start of my next billion!"

That's the power of compounding.

Takeaway 2: Be very skeptical of new paradigms

"New paradigm. It's like new sex – there just isn't any such thing!"

In 1999, just before the dot-com bubble went burst, people spoke about a "new paradigm" when referring to the stock market. Many expected returns averaging 20% per year, and they thought that Buffett was crazy who didn't want to buy the hyped up internet stocks.

Buffett was VERY skeptical, and explained that there are only 3 cases in which high valuations like these ones could be motivated:

  1. Interest rates are low and will continue to be so, or decline even further.
  2. The share of the economy that goes to investors increase. In other words, employees and the government get less.
  3. The economy starts to grow faster.

He added that during the current circumstances, this was wishful thinking.

The market is a voting machine in the short run and a weighing machine in the long run. There's no literacy test that leads to voting qualification, which the market proves over and over again.

But eventually – weight will count.

Ultimately, the value of the stock market can only reflect the output of the economy.

Between 1964 and 1981, the Dow Jones Industrial Average stood still. At the same time though, the economy grew fivefold!

Why would investors pay the same price for something that generates 5 times the money? Well, simply because they thought that the rules of the game had changed in 1964 – and they paid a high price for thinking so.

Herd mentality makes it easier said than done to be skeptical when we enter into bubble-like valuations.

It's simpler to go through life as the echo – but only until the other guy plays a wrong note.

You are neither right nor wrong because people agree with you – you are right because your facts and reasoning are right.

During times of wacky valuations, it helps to be guided by an "inner scorecard" rather than an "outer scorecard".

Consider this: would you rather be the world's greatest lover, but have everyone think that you're the world's worst lover?

Or would you rather be the world's worst lover, but have everyone think that you're the world's greatest?

If you would pick the previous option rather than the latter one, you are guided by an inner scorecard, which is very helpful in resisting to participate in the madness that the market sometimes displays.

Takeaway 3: Stay within your circle of competence

According to the story: A man was able to corner the market of shoe buttons – a very small and niche market, but he had all of it.

Once he had accomplished this, he imagined himself as the expert of basically everything! While among his friends, he always knew best. Whether they were discussing relationships, love making, health, or, or any other topic for that matter.

Because of his expertise in one area, he thought he was a master of everything.

Warren Buffett and Charlie Munger, his right-hand man, referred to this as the "shoe button complex".

Buffett attributes much of his success to the fact that he was able to avoid this, and instead stay within his circle of competence – money, business and his own life.

For instance, Buffett could have pursued his grandfather's dream of becoming an author, but did not.

Within the field of investing, this is especially important.

Buffett explained it like this: "We will not go into a business where technology – which is way over my head – is crucial to the investment decision. I know about as much about semiconductors or integrated circuits as I do of the mating habits of the "Chrzaszcz".

You are investing in business, not a stock.

Remember this well and see to it that you understand what kind of company you are actually buying.

This could mean that you want to focus on industries aligned with your education.

For example – a medical students might want to invest in health care and pharma stocks, while an electrical engineer might want to focus on the energy sector.

This could also mean that you want to invest more of your money in your domestic market, or companies exposed to your domestic market, as you understand the business environment there better.

Takeaway 4: Use a margin of safety

Let's pretend that you're a construction engineer. You've been assigned with the task to build a bridge. The bridge is a very complex one, especially the calculations regarding the carrying capacity.

You've been told that the trucks passing your bridge sometimes will weigh as much as 40 tons.

Will you build a bridge so that your calculations say that it supports 40 tons, or 60 tons?

If you picked 41 tons, this could be a possible scenario:

You made a small mistake in your calculations. So your bridge could only carry 38 tons in reality. Now this really heavy truck tries to drive across it …

Not so nice, right?

Sure, this could happen if you try to build one which supports 60 tons as well, but the risk is reduced.

Let's face it – our estimations when trying to predict the future of a stock or often … wrong.

Therefore, we need plenty of room for error – a margin of safety.

If you think that a stock is worth $50, you don't buy it if it also costs $50 in the market.

In this situation, you might want to wait until the stock costs $40 instead, assuming that you still think its value remains the same at that point, of course.

Warren Buffett understood this early, thanks to his teachers Benjamin Graham and David Dodd.

The margin of safety helps so that your profits from good decisions are not wiped out by the losses of your errors.

A certain category of stocks that fulfills the margin of safety, which Buffett liked to invest in during his early career, are the so called "cigar butts".

These are cheap and unloved companies. They aren't the best ones, but they're often good for one more "puff".

Buffett learned this approach from Graham as well.

He looked for companies that will be worth more dead than the current price of the stock.

Meaning that, if all the assets of the company was sold and it closed, the shareholders would earn a profit.

For such a company, the operating business is essentially free!

Buffett never abandoned this approach of a marginal safety.

This is also why he could stay ahead during many of the most speculative bubbles in the market.

If he couldn't find companies that fulfilled his criteria – he stayed in cash.

He didn't join the herd when it was heading for the slaughter that is the peak of a bull market.

Takeaway 5: Invest where there's a toll bridge

Graham had taught Buffett to be a true value investor and focus on cheap and disliked stocks.

In 1959, when Buffett met Charlie Munger for the first time, this would partly change.

Munger was more focused on the competitive advantage of a firm over time.

The idea with the "toll bridge" is that once the initial investment is made, (building the bridge), the tolls can be increased in a monopoly like fashion – because there's no other simple way of receiving a similar solution for the customers (getting to the other side of the bridge).

At one point Buffett and Munger actually owned 24% of a bridge which connected Detroit In The US and Windsor in Canada.

With such a business, you could be stranded on a deserted island for years without having to worry about your investments.

Buffett summarized it in this statement:

It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.

Let's look at examples of toll bridges (otherwise known as moats):

Moat 1: Brand

Coca-Cola has, through its brand, secured profits for many years ahead.

Even if someone would manage to create a better tasting soft drink than Coke, they need to spend billions in advertising to be a threat.

Moat 2: Network effects

All social media platforms are great examples here.

YouTube and Facebook become more and more valuable for each individual user, the more users there are on the platform.

It wouldn't be so fun on YouTube without any content creators, right?

Therefore, a new entrant in the market, which by definition must be small in the beginning, can't deliver the same value, and therefore never gets a chance to grow.

Moat 3: Switching Costs

When customers face high switching costs, changing from company A's product to competing company B's product, company A tends to be a good investment.

Such an example is the enterprise software company SAP.

Its products take significant time, effort and money to learn.

So once you understand them, you don't want to start all over by switching to the product of another company.

Moat 4: High set up costs

If it takes a significant amount of money just to serve the first customer, competitors usually hesitate before entering the market.

Railroads and electrical grids are great examples.

Setting up a second rail, or a second grid next to the already existing one is a game of very, very high stakes.

Warren Buffet: The Snowball Recap

In this summary, we covered the following ideas:

  • The power of compounding income – you money will work harder and harder for you over time
  • Be very skeptical of new paradigms – don't get greedy just because others are greedy
  • Stay within your circle of competence – if you can't understand the business, you would not know what the strengths (more importantly, the weaknesses) are.
  • Use a margin of safety – this is so you can err on the side of caution
  • invest where there's a toll bridge – what competitive advantage does the company have? Here are some of the more common toll bridges:
    • brand – people will default to the brand they trust
    • network effects – the more people are using it, the less likely that they would want to leave
    • switching costs – when it becomes really hard to switch because of how complex things are
    • high set up costs – when it costs a lot of money to compete, competitors will not want to get involved.

Our Thoughts at More Money Malaysia

Warren Buffet is a huge role model for what we believe is possible for the everyday person.

He is able to have such amazing returns, beating pretty much the whole world, and his team is just a small group of people compared to all the banks and their dozens of traders.

The only challenge is that if you would like to be like him, you will need to be willing to put in countless hours for at least one year to learn the basics of value investing.

But if you do put the time in to learn and practice value investing for the rest of your life, everything you want in life will be possible.

Action Steps

Now that you have an understanding of how Warren Buffet became so successful, here is the only next steps.

Step 1: Determine whether you will spend the time required to learn value investing.
Learning value investing will take hours each day for the next year before you are ready to invest like a pro.

Are you willing to put that time in or would you rather spend your time doing other things?

If you are interested in learning value investing, then go through all our videos around investing and start reading the books.

Otherwise, invest using robo advisors (such as Stashaway or Wahed) or by yourself with index funds.

This is what Warren Buffet has told everyone to do, and is also what will happen to his wealth once he dies.