I recently re-read two interviews with Alice Schroeder (#1, #2). Schroeder is the author of The Snowball: Warren Buffett And The Business Of Life. This is the only authorized biography of Buffett so Schroeder got unprecedented access to Buffett and his files.

Buffett is a prolific writer and does his best to explain the principles he used to build Berkshire. The problem is asking Buffett to explain how he built Berkshire is like asking a fish to explain water. This is where Schroeder comes in. She spent over 2,000 hours studying Buffett at his side. In doing so, she noticed that what he says is not always what he does.

Buffett preaches classical value investing. These are the principles he learned from Ben Graham and which Graham and Dodd laid out in Security Analysis and later in The Intelligent Investor. This school of value investing rests on three core beliefs:

- A security is a partial ownership in a business.
- Mr. Market is your servant and not your master.
- Always invest with a margin of safety.

Schroeder argues that Buffett uses three related-but-different principles:

- Focus on compounding.
- Think like a horse handicapper.
- Always invest with a margin of safety.

**Focus On Compounding**

Einstein supposedly said:

- “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
- “Compound interest is the most powerful force in the universe.”
- “Compound interest is the greatest mathematical discovery of all time.”

Einstein was impressed by compound interest because it is an exponential function. This is a function where a number (one plus the rate of return) is raised to a variable exponent. In the compound interest function the exponent represents time.

As time passes even a small rate of return will compound into a large sum. Consider the purchase of Manhattan from the indians. In 1626 Peter Minuit purchased the island for the equivalent of 60 Dutch Guilders. This is estimated to have the same purchasing power as $1,050 U.S. Dollars in 2015. In 2014 the total value of Manhattan, including all improvements, is estimated to be $1.4 trillion. Peter Minuit got a great deal, right?

This implies a 3.7% compound annual return. But the stock market has averaged a 7% annual return, net of inflation, since our earliest data. The modern stock market wasn’t around in 1626, so let’s say Mr. Minuit could only have earned a 5% return. If he had, his $1,050 would be worth $175 trillion in 2015. So the Dutch gave up about $174 trillion by buying Manhattan.

The moral of the story is that compound interest, even on small amounts of money at low rates, can produce staggering sums if left alone for a long time.

Schroeder said:

Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that.

15% is a high rate of return, especially in today’s low-rate environment. Yet it isn’t impossible. At a 15% rate you will double your money every 5 years. Over a lifetime this will produce unimaginable sums.

**Think Like A Horse Handicapper**

Handicapping is all about expected value: the odds of winning times the payout for winning minus the odds of losing times the potential loss. Making money at the track is not as simple as picking the fastest horse. The fastest horse may have the highest odds of winning, but will also have the lowest potential reward and highest potential loss. The fastest horse is not always the best bet, nor is the slowest always the worst. This is what Howard Marks means when he says “There are no bad assets, only bad prices.”

When Warren is handicapping something he first asks:

What are the odds that this business could be subject to any type of catastrophe risk—that could make it (the business) fail?

Anything times zero is zero, which means that an investment that goes to zero wipes out all prior compounding and prevents any future compounding. Investors need to avoid zeros at all costs. Buffett doesn’t want to waste time thinking about anything that could go to zero, because if it can happen someday it will.

When Buffett finds something without catastrophic risk he tries to focus on the 1-2 factors that are most important. Schroeder writes:

In going through hundreds of his files, I never saw anything that looked like a model. What he did is he did what you would do with a horse….he figured out the one or two factors that determined the success of the investment. He relied totally on historical figures with no projections.

**Always invest with a margin of safety.**

The purpose of a margin of safety is to render a forecast unnecessary.

A margin of safety is always dependent on price paid. Almost any asset becomes a good investment at a low enough price. Think about buying a rental property. If the current tenants pay $1,000 per month and you can buy it for $50,000 it’s obviously a good deal. You don’t need an Excel model or detailed population growth statistics to know that. But if you need to pay $300,000 or more it’s not immediately obvious if it is a good deal or not.

As a rule of thumb, if you can’t see the margin of safety doing the math in your head with rounded numbers, it’s not wide enough.

Investing with a margin of safety is the most important aspect of investing because it links compounding with handicapping. The bigger and more obvious the margin of safety, the lower your odds are of taking a zero and interrupting compounding. A wide margin of safety means you don’t have to be an ace handicapper and get the future probabilities exactly right.

Questions or comments? Email matt@eaglepointcap.com

This is not a recommendation to buy or sell any stock mentioned. I do not have a position in any stock mentioned unless otherwise noted in this post. Do your own research: you are accountable for your own returns. Please read my full disclosure