Last week, I described the arithmetic that has made Warren Buffett the world’s richest man.  The magic of compound interest over four decades, based on steady investment outperformance and a frugal lifestyle, has transformed a modest sum into an extraordinary fortune.  But the larger question is not the arithmetic, but the business economics.  What is the secret of Buffett’s investment success? 

Buffett is often identified as the heir to his mentor, Benjamin Graham.  Graham emphasised intelligent investment based on fundamental value.  But in Graham’s day, the ability to read a company balance sheet made an investor intelligent.  Many trading companies sold in the market for much less than the realisable value of their assets.   As Graham recognised by the time of his death in 1976, these days are over.

Buffett’s central achievement was to recognise earlier and more clearly than others that these balance sheets no longer had their old meaning.  Once, large business organisations found their rationale in the ability to finance and operate large industrial plants – such as the textile mills that were once Berkshire Hathaway’s principal activity.  The returns to shareholders were the reward for providing the buildings plant and machinery.

Today we have capitalism without capital.  Most large companies do not make things, they provide services. Few businesses own the premises in which they operate.  You probably don’t know who owns the desk you sit at or the computer you use, and it doesn’t matter anyway.  Returns to shareholders are no longer payments for the use of their plant but rewards to risk and shares in economic rents. The capital investors put into the stock market does not now finance productive investment, but buys a share of established streams of earnings.

Buffett made a mistake in taking control of Berkshire Hathaway.  But his first major investment coup, in American Express, recognised that the company did not just possess a legendary brand name.  The market position the company had created was very difficult to replicate.  For a customer there is little point in having any travellers’ cheque other than the most widely accepted, and American Express was the most widely accepted.  The company had leveraged its brand into another market – plastic cards – with similar characteristics.

Not only were intangible assets important, but their irreproducibility determined their long run value. The defensive qualities of American Express’s moat, as Buffett would call it, gave the stock exceptional value.  

Buffett’s biographer reports a complaint from young Warren: his friends the Russells derived only noise from the traffic passing their house.  ‘What a shame you aren’t making money from the people going by’.  The schoolboy demonstrated a probably unhealthy obsession with business, but also an early recognition that you needn’t control an entire activity to profit from it.  You don’t need to own the road, only the toll booth on the traffic artery.  The brand, the business systems and the customer and supplier relationships were the business analogue of the point that all vehicles must pass.

So the Buffett empire focussed on  businesses with market positions that could not be replicated.  Disney, with its inimitable repertoire.  The Washington Post and local newspapers and broadcasters with local dominance.  Businesses whose powerful consumer brands – Coca Cola, Gillette – not only commanded consumer recognition but were entrenched in distribution systems.  

American Express had a secondary advantage which would also become a Buffett theme.  People paid for cheques up front, and cashed them later, if at all, so the business generated a float on which the corporation could earn returns.  Just as there could be assets without capital, so there could be cash without assets.  The concept of float led Berkshire Hathaway into the insurance business, Graham’s central idea – that market prices varied by more than fundamental values and often independently of them – was as relevant there as in stock markets.

Buffett’s success demonstrates the weakness of one economic theory – the efficient market hypothesis.  And the strength of another – the central role that the pursuit and defence of economic rents in modern corporate life.  Still, the first view remains much more popular amongst economists than the second. And so Warren Buffett became the first man in economic history to parley an economic disputation into great personal wealth.