So you wanna know the secrets of Buffett’s investing success? Who doesn’t.

Most of the books out there are great for picking up on the important stuff regarding the financial qualities Buffett seeks in a company - profit margins, high return on equity, low debt, hefty cash flow, etc. But there’s a problem with just about all of the information out there: It tries to distill Buffett’s investing prowess into a formula that anyone can use by plugging in numbers. But it’s far from that simple.

When I had the great fortune of meeting Mr. Buffett, he said he does not place nearly as much emphasis on the financial elements of a company as he does the qualitative factors. And for all the stress everyone places on precise DCF analysis, Charlie Munger quipped at a Berkshire Hathaway meeting that he has never seen Buffett run one.

Obviously, the financials matter. They ultimately drive the value of the business. But there are more important considerations that must be taken into account before they mean anything. That is, a company which looks good from a numbers perspective may be of little interest to Buffett. Thus, the logicians might say that strong finances are a necessary, but not sufficient, condition for investment.

So what are the important considerations, and how does Buffett evaluate them? If we can answer this question, I contend, we get “the secret.”

Well, it’s no surprise that Buffett is seeking companies with “durable competitive advantages” and which are run by honest and capable management. He’s gone on record countless times saying this. And to this end, Berkshire’s acquisitions and stock purchases seem to verify the truthiness of Mr. Buffett’s not-so-secret claims. He ain’t hiding anything here.

But how does one find and evaluate these competitive advantages? And how does one evaluate management?

As for the latter, I’ve already written on evaluating management here. So no need to reinvent the wheel. On to competitive advantages…

Many companies that are household names have competitive advantages that are obvious and which we’re all aware of. Coca-Cola has an indestructible brand name and high customer loyalty. Microsoft has a huge market share with its Windows operating system. Google is the king of internet search and its Google Adwords a virtual necessity for online advertisers. Wal-Mart can undercut any competitor with absurdly low costs. The Altria Group sells an addictive product, sporting the ultimate form of customer retention, with a strong brand in Marlboro and Parliament to boot.

But not all competitive advantages are as obvious. What kinds of advantages does Buffett look for, and how does he spot them? There are several prospects we can consider:

1) Brand name – a company with a recognizable and trusted brand can count on important benefits. Products with brand names can be placed right next to generic competitors, command higher prices, and STILL sell in higher volumes. Just ask Advil. Normally priced at a premium to the generic Ibuprofen bottles that flank it, it sells a lot more at nearly any drug store.
2) High switching costs – This is sometimes, but not always, closely related to a strong brand name. When a company or its product has some unique quality that leads to intense consumer loyalty or makes it difficult for consumers to switch to another company’s product, they benefit from “switching costs.” Trying to get Windows users to switch to a new operating system when they are so intimately familiar and used to Windows is no easy task.
3) Superior Product – Some companies just know how to provide a better product or service than others. Google’s search is simply superior to others’. Internet users have quickly come to realize that.
4) Intellectual property – Patents can bestow temporary, legal monopolies upon a company. Pharmaceutical companies can rely heavily on this advantage, which enables them exclusive rights to sell a product for a period when no others can.
5) Economies of Scale – This refers to the advantage a company can get when it leverages size to obtain lower costs for itself. Wal-Mart is a classic example. By buying in HUGE amounts from suppliers, it can obtain tremendous volume discounts, passing these on to customers in the form of low prices.
6) Unmatched human capital – The people behind a business are absolutely crucial to the business’ success. In some cases, the people running and/or staffing a business are so incredibly good at what they do that they bestow a competitive advantage upon their companies. Berkshire Hathaway, with legendary investor Warren Buffett at the helm, is one such example. Goldman Sachs, with its ability to attract the top minds in the world, is another.
7) Government granted monopolies – Sometimes, the government regulates an industry and one or two companies obtain monopolies that prevent others from entering the business. Utilities are a common example. And Buffett has invested in them before (think MidAmerican).
8) Huge fixed costs – A company may get itself a “natural” monopoly if it has very large startup costs, which would prove prohibitive for any competitor to try to duplicate. For instance, network television used to have such an advantage. After a huge initial investment in the infrastructure, the company would profit as it had little ongoing (marginal) costs.

Now, anyone who knows anything about Buffett knows that he would not invest in Google or a pharmaceutical company. This is partly because he does not understand them and partly because he wouldn’t rely on something like patents as a durable competitive advantage (after all, they’re not durable). Our next questions, then, are 1) what does it mean for him to “understand” something (after all, Buffett’s not a dumb man) and 2) what makes the competitive advantage durable and, hence, appealing to him?

Well the first question is often misconstrued but has an easy answer. When Buffett claims to understand something, he means he understands it almost 100% and can say with virtual certainty what the company will look like in ten or twenty years. It’s not that Buffett is out of touch and doesn’t know what a computer or a prescription drug is. He may have you think that in jest, but, as Bill Gates has said, he knows their businesses, opportunities, and challenges quite well. Yet, and here’s the key, he does not have any advantage or insight into how the will perform in ten years due to the fickleness of their industries.

The second question is a bit tougher to answer. What makes a competitive advantage durable? How does Buffett know? Again, some of these are obvious. For instance, Wal-Mart won’t have many competitors able to duplicate its success anytime soon.

Here the discourse gets a bit fuzzier, Buffett’s analysis (at least my claim of what it is) becomes a bit less concrete, and, heroically, Charlie Munger enters the scene.

I personally believe Munger’s influence at Berkshire and on Buffett’s thinking goes, regrettably, unsung. Very unsung. If Munger hadn’t been around, Buffett arguably would not have gained an appreciation of buying great businesses rather than cigar butts. Munger helped make Berkshire’s returns phenomenal, while allowing for scalability that could not have otherwise been achieved. In other words, Berkshire could never have been scaled to its huge size by purchasing cigar butts — there aren’t enough of them, and the returns are not “continuing” (i.e. when they reach fair value, there’s no further upside. You must sell it and move on). Berkshire, therefore, needed to invest in great businesses that it could hold on to.

But I digress. Back to Munger and durable competitive advantages.

Charlie Munger is a staunch proponent of a type of interdisciplinary model of thinking in which one draws on the accumulated wisdom of many different disciplines (including, but certainly not limited to, psychology, physics, biology, economics, etc.) and understands how they interact. This “latticework” of mental models ultimately becomes worldly wisdom. And it is a structure for thinking, solving problems, and, yes, finding investments.

Why is this important for Buffett? Because he runs Berkshire this way. He manages people this way. He finds investments this way. And it is a tool for determining what is a durable competitive advantage. An example would probably help.

In Poor Charlie’s Almanack, a great read that I highly recommend to anyone, Munger gives a talk in which he poses the hypothetical problem of how to turn $2 million into $2 trillion in less than 150 years. Thus he begins the “fictional” proposition that he and his partner, Glotz, create a non-alcoholic beverage. But to make this worth $2 trillion, generic won’t do. So they create a trademark and brand: Coca-Cola.

The story continues as Munger and Glotz figure out how to make this work. Key, they know, is human psychology. For instance, they must get customers “classically” and “operantly” conditioned to drink this beverage. That is, customers must associate the brand with positive things so as to create positive Pavlovian mental associations. They must also be “trained” so to speak, to reach for the beverage when they see the brand and the beverage must maximize rewards while minimizing the possibility that reflexes are extinguished. And, since they need a huge market share, the brand must be ubiquitous and lots of people must be conditioned in this way. But for this to work, of course, and so as not to risk competition with others, the drink must be available anywhere and at anytime. This all starts to create what Munger calls a “lollapalooza effect” — an outsized result coming from a combination of factors working together.

So they create an exotic-sounding, good-tasting, stimulating drink and advertise it heavily. But that’s not enough. They think in reverse (an important skill, says Munger) and avoid the things they shouldn’t do. They know every drink must taste the same and that they must avoid changing the flavor, because they cannot afford to lose or extinguish the conditioning they have achieved. So they guard their secret recipe, protecting their creation and adding to the allure of the product. Of course, if all goes according to plan, they will create a durable competitive advantage. Even if, say, some crazy competitor (Pepsi, anyone?) comes along and takes some market share, Coke will still be so ingrained in culture and human psyches that it can remain dominant and valuable as ever. And even if the flavor can be duplicated to perfection by someone else and priced lower, no one would overcome the powerful psychological effects and the indestructible brand of Coca-Cola. So the advantage is durable.

This is all how the plan played out in real life and Coke, no doubt, has done pretty well and should continue to do so. Naturally, it doesn’t take a genius to realize that Coke has competitive advantages. And clearly, not every opportunity can be analyzed exactly like Coke. Each durable competitive advantage is different. So understanding why something (like Coke) has advantages can shed light on how to think about less obvious opportunities. Learning how Buffett and Munger think is far more important than learning what they think.

To truly understand a durable competitive advantage like Buffett and Munger, I believe, requires a thought process uncommon amongst investors, or, for that matter, anyone. And most importantly, Buffettologists, if you will, should stop trying to turn Berkshire’s investment strategy into a quantitative formula, because that misses the whole point. So what does one need to do to start thinking like Buffett and Munger? Here’s my top five list. Be forewarned, it requires work and it cannot be turned into a formula (sorry!)…

1) Read. Alot. Draw from different disciplines. See and appreciate how they interact and what they can learn from one another. One who pigeonholes disciplines goes through life, as Munger has said, as a one-legged man in an ass-kicking contest.

2) Know about human psychology. Understand what motivates people, why and how they misjudge things, and start to change your own biases (and yes, you do have them).

3) Think in reverse. Working through a problem forwards is usually not enough. One must think backwards (not to be confused with backward thinking). For instance, always ask “what should I not do here?”

4) Question everything. Know the “why” and “why not.”

5) Know what you know. That’s not a tautology. It means to define clearly your circle of competence. Humans typically have trouble knowing when they do and do not truly understand something. Be sure you truly understand something before investing in it. Don’t be afraid to say “I don’t know.”

Hopefully, I’ve given you some insight into my own thoughts on the methods of Mr. Buffett and Mr. Munger. Unfortunately, talking the Warren Buffett talk is easier than walking the Warren Buffett walk. And it simply cannot be turned into some quantitative screen or simple checklist. After all, why should it be that easy?

Some of you are probably aware that I’m not the biggest fan of what academia teaches investors about the stock market and finance.

But I had the pleasure recently of sitting in on my brother’s finance class at Fordham University taught by Dr. Frank Werner. During the class, Dr. Werner instructed students on the intuition behind the Capital Asset Pricing Model and, in general, did a darn good job of teaching (and my brother can’t say enough how great a teacher he is). But that’s not what grabbed my attention.

I spoke with Dr. Werner after the class about one of the (arguably many) problems of CAPM. I’ll try to avoid being too technical here, but for those familiar with CAPM, I believe there could exist omitted variable bias in a regression performed on a portfolio with the market. That is, while CAPM tries to determine the correlation of a stock with the market, the variance accounted for in the error term might be omitting the stock/portfolio’s effect on the market. In other words, factors “local” to a stock could actually have an impact on the market, meaning that a single variable regression just won’t do.

Think of it this way: say you take a portfolio of the 10 or 20 largest stocks. While CAPM tries to correlate these with the market, it may miss the point that something like Wal-Mart’s same-store sales or Exxon-Mobil’s profit margins or any host of local factors can actually have an impact on the market. This would lead to what statisticians call “omitted variable bias.” So what would need to be done to tweak CAPM is a multiple variable regression that “separates” these factors out and includes them along with the “macro factors” assumed to be independent of the stock(s).

This is certainly not a groundbreaking discovery on my part, and some folks have been running this sort of analysis for a while. Dr. Werner and I share an appreciation for the importance of looking at a business as a business and not a piece of paper driven by macro-factors. This means that the variables that should be looked at are those unique to the business rather than the market as a whole. CAPM just doesn’t cut it in this regard — so if academia insists on trying to find correlations and measuring risk as covariance, betas aren’t enough.

And what Dr. Werner is working on (and I believe he’s on to something important), is studying the less tangible factors, like a company’s adoption of green technologies, for instance, and how these affect performance. I personally believe we’re in the midst of a paradigm shift where companies who do things like treat employees very well, adopt environmentally friendly policies, “give back” to their communities, and invest in brand-building through social responsibility will be rewarded with a bigger bottom line. Some investors may still balk at the idea of a company spending money on things that don’t seem to be an immediate value-add, but I can’t wait to start seeing some results in academia that demonstrate the quantitative benefits of these policies.

I applaud Dr. Werner and his colleagues who are working on improving the inherent limitations of Modern Portfolio Theory and I await the day when Wall Street and academia both drop their myopic views of stocks as ticker symbols with little more than betas and quarterly expectations. Okay, maybe that last part is wishful thinking, but you get my point.

I continue to receive a flurry of comments and emails regarding the INVESTools, Inc. post. I wanted to make some important clarifications:

1) I am not actually recommending a naked short position on SWIM. You’ll note from the opening statement and the paranthetical note in the article that I personally never short stocks. It’s risky business, and my regular readers are aware and my new visitors should know that I never really advise it. It was largely for “effect” in the post, and I should have made that clearer from the start. My apologies.

2) I am not claiming that INVESTools is necessarily a scam. In fact, I make the assumption in the post that it isn’t a scam, and try to argue that a “proven formula” still couldn’t sustain itself for long. Very few people have really responded to this argument. Furthermore, the main take away point from the discussion should be this: Either the company’s educational programs are a ripoff (since no program could actually fulfill the promises made in that infomercial) OR the company is using questionable marketing tactics. So one way or the other, the company is doing something wrong.

3) I am not calling into question the ethical fiber of the company’s management. Lee Barba and Tom Sosnoff have both posted responses on the comments section that deserve to be read and heard clearly. I do not, and you should not, victimize them or call into question their standing as reputable businessmen.

4) The post no where mentions that the ThinkorSwim platform is a scam or ripoff. My arguments are referring to INVESTools educational programs, not TOS.

So, what would it take to really prove that INVESTools is worth it? What do I need to see to eat crow and concede?

I’ve gotten responses from a number of folks who say they have not done so well with INVESTools. Others have said they do remarkably well with INVESTools. My hat goes off to them. One common theme amongst these folks is (not surprisingly) that much of their success is due to hard work and dedication. Several readers have, therefore, likened INVESTools to a college education — you get what you put in, it doesn’t guarantee success but helps, etc. I’ve already mentioned that I find this analogy misguided.

Earning a degree from an accredited University is an important and rewarding life experience, that any return on investment cannot fully capture. You grow, you learn, you experience, and many don’t even pay the tuition just to earn a bigger paycheck. Nonetheless, at the end, you at least have something (a degree) that makes you statistically more competitive in the job market (just look at any regression on wages and college education). So in that sense, at least college has data backing up its efficacy.

Some have gone further and used my own school, Yale, as a comparison. Yale, in particular, does have data about its average student that I took from a friend who works in the development office, which is quite impressive and from a purely monetary standpoint (which I think is a foolish way to evaluate a university, but that’s neither here nor there) it appears to be well worth the tuition: the average graduate from Yale 20 years out of graduation makes enough to put them in the top 1% of American households — so the average Yale grad can expect to be in the 1% income bracket by the time he or she is 42.

Here’s the honest to God catch, though. Even this doesn’t say much because correlation does not imply causation. Are students who go to Yale more likely to be successful because of Yale, or because of themselves? Is there a text-book self-selection bias? That’s a similar dilemma to INVESTools. The only difference is that INVESTools can do a controlled study to prove causation! A university, for practical and ethical reasons, can’t (and probably shouldn’t).

So for me to be convinced of INVESTools’ value, I would need to see two things:
1) That the average/median graduate (who uses the system the right way) beats the market over time
2) A controlled study showing that students performance improved because of INVESTools (that is, that they would not have done as well on their own).

You should note that it is not enough just to say that the average student makes money or that INVESTools leads students to perform better than they otherwise would have if this still means they underperform the market. The average graduate needs to beat the market net of all INVESTools fees and tuitions for the program to be worth it. Otherwise, INVESTools adds little value for the typical student, since most would be better off simply dropping money into an index fund, saving time, cash, and headaches. It is also necessary to demonstrate these results over time. Otherwise, results may simply be a “fluke” and/or the “proven systems” may not be sustainable through time (that is, they’re just “quick profits”). It is also not sufficient to say “well, some people make a lot, so that justifies it.” There can be aberrations in a sample size of 250,000+ graduates, and on the tails of any normal curve will be highly successful investors. What matters is the mean and the median over time, net of fees, and because of INVESTools.

Thus, I’ll extend a second challenge to the company (in addition to the first to allow me to try the product for myself, which has not been taken): Show me the results of an independent, controlled study that indicates your students perform statistically significantly better than the market AND do better than they otherwise would have.

I’ll then proceed to extol the glories of INVESTools and shut up.

(But the infomercial still needs to go…)

So the response to the SWIM piece has met with a very animated response on both sides judging both by the comments and my inbox. I wanted to take the time to post Mr. Lee Barba’s response on the front page, as well as my own counter. Mr. Barba is the CEO of SWIM, and writes the following:

“Joe,

I am the CEO of Investools (NASDAQ: SWIM). We have built our business since 1983 with a focus on the individual investor and providing them the education and service they require to make better investment decisions. Over 265,000 individual investors have graduated from our Foundation and Continuing Education Workshops and Home Study programs and we have provided our proprietary education content to the leaders in media and online financial services, currently including Yahoo! Finance, BusinessWeek Online and Forbes.com.

We recently acquired thinkorswim, the #1-rated online broker in the most recent Barron’s ranking, a #1ranking they received for the second year in a row. We have over 650 employees located in New York, Chicago, Salt Lake City and Palo Alto who are dedicated to the development of the leading financial services technology, risk analytics and online education services in the marketplace.

While we respect your right to state your opinions about the investment prospects of SWIM, we are offended by your uninformed comments about our Company and our products. We invite you to attend one of our events and use our products so that you can reach an informed conclusion regarding our commitment to provide the individual investor with the service, analytical tools and institutional-quality data and information to make better investment decisions….we look forward to seeing you in one of our classes and on the thinkorswim platform.

Lee Barba, CEO, Investools Inc.”

In response to Mr. Barba and the other posters, I counter:

“Wow, some very strong comments here and on the “Avoiding the Charlatans” board.

Allow me to respond. First, note that my comments are directed to the educational products, not the integrity of the company’s management or, for that matter, the quality of the brokerage. Second, if it is true that INVESTools products are legitimately educational, then the marketing of said products absolutely must change, for your, your shareholders’, and your customers’ good.

The tactics used and (potentially misleading) statements made on that infomercial are downright ridiculous. Trying to tell consumers that riches await them without needing any money to start, without taking on substantial risks (and don’t dare tell me options trading is not risky), and without doing much more than “following the red and green arrows” sounds nothing short of a get-rich-quick scam to me.

Most commenters have noted that I am not familiar with the products, and that they are truly and legitimately educational tools. Thus, they say, I have no basis to make claims about the product or the company, and doing so is unprofessional or unfortunate. I offer a response and a challenge:

It is true that I have not tried the products, but please tell me what I should think about the legitimacy of the product given a) how it was marketed and b) the numerous complaints from customers who remark that either:
1. The product simply doesn’t work
2. They never recouped their initial multi-thousand dollar investment into the education, and when they asked for a refund were pushed off
3. The product offers nothing beyond what is already available free of charge on the internet
4. The only way for the product to work is to use it in ways that diverge from the company’s directions
5. The company is too focused on selling the next thing rather than their student’s success.

I think that the relatively low percentage of BBB claims doesn’t really say too much, for two reasons. First, many customers go a long, long time before saying something formally to the BBB and, of course, many never do so at all (they just don’t think of it or rather not be bothered!). And few folks who simply feel they’ve paid too much for a product will complain to the BBB. Second, there has been at least one comment by a user (on another site) who remarks that the BBB itself did not return calls or file his complaint. So not all complaints are captured by this statistic, and it may in fact dramatically understate how many people are underwhelmed by the product.

So, it seems either the product is illegitimate and/or not worth its price (that is, a ripoff), or, at the very least, it’s marketed in an extremely questionable manner, misleading consumers and making outrageous claims. So no matter how you look at it, the company is doing SOMETHING wrong, and this is simply a logical truth. Mr. Sosnoff, with all due respect, a single infomercial can say alot about a product and a company. In fact, if I’m not mistaken, that’s what it’s intended for! No? And furthermore, if you read my opening statement and follow my blog as my readers do, you would realize that I never recommend naked short positions.

Finally, the challenge: Mr. Barba and Mr. Sosnoff, you have both invited me to try the product for myself. As you can probably guess, I will not pony up thousands for it. But I am more than willing to try out the product to judge its legitimacy if the company is so willing to get a brutally honest review from a big skeptic. If it turns out that I’m wrong, and the product does make me bundles, I’ll share with my readers the wonderful products, and rescind any negative posts about the company.”

Mr. Barba and his colleagues deserve a chance to be heard in a full rebuttal. Also, please note (and this is important): the original post was in no way a comment on the integrity of the management and employees of SWIM. It is a comment on the product and the infomercial, and a “logic” argument why products claiming Black Box type investing success as they do on the infomercial cannot sustain themselves. I am more than happy to personally test their products and offer an honest review, as you see from my comments above…

So I never really short stocks, but I’m sitting here with the flu watching the tube (no, not YouTube — good old-fashioned television), and for the last 20 minutes I’ve been really tempted. It’s not because the flu has gone to my brain and driven me mad, it’s because an infomercial for a product called INVESTools, whose parent company is publicly traded, is driving me mad.

The company is making absurd promises (see “Avoiding the Charlatans“) that students who attend their seminars and use their pricey software will destroy the market in no time. Some of the testimonials even make claims of outrageous 800%+ profits in just two weeks! The software and “education” is based on a system of just “following the red and green arrows” that indicate by technical signals when to buy and sell.

That’s it. No research, no bothersome accounting to learn, no money to start, no problems!

At this point you probably know what I’m going to say: if this isn’t a scam, it’s at best a massive ripoff. And in the long-run, you can probably make a bundle shorting the company (note, though, I’m not actually recommending you do this, and I myself never do).

In case you’re not convinced right off the bat that something like this is bonkers, allow me to convince you. First, as I’ve argued in the past, technical analysis (especially “systems” using these special, mass-marketed, cookie-cutter strategies) are almost always bound to failure. But I’ll bite my lip on this, and save it for a different place and time. Instead I’ll make the ridiculous assumption that the system does work, and show why it just ain’t sustainable.

Even in the extremely unlikely case that the “system” did make its students a ton of money, like any trading system, the returns one could garner would disappear when everybody does it. That’s just part of the game. All good things must come to and end. Ask hedge fund gurus like Steve Cohen, who himself admits that opportunities become scarce when everyone is in on it. And, trust me on this, if there is some elegant system like this that actually works for an extended period, you can count on the hedge fund folks to find it and trade it away before INVESTools does. So the product seems bound to mediocrity or failure.

Furthermore, the way I understand it, INVESTools’ students often spend upwards of $10,000 on seminars and software and what they actually “learn” is not stock trading, but actually option trading. Right off the bat, this should scare anyone who knows anything about options. They’re not exactly easy money. It’s a bit frightening that this company is teaching the average Joe (and yes, when it comes to options you can include this Joe on the list) that this is somehow safe and guaranteed money (and yes, they are saying that).

Worse still, the web is littered with disgruntled students who never made a dime and whose attempts at a refund prove futile. It seems only a matter of time before this fad, to put it nicely, comes to an end.

From an operating standpoint, the company has grown the top line dramatic over the past few years. And its cash flow is strong, despite mounting accounting losses (which are mostly a function of the fact they collect the cash for services up front, but book revenue over the course of the subscription, leading to a large deferred revenue line item). The stock trades for around 20 times the TTM cash flow.

Nonetheless, with the basically-bound-to-fail product, I have trouble seeing any sustained growth, and would be surprised to see much of anything at all in a few years when everyone catches on that the product just isn’t worth it. I encourage anyone who has used the product to share your thoughts, and I hope that any bulls would share their take.

Earlier this week I had the pleasure of answering Geoff Gannon’s 20 Questions. If you’re interested in my responses, check the post out here. I admire Geoff and his work, and encourage you to check out his blog regularly for some great insights.