How Warren Buffett Used Probability Analysis for Investment Success

Warren Buffett considers one basic principle, elementary probability, the core of his investing philosophy. From selling papers to running the multi-billion dollar Berkshire Hathaway, he has successfully leveraged his assets decade after decade, amassing an armada of wealth-producing companies.

Combining this with a logical understanding of business operations and a value orientation learned from Benjamin Graham, Buffett is by far one of the best—and most well-known—investors of all time.

There are a variety of investment styles to choose from. Warren Buffett has become known as one of the savviest investors by using a simple approach. Buffet’s elementary probability approach keeps his investing analysis simple: he focuses on transparent companies with a wide moat that is easy to understand and logical in their progression.

However, Buffett is also known for his deep value approach which he perfected through his study and work with Benjamin Graham. His value approach combined with a simplified understanding of companies limits the investable universe for Berkshire’s portfolio to companies with low P/Es, high levels of cash flow, and sustained earnings.

The confluence of his investing style has also helped him to identify the winners and losers among emerging trends. One example is the green technology sector where Buffett has openly proclaimed he has a high capacity for new investments. The sector is broadly emerging across the globe with over 60% of new energy investments coming from green tech. As of June 2018, Buffett’s stake in the sector has mostly been through his subsidiary Berkshire Hathaway Energy but he is also, likely to add to this sector in the equities portfolio as well.

It took Warren Buffet some time to evolve the right investment philosophy for him, but once he did, he stuck to his principles. By definition, companies with a durable competitive advantage generate an excess return on capital and their competitive advantage acts like a moat around a castle. The “moat” ensures the continuity of excess return on capital for the company because it decreases the probability of a competitor eating into the company’s profitability.

Warren Buffett began applying probability to analysis as a boy. He devised a tip sheet called “stable-boy selections” that he sold for 25 cents a sheet. The sheet contained historical information about horses, racetracks, the weather on race day, and instructions on how to analyze the data. For example, if a horse had won four out of five races on a certain racetrack on sunny days, and if a race was going to be held on the same race track on a sunny day, then the historical chance of the horse winning the race would be 80%.

As a young man, Buffett used quantitative probability analysis along with “scuttlebutt investing,” or “the business grapevine” method that he learned from one of his mentors Philip Fisher, to gather information on possible investments.

Buffett used this method in 1963 to decide whether he should put money into American Express (AXP). The stock had been beaten down by news AmEx would have to cover fraudulent loans taken out against AmEx credit using salad oil supplies as collateral.

Buffett went to the streets —or rather, he stood behind the cashier’s desk of a couple of restaurants—to see whether individuals would stop using AmEx because of the scandal. He concluded the mania of Wall Street had not been transferred to Main Street and the probability of a run was pretty low.

He also reasoned that even if the company paid for the loss, its future earning power far exceeded its low valuation, so he bought stock worth a significant portion of his partnership portfolio, making handsome returns selling it within a couple of years. Through the years, however, Buffett has continued to hold American Express as a part of Berkshire Hathaway’s portfolio.

In 1988, Buffett bought $1 billion worth of Coca-Cola (KO) stock. Buffett reasoned that with almost 100 years of business performance records, Coca-Cola’s frequency distribution of business data provided solid grounds for analysis. The company had generated above-average returns on capital in most of its years of operation, had never incurred a loss and posted an enviable and consistent dividend track record.

Positive new developments, like Robert Goizueta’s management spinning off unrelated businesses, reinvesting in the outperforming syrup business and repurchasing the company’s stock gave Buffett confidence that the company would continue to generate excess returns on capital. In addition, markets were opening overseas, so he saw the probability of continuing profitable growth as well. To date, this has been one of his most simple, elegant, and profitable investments.

In the early 1990s amid a recession in the U.S. and volatility in the banking sector over anxiety about real estate values, Wells Fargo (WFC) stock was trading at a historically low level. In his chairman’s letter to Berkshire Hathaway’s shareholders, Buffett listed what he saw as the pros and cons of taking a large position in the bank.

• A major earthquake, which might wreak enough havoc on borrowers to in turn destroy the bank’s lending to them.
• The possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.
• [And the fear] that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

On the pro side, Buffett noted that Wells Fargo “earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank’s loans—not just its real estate loans—were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even. A year like that—which we consider only a low-level possibility, not a likelihood—would not distress us.”

In retrospect, Buffett’s investment in Wells Fargo in the early 90s has been one of his favorites. He has added to his holdings over the last decades, and as of the third quarter of 2018, Berkshire held 442 million shares.

Elementary probability, if learned well and applied to problem solving and analysis, can work wonders. Buffett combines this with a value-oriented approach to valuation and analysis that has proven to be successful over many years. Although there is an infinite amount of information regarding investment choices, Buffett has proven time and time again that his probability approach is one that truly shines.