Buffett's Secret Influence

Philip Carret introduced quality investing in 1930 — Buffett’s quality evolution can be viewed as a return to Carret’s teaching  — The investment philosophy Buffett popularized has been in use for 95 years.

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BUFFETT'S SECRET INFLUENCE

In 1930, Philip Carret wrote “The Art of Speculation,” laying the foundation for nearly every active manager’s investment philosophy, including Warren Buffett’s.

Buffett’s pivot to quality investing is considered an epiphany that led him away from his Graham & Dodd value investing roots. In reality, he was familiar with this style from his early interaction with Carret. Analyzing Carret’s investing tenets foreshadows Buffett’s philosophical evolution.

Buffett & Carret

During the morning session of the 1995 Berkshire Hathaway shareholders meeting, Buffett lauded Carret for his contribution to the investment world. According to Buffett, Carret has “the greatest long-term investment record in this country’s history...anybody that can get Phil to talk to them, listen carefully. I advise that.”¹

Buffett also noted that he had gotten in touch with Carret in 1952 after learning of his early track record at the Pioneer Fund. This was after Buffett’s time at Columbia Business School, but before he joined Graham-Newman. Notably, this was seven years before Buffett met Charlie Munger.

Philip Carret likely planted the seed that evolved in Buffett’s exceptional philosophy.

Carret The Compounder

Carret had an early appreciation for the value of a business’s retained earnings. In 1930 this remained a novel concept. First written about by Edgar Lawrence Smith in his 1924 publication “Common Stocks As Long Term Investments,” investors were only beginning to value stocks based on earnings as opposed to dividends.

Beyond simply appreciating stocks over bonds, Carret grasped the truly differentiated returns retained earnings could generate. Carret provides what is potentially the earliest reference to a compounding stock noting “the holder of the stock of a profitably managed company is favored by the law of compound interest no less than the savings bank depositor.”^{2, 3} Buffett clearly leaned into this approach after his quality pivot.

In addition, Carret identified that higher quality companies should earn higher valuations, unlike Graham’s approach that largely ignored business operations. Carret analyzed the basic functions of a business from first principles, asking “what does the manager of a business do?”

His answer: “[The manager] controls men, materials and money, seeking to handle them in such a way that the business will produce a profit.”⁴ These tenets, “Men, Materials, and Money” provide an early framework for the quality investing we know today.

Men And Women

Carret believed people were essential to the success of any business. In other words, Carret identified leadership, business culture, and capital allocation as key determinants of future performance.

Buffett adopted this approach in some of his early investments. His longstanding friendships with Katherine Graham, Tom Murphy, and Lorimer Davidson demonstrate Buffett’s appreciation for top tier management.

Materials Are The Moat

Carret identified that specific attributes of a business determine its quality, not simply the industry in which it operates. “In analyzing stocks, industrial or otherwise, the speculator must constantly bear in mind that no two companies are strictly comparable.”⁵ Carret believed some businesses were objectively better than others.

Carret’s view was more innovative than it appears at first glance. This was a time when buying any stock that wasn’t a dividend paying railroad or utility was considered pure speculation. Carret notes that “the speculator of the generation between the Civil War and Spanish War had practically no industrial stocks as vehicles for trading.”⁶ Industrial stocks were a new concept and generally not to be recommended by reputable brokerages.

But Carret ignored conventional wisdom. To Carret, the “materials” controlled by a business—facilities, brands, trade secrets, land, licenses, relationships, etc.— ultimately determined its quality.

Carret highlighted the need to evaluate a business based on the state of competition in the industry, relative size of the business in comparison with competitors, and the business’s prospects for long-term growth. This competitive focus is an early attempt to find an economic moat.

A moat, of course, is nothing more than protection against competition. In the same meeting that Buffett acknowledged Carret, he admits “the most important thing...is we’re trying to find a business with a wide and long-lasting moat.”¹ Carret had identified the importance of competitive protection almost 60 years prior.

Money

Prior to the publication of Security Analysis, Carret had already identified valuation as a key criteria in selecting stocks. Carret believed in evaluating the long-term prospects for a particular business and, as a “speculator,” was willing to pay for this future performance. This process foreshadows Buffett’s approach after he moved beyond the “net nets” of Graham.

The “money” component of Carret’s philosophy was broader than valuation though. Carret appreciated a strong balance sheet and recognized that high debt levels were “a condition dangerous to owners.” This risk-averse approach has also been adopted by Buffett.

Nothing Ever Changes

Traditional wisdom suggests that Graham invented value investing while Buffett and Munger added the focus on quality franchises and long-term compounding. In reality, Carret had identified, and written about, these concepts before Buffett even joined the buyside.

A new look at Buffett’s philosophy shows that the seeds of quality investing were likely planted by Philip Carret. Through this lens, Buffett’s evolution could more aptly be described as a pivot from Graham to Carret, instead of a grand epiphany. In the investment world nothing is ever new, this time is never different, and, for at least the last 95 years, the secret to success has been hiding in plain sight.

Sources & Notes:

1 Berkshire Hathaway 1995 Annual Meeting Transcript

2 Art of Speculation, Philip L. Carret, 1930 (Page 353)

3 Carret also provides an example to highlight the exponential power of reinvestment. “If the $2.50 surplus earnings can be reinvested at 13%, earnings per share in the following year, other conditions being equal, will be increased by 32 cents. Carry out this program for five years and the per share earnings would theoretically increase by more than 60%.” (Art of Speculation, Page 354)

4 Art of Speculation, Philip L. Carret, 1930 (Page 344)

5 Art of Speculation, Philip L. Carret, 1930 (Page 251)

6 Art of Speculation, Philip L. Carret, 1930 (Page 241)