Thoughts on Mental Models, Part 2 - Buffett’s Shift to Wonderful Businesses
Part two isn’t going to talk much about individual stocks. Instead, I want to talk about what I think is the most underrated part of Buffett’s career: the switch he made from Graham’s “cigar butt” style investing to a “wonderful business at a fair price” style.
What’s so remarkable about this is Buffett had a style of investing that worked perfectly well; actually, it worked more than perfectly well, it beat the pants off the market. Both Buffett’s early investment success and Graham’s own investment success proved that. Yet Buffett was willing to switch away from an already successful investment style to a new one.
Consider the sciences. Breakthroughs in science are rarely made by older scientists. Older scientists spend their entire careers supporting one paradigm. To break that paradigm would invalidate both their and their friend’s entire life’s work. Because of that, breakthroughs are normally made by younger scientists who aren’t completely committed to the paradigm. And older scientists fight the new paradigm until their dying breath. The church throwing Galileo into jail until he stopped saying the earth circled the sun is an extreme example of this, but there are plenty of other examples of older scientist violently fighting against new paradigms even after it’s been proved the new paradigm makes more sense.
Yet somehow Buffett was able to replace his old, profitable “cigar butt model” with his new wonderful business model. Why?
I don’t have a definitive answer. Surely Charlie Munger has some influence, though I’ve seen Munger say several times (including, I believe, in the intro to Poor Charlie’s Almanac) that he believes Buffett would have made the leap without Munger’s influence.
But I personally believe Buffett made the leap because of practicality. Cigar butts tend to be much smaller companies with limited liquidity, and thus only appropriate for a small sum of money. Wonderful businesses probably have a tendency to be larger businesses because their pure greatness encourages them to grow. Cigar butts tend to be more of a one time trade- you buy below liquidation value and sell at liquidation value or maybe a little past that, but they don’t really grow and compound, so you constantly need to find new cigar butts to invest in. And if you assume you have profits from you cigar butt trades, you need to find three new cigar butts to replace every two you sell, even without taking in new investors money. Wonderful businesses compound and grow intrinsic value. As Buffett’s shown with his investment in Coke and Washington Post, it’s actually best not to sell them because of the tax free loan the government provides by deferring taxes until profit is realized (the one exception to this would be when they go into bubble mode, a la Coke 1999).
Of course, there are downsides to the “wonderful business” model.
I’m currently reading The Success Equation. One of the analogies in it is to what it takes to be successful. You can be among the best plumbers or mechanics in town purely through gaining experience. But to be the best musician or basketball player, it takes years of deliberate practice. What’s the difference between the two? In my opinion, it’s that plumbers and mechanics are a local market, while athletes and musicians are a national and increasingly international market. What’s required to be the best in a local market is much different than what’s required in a national market.
Another way to think of that would be the difference between high school basketball, college basketball, and the NBA. In high school, you’ll often find people who are not necessarily very athletic but willing to work hard and practice their skills constantly playing key roles on teams. In college, those people can’t cut it, as they’re replaced by people with good athleticism who are willing to work hard. Why? College pulls from a much larger pool of players (a national pool) than high school does. And then in the NBA, those players are replaced by people with elite athleticism who are willing to work even harder. Why can college players not cut it? Because the NBA pulls from players of all ages, not just the 18-22 age, and also from the international player pool.
So what does this have to do with cigar butt and wonderful businesses Cigar butts are much smaller companies. Larger, professional investors often can’t or won’t invest in them. Many individual investors are turned off of them for one reason or another (“dying” industry, lack of growth, low liquidity). You can outperform in cigar butts simply through experience, some math, and maintaining your cool through panics. Cigar butts are the high school basketball of investing. On the other hand, wonderful businesses are picked over constantly by professional investors. Sure, maybe some extremely small ones escape their attention, but even those are normally bid up by smaller investors attracted to their growth story and solid profits. Because they’re so well followed, wonderful businesses are the NBA of investing (small wonderful businesses would be the college basketball!).
So, to bring it back to Buffett, I believe he replaced the cigar butt model with the wonderful business model for one reason: it was time to move on. Buffett had dominated the “high school” level and it was time to graduate- he had simply too much money to keep investing in cigar butts. Many basketball players can’t make the transition to the next level. They’re used to dominating at the lower level, and they are unwilling to put in the work and adjust their game for the realities of the new level. But not Buffett. He abandoned the old model that he knew wouldn’t work at the new level and started up with a new one.
Disclosure- Long the cigar butt model. Working on the wonderful business one.