Warren Buffett (Trades, Portfolio) is well known for his desire to pick up attractive assets at attractive prices. But what does this really mean? What is an attractive asset, and what is an attractive price?
There's no one set answer for this question. Every single asset will have a different value to different investors. That value will depend on numerous factors, such as the rate of return offered, the market risk-free rate and the individual investors' understanding of the particular sector or industry. For example, an investor who knows a lot about the real estate market might be willing to pay more for a real estate asset than one who does not.
A tremendous amount of evidence shows the price paid for a particular investment is more important than any other factor. Pay the right price for a specific return stream, and the investment will yield good results. Pay the wrong price, and it is most likely that the investment will produce bad results.
Understanding this critical part of investing strategy isn't easy. Indeed, there is no one strategy that is any better than others at identifying how much an asset should be worth. It will vary from investment to investment, as explained above.
With that being the case, when analyzing an investment, investors need to understand not only what sort of return stream the investment could provide, but how that would compare to other opportunities.
For a case study, we can look back at the comments Buffett made at Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) 2012 shareholder meeting. The Oracle of Omaha was asked if there were any situations where he would consider buying run-off annuities. These books of businesses can be highly cash generative in the right hands, but they are not going to provide the same growth as winning high-growth tech stock.
Managing annuities typically provides a steady, predictable cash flow stream for decades, although the rate of return is relatively small compared to the overall asset value. That's what Buffett understood, and that's why he explained that Berkshire would only be happy to enter the sector at the right price. Here are his comments in full:
"We would take on annuity books. The problem is there, we're not going to assume anything much better than the risk-free rate in making a bid for that sort of thing.
I mean, we do not like the idea of taking on long-term liabilities and paying 150 basis points, you know, above Treasuries or something, to do that. And there are people that will do that. They may not be quite as likely to fulfill those promises in the years to come as we would. But we want to get money on the liability side at attractive rates.
Now, the most attractive is if we can write property-casualty business at an underwriting profit and get it for nothing. But we're willing to pay for annuity-type liabilities, and I don't think it's impossible you'll see us do a little of that."
So, Buffett said that he was happy to buy this relatively low return product, but only at the right price. He would not be willing to have all of that capital tied up for decades at a low rate of return. There were just too many other opportunities elsewhere in the market.
This is something investors need to consider when making any investment. A stock may look particularly attractive based on its potential future returns, but this isn't very meaningful if it isn't compared to other assets.
Considering this opportunity cost isn't easy, but there is no substitute for the hard work required. Overpaying for an asset can be terminal. It's better to try and avoid making this mistake altogether.
Disclosure: The author owns shares in Berkshire Hathaway.
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