A wonderful company at a fair price
If you have read Berkshire’s (BRK.A, Financial) (BRK.B, Financial) letters or my reviews of them, in many of the early years, Buffett struggled with what to do with the textile business. He admitted he knew it was an unpromising business when he bought it, but was enticed by it because the price was cheap. By 1965, the guru said he was “becoming aware” that the strategy of buying on valuation alone was not ideal, yet he still bought it. The cheapness should give you a chance to make a profit, which Buffett calls the "cigar butt" approach to investing. There might be one profitable puff left thanks to the bargain purchase price. However, he concluded:
"Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in 10 years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre."
Buffett said he did not learn his lesson and made several more investments, buying at a substantial discount from book value, and these deals had to be exited at about break even despite having other attractive features on investing. So, Buffett wrote:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first- class managements."
So, what makes a wonderful company? It is a combination of good economic characteristics with great managers. Buffett said, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
The Oracle of Omaha's next lesson is brilliant, again learned through experience of investing in and supervising many different business types. Buffett and Charlie Munger (Trades, Portfolio) did not learn how to solve difficult business problems, but they learned how to avoid them. We live in an age of activist investors, financial engineering and constant business restructuring. Sometimes, I feel like my years of financial and business education and experience are inadequate because of the complexity of some deals and investments I read about. Yet Buffett is saying less is more, and simplicity is beautiful. This gives me a lot of reassurance as an investor. This is probably why his track record has been so good over such a long period of time as he simply avoided complex opportunities often found in technology, special situations, emerging markets and alternative investments – which have often blown investors up. Buffett wrote:
"To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult."
This is not to say that Buffett is a complete simpleton. He does say that “on occasion” a great investment opportunity occurs when a marvelous business encounters a “one-time huge, but solvable, problem," providing American Express (AXP, Financial) and Geico as examples.
The institutional imperative
Buffett said his most surprising discovery was finding that decent, intelligent and experienced managers did not always automatically make rational business decisions. He called this “the institutional imperative."
"For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated."
At first, Buffett ignored this and said it caused some expensive mistakes. By 1989, he said he had tried to “organize and manage Berkshire in ways that minimize its influence” and attempted to concentrate investments “in companies that appear alert to the problem.”
In today’s world of social media, 24/7 news and information overload, this problem still exists. It is why I think good corporate governance is very important. It is also why I think a company’s capital allocation is so important. If a company cannot find growth opportunities that it is qualified to attack, then just return capital to shareholders. Conversely, if a company has excellent opportunities, then returning capital to shareholders is a bad idea. Europe suffers from this problem a lot, in my opinion, as investors demand dividends and profits when sometimes the best corporate strategy is to invest for growth. It is also why I think companies that are a little bit different are interesting because management is not focused on simply trying to match its peer group.
Next, Buffett recommended to only deal with people you “like, trust and admire,” As noted earlier, this policy itself will not ensure success, but an investor can do wonders if he manages to associate himself with such people in businesses that have decent economic characteristics. He wrote:
"Conversely, we do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We've never succeeded in making a good deal with a bad person."
Other mistakes Buffett admits to were good investments he recognized but missed. Although he is fine with missing great opportunities that are outside his circle of competence, he regrets a few “really big purchases that were served up to me on a platter and that I was fully capable of understanding… the cost of this thumb-sucking has been huge.”
The choice of language here is remarkably interesting: capable of understanding and thumb-sucking, which suggests Buffett lacked a motivation or work ethic to do a final piece of due diligence and pull the trigger. I would be speculating here, but does it mean Buffett was simply lazy to finalize an investment, or does it mean he found good opportunities but decided to play it safe? This reminds me of something Stanley Druckenmiller (Trades, Portfolio) has said: "When you have tremendous conviction on a trade, you must go for the jugular."
What Buffett does not regret, however, is Berkshire’s consistently conservative financial policies. He wrote:
"In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default."
Enjoy the process
Buffett’s conclusion here is that if your actions are sensible, you are certain to get good results. However, the final lesson, perhaps unintended, is when he wrote, “We enjoy the process far more than the proceeds.” Investing is not just about returns; if you hate doing research, you are probably hiring a fund manager, but if you like doing research, there is no reason why you should not do it yourself.