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Grahamites
Grahamites
Articles (309) 

Decoding Buffett's Famous Quotes

March 16, 2015 | About:

Most of us can recite most of Mr. Buffett’s famous investment-related quotes. I have constantly kept reminding myself of his wonderful quotes. However, earlier in my investment career, I realized that the fact that I can recite those quotes adds very little value to my investment skills because I didn’t go a step further and ask the question why and what experiences taught Mr. Buffett these lessons. Being a slow learner, it took me a while to grasp the power of what I call “decoding Mr. Buffett’s bites.” In this article, I’d like to share with the readers the approach I adopted in order to get a deep understanding of Mr. Buffett’s investment wisdoms. Although it has worked well for me, I cannot guarantee that it will work well for you.

Let me use one of my favorite quotes as an illustration:

“It is far better to buy a wonderful business at a fair price than buying a fair business at a wonderful price.” – Warren Buffett (Trades, Portfolio)

If we step back and think about it, the above quote is just a conclusion. Anybody who follows Mr. Buffett knows this conclusion. But why is that and how did Mr. Buffett come to this conclusion?

The answers came to me when I was reading Snowball for the second time during 2013. Earlier in Mr. Buffett’s career, he bought a windmill company called Dempster Mill. You can find the details of the story in Snowball but the short version of it goes something like this – Dempster Mill was selling at a price much lower than its tangible book value at the time Mr. Buffett bought it. The business was deteriorating rapidly and hemorrhaging cash at a dangerously fast speed. Much sooner than Mr. Buffett had expected, the business was facing real possibility of bankruptcy and Mr. Buffett had put a substantial amount of the partnership’s money in it. To Mr. Buffett’s rescue, Charlie Munger (Trades, Portfolio) knew a turnaround expert who was later hired by Mr. Buffett to turn the business around. Mr. Buffett paid him handsomely to relocate and finally the expert turned the business around. In the end, Mr. Buffett made a ton of money out of this investment but the outcome could have been very unpleasant had the turnaround did not work. This is an instance of buying a fair business at a wonderful price. I wonder what would Mr. Buffett’s results on this particular investment be had he held Dempster Mill for a much longer period of time.

Later on in Snowball, as Mr.Buffett moved on from the 1950s to the early 1960s, as we all know, he bought Disney and American Express at wonderful prices due to temporary hiccups in the business, which made their stocks plummet. What would happen if you bought American Express’s stock the day before Mr.Buffett bought it and held it all the way through today? If Mr.Buffett paid a wonderful price on the day American Express’s stock sank like a stone, then you probably paid fair price, or more than the fair price the day before. It turned out that over a long period of time, your compounded annual rate of return on American Express (NYSE:AXP) would have been only 0.1% worse than Mr. Buffett even though you paid a much higher price. And we know Mr. Buffett has done extraordinarily well with his American Express investment. This is the power of buying a wonderful business at a fair price.

After we know the experiences that shaped Mr.Buffett’s preference for wonderful businesses over fair businesses, the next step would be asking us the question why that is. And of course the answer is over a long period of time, stock return mirrors the growth of business fundamentals. Wonderful businesses are able to compound the fundamental of the business at a wonderful speed, which in turn results in a wonderful compounding of the stock prices. Therefore, the fair price you pay today will almost always look like a bargain price a few years out in the future. On the contrary, if you buy a fair business or a lousy business, there is real danger that business fundamental will deteriorate year over year and naturally so should the stock price. The wonderful price you pay today will look like a ridiculously expensive price a few years out. Look at what happened to Radio Shack (RSH), Weight Watchers (WTW) and JC Penney (NYSE:JCP). By the way, this should remind you of another Mr. Buffett’s quote –“time is the friend of a wonderful business and the enemy of a lousy business. ”

Now to step up the game, it is time to come up with your own version of Mr.Buffett’s bite. Here is my version for your amusement:

“It is far better to buy a wonderful business at a fair price than buying a fair business at a wonderful price because wonderful businesses can compound their intrinsic values over time, while fair businesses face the peril of deteriorating fundamentals over time. Fair price may look like a bargain and wonderful prices may look awfully expensive a few years out in the future.”

Let me end this article with a challenge to the readers – decode the following wisdom from Mr. Buffett.

“A good business earns high return on tangible assets. A great business not only earns high return on tangible assets but also grows.”

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (8 votes)

Voters:

Comments

michelc
Michelc - 4 years ago    Report SPAM

Ans.: The wonderful business grows because it can reinvest a significant part of its earnings at such high returns.

vgm
Vgm - 4 years ago    Report SPAM
I think Francis Chou (Trades, Portfolio) gave a solid answer to this in his recent Q&A with GF. Talking about great businesses, he said:

"There are numerous hidden margins of safety in 1) wonderful economics of the business, 2) great management who know how to allocate capital, 3) growing and sustainable free cash flow that are being deployed wisely, 4) you can make a mistake of paying up and still it may not matter that much because the intrinsic value is growing at a reasonable clip, and so on. The difficulty is in identifying them."

Thanks for the stimulation, Grahamites!

snowballbuilder
Snowballbuilder - 4 years ago    Report SPAM

While philosofically i agree in reality i see many investor use these quote to justify buying big blue chip at 30 Times earning and 4 - 6 x book.

Munger , who is the mentor of the "buying great business", has buyed WFC in march 2009 at around 9 dollar a share. Thats the way to get rich and achiving outperformance.

He has recently stated that while He think COSCO is a really great business He is not going to pay 25 Times earning to increase his position. He will not add and He will not reduce . He will just wait.

the problem , in my view, is that what is a FAIR price for many (average) investor is not the FAIR price Munger is willing to wait for.

Just some thoughts. Best Snow.

maurodejesus
Maurodejesus premium member - 4 years ago

Thanks for the article! very instructive.

I recently read Buffett's last letter, and he wrote: "My cigar butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance... Even then, however, I made a few exceptions to cigar butts, the most importante being Geico... Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices... but...cigar butt investing was scalable only to a point. With large sums, it would never work well".

It seems that his best years in terms of return were made by purchasing mediocre business at bargain prices, in the 1950s.

Regards

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

A great article as usual. Always thought provoking! Thanks so much for publishing this. Best - Tom

efb.quest
Efb.quest - 4 years ago    Report SPAM

Nice article. Thank you.

value1000
Value1000 premium member - 4 years ago

Good article, another way to look at this is if you buy a non-wonderful business or company it will cause you a lot of anxiety and you may not be able to sleep at night. You will constsntly be looking at stock prices to see if it went up or down or bankrupt. This is what I did in my early days of investing. Those cigar butt companies- well those "last puff" companies and your money will light up in smoke. I look for wonderful companies with larger revenues such as At&t that have over 100Bil in revenue and good earning, cash flow, dividends, net and operating margins, interest coverage, etc. It's a totally different psychological mindset. Wonderful businesses have also a monopolistic feel so also keep this in mind.

jtdaniel
Jtdaniel premium member - 4 years ago

Hi Grahamites,

I appreciate your good thinking and writing. Given Mr. Buffett's history, I would think the "also grows" quote refers to strong EPS and ROE associated with businesses rich in intangible assets like branding and mind share.

I would agree with Snowballbuilder's point that valuation is key to strong results in a reasonable holding period. It would be interesting to parse what Mr. Buffett actually means by "fair price". If he considers 1.2 X book a fair price for Berkshire, my guess is that his idea of a fair price is much more conservative than that of most writers who tout stocks almost daily on GF.

spark411
Spark411 - 4 years ago    Report SPAM

I wonder if Buffett would have started his career buying a wonderful business at a fair price versus what he actually did which is to buy fair businesses at a wonderful price. It seems like you have to do exactly what he did. Go through a high return/accummulation phase then go to a compounding strategy which is to buy a wonderful business at a fair price. Compounding is where the big dollars are made but compounding needs a strong base of assets to start from. What is the best way to build a strong base? Would be interested in hearing others' thoughts.

Grahamites
Grahamites - 4 years ago    Report SPAM
Michelc - Capital redeployment opportunity and capital allocation ability are two ingredients of a great compounding machine. Thanks for the comments.

Vgm - Thanks for citing Francis Chou (Trades, Portfolio). He sure gave a very solid answer:)

Snowbuilder - I wholeheartedly agree. What the fair price is depends a lot on the fundamental of the business, the projected growth rate, the likelihood and probability of alternative paths, and human psychology. I think a combo of consistent and committment, excess self-regard and deprival super-reaction bias will cause a lot of investors to have the mentality of fear of missing out and therefore, paying up.

Grahamites
Grahamites - 4 years ago    Report SPAM

Maurodejesus - He is probably right but I would point out 2 things. First of all, Buffett essentially went on activism on quite a few companies in order to unlock the liquidation value (Dempster Mill for instance). Secondly, the net nets in his era were probably vastly different in a good way than the nets nets today. The markets have evolved.

I could be very wrong though. Thanks for the stimulation.

Grahamites
Grahamites - 4 years ago    Report SPAM

Tom and efb -Really appreciate the nice words:)

Grahamites
Grahamites - 4 years ago    Report SPAM

Value 1000- Absolutely agree wonderful businesses make you sleep better. I wrote an article on that topic a while ago. You have better conviction and you can act more confidently if price drops when you have a wonderful business. I'm not so sure if that's true for cigar butts:)

Grahamites
Grahamites - 4 years ago    Report SPAM

Jt - Thanks again for your nice words and thoughtful comments, as always. In my mind, fair price is both absolute and relative. You want to pay a price that gives you a fair amount of margin of safety but you also need to consider your opportunity cost on a risk adjusted basis. And like I said in my respons to Snowbuilder's comments "what the fair price is depends a lot on the fundamental of the business, the projected growth rate, the likelihood and probability of alternative paths, and human psychology." So you have to have the business, financial and accounting knowledge, the experiences needed, as well as understanding and keeping yourself in check with the human side of investing all the time. This goes back to my article on personality. Buffett's ISTJ type. People with that personality profile are usually more logical and even tend to be emotionless. This is a natural advantage. If you are an ENFP, you are almost wired not to be rational about purchasing decision. There's a lot going on with how an investor decides what a fair price is and I'm not sure that is understood well enought.

Grahamites
Grahamites - 4 years ago    Report SPAM

Spark411 - Mr.Buffett said numerous times he would be buying small companies if he starts over with a small sum. You'd be surprised by how many great small companies there are out there and a lot of them are under-followed. For instance, look at Exponent, a specialty consulting firm. Look at this company has compounded its intrinsic value consistently over its history. And you have plenty of opportunities to buy this company in the past few years and make a lot of money. There are not a lot of them but plenty for you to shop around.

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