Warren Buffett (Trades, Portfolio) is known for his annual shareholder letters, which contain not only important information about Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) current holdings, but also provide valuable insight into his and Charlie Munger (Trades, Portfolio)’s investment and life philosophies. Both men are notable for their humility and willingness to admit past mistakes, despite their extreme wealth and success. Indeed, it is arguably this open-mindedness and ability to self-critique that has fueled much of their success. As such, their letters are essential reading for any value investor.
Cigar butts
In his shareholder letter for 1989, Buffett addressed what he called "cigar butt investing":
“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying businesses is fooling. First, the original ‘bargain’ price probably will not turn out to be such a steal after all. In a difficult business, not 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”.
In other words, beware of bargain-basement businesses that look cheap based on past history or price-earnings alone. There is an ocean of difference between buying a quality company that is going through some cyclical or market-wide downturn - for example, the way that Buffett loaded up on Goldman Sachs (GS, Financial) during the 2008 financial crash - and buying distressed companies that are tanking due to their own shortcomings. Furthermore, consider the opportunity cost inherent in tying up your capital in a cheap, low-quality business and then waiting years for it to maybe recover.
The institutional imperative
In the same letter, Buffett discussed "the institutional imperative," which he described as:
"(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. Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided...Charlie [Munger] and I have attempted to concentrate our investments in companies that appear alert to the problem”.
The point being made here is that, left to their own devices, businesses will naturally tend toward misallocation of funds and excessive executive compensation. The best that boards can do to rein this in is to remain vigilant and act to restrain this natural tendency. For the retail investor, this means looking at more than just financial statements. To gain an accurate picture of the type of company you are about to invest in and how it plans to spend your money, you need to scrutinize Securities and Exchange Commission filings that contain this type of information, including 8K, 10K, 10Q and S1/3 forms.
Disclosure: The author owns no stocks mentioned.
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