Friday, January 25, 2013

Buffett: Cigar Butts & Wonderful Businesses

Warren Buffett wrote the following in the 1989 Berkshire Hathaway (BRKashareholder letter:

"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. I call this the 'cigar butt' approach to investing. 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 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 ten 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.

You might think this principle is obvious, but I had to learn it the hard way..."

Buffett provides one example (Hochschild Kohn, a Baltimore department store) of a bargain that turned out not to be one at all, and says he could offer more.

So, with the mediocre businesses, what seems like it's selling at a big discount at the time often proves otherwise. He then later in the letter added this:

"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."

Businesses with sustainable advantages that generate high return on capital have the capacity over time to do just fine even if the investor, on occasion, mistakenly pays a price that proves to be somewhat expensive. Margin of safety is always a very important aspect of the investing process -- and an investor can't do very well if they often pay too much -- but errors in judgment about current value inevitably happen.

That wind isn't at your back in a low return business. What seems cheap at first isn't at all.

Adam

Long position n BRKb established at much lower prices
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