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Lessons from Warren Buffett - XXXVI

Apr 24, 2008

In the previous article, we read why Warren Buffett prefers long periods of inactivity when it comes to making investments. Let us go further down the same letter (1996) and see what other investment wisdom he has on offer. As ordinary investors, we would expect Buffett to be a prognosticator of the highest order and skillful at investing in industries that are going to emerge as the winners in the future. After all, if one is compounding money at such a great rate, one has to stay ahead of the crowd and invest in every potential multi bagger there can be. However, nothing could be further from the truth. The master, contrary to what we think of him, detests change when it comes to investments. Instead, he prefers industries with longevity and stability to the ones that grow exponentially in the initial years but eventually decline in few years.

The reasons would not be difficult to find. As individuals, we always endeavor to stick with the tried and the tested, especially when the stakes are high. But in investing, the greed of earning outsized returns is so high that we tend to invest in companies that show a lot of promise by being in industries at the forefront of technological breakthroughs but have little by way of earnings. This may not be such a good idea because while a lot of companies try to reach the top, very few manage to do so and hence our odds of zeroing in on a winner are not in our favour. Further, there is also an additional risk of technological obsolescence associated with the products of such companies, which may prove to be a big drain on cash flows, thus lowering returns. Little wonder, the master prefers businesses that are able to grow their profits for many years into the future and whose products are not impacted by the dynamics of technology that otherwise improves the standard of living of society.

Let us now read the master's thoughts on the issue in his own words.

"In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek."

"I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride."

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