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Lessons from Warren Buffett - XV - Views on News from Equitymaster
 
 
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  • Oct 25, 2007

    Lessons from Warren Buffett - XV

    Last week, we saw Warren Buffett mention about his investment mistakes of the preceding 25 years in his 1989 letter to shareholders. Let us round off that list by discussing the rest of what he feels were his key investment mistakes.

    "My most surprising discovery: the overwhelming importance in business of an unseen force that we might call 'the institutional imperative'. In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play."

    How often have we seen merger between two companies not producing the desired outcome as was projected at the time of the merger? Or, how often have we seen management retain excess cash under the rationale that it will be used for future acquisitions? Further still, a lot of companies do things just because their peers are doing it even though it might bring no tangible benefits to them. The master has labeled these so called propensities to do things just for the sake of doing them 'the institutional imperatives' and has termed them as one of his most surprising discoveries. Further, he advises investors to steer clear of such companies and instead focus on companies, which appear alert to the problem of 'institutional imperative'.

    Given the master's great predisposition towards choosing business owners with the highest levels of integrity and honesty, it comes as no surprise that one of his investment mistake concerns the quality of the management. This is what he has to say on the issue.

    "After some other mistakes, I learned to go into business only with people whom I like, trust, and admire. As I noted before, this policy in itself will not ensure success: A second-class textile or department store company won't prosper simply because its managers are men that you would be pleased to see your daughter marry. However, an owner - or investor - can accomplish wonders if he manages to associate himself with such people in businesses that possess decent economic characteristics. 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."

    Next on the list of investment mistakes is a confession that makes us realise that even the master is human and is prone to slip up occasionally. But what makes him a truly outstanding investor is the fact that he has had relatively fewer mistakes of commission rather than omission. In other words, while he may have let go of a couple of very attractive investments, he's hardly ever made an investment that cost him huge amounts of money.

    This is what he has to say: "Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn't make. It's no sin to miss a great opportunity outside one's area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire's shareholders, myself included, the cost of this thumb-sucking has been huge."

    The master rounds off the list with a masterpiece of a comment. It gives us an insight into his almost inhuman like risk aversion qualities and goes us to show that he will hardly ever make an investment unless he is 100% sure of the outcome. It comes out brilliantly in this, his last comment on his investment mistakes of the past twenty-five years: "Our consistently conservative financial policies may appear to have been a mistake, but in my view were not. 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.

    We wouldn't have liked those 99:1 odds - and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also."

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