X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Lessons from Warren Buffett - LXV - Views on News from Equitymaster
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Lessons from Warren Buffett - LXV
Dec 22, 2016

The journey into the enlightening world of Warren Buffett's letters brings us today to his 2014 letter to shareholders. This letter distills in plain words all the basic principles of sound investing. Its lessons are broad in scope and deep in wisdom.

The 2014 letter was special, as that year marked 50 years since Buffett took control of Berkshire Hathaway in 1965.

It's really three letters in one. First, there's Buffett's usual look back at Berkshire's performance in 2014.

Then there are two more notes, one from Buffet and another from Berkshire Vice Chairman Charlie Munger - both on the past, present, and future of Berkshire.

Buffett's note on Berkshire - Past, Present, and Future is our focus today.

Cigar-Butt Strategy

Warren Buffett's ability to adapt has held him in good stead.

He began searching for bargain stocks primarily using statistical filters, a method ingrained in him by his mentor Benjamin Graham. Buy stocks below their asset values and sell them when the stock price and asset prices converge.

Buffett called this a 'cigar butt strategy'. A recently smoked and discarded cigar will usually still have a puff or two to offer. So if you're willing to dig through the ashtray, you get to smoke for free. This strategy worked extremely well for Buffet early in his career...

  • 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.

However, as the money under management grew, Buffett found it increasingly difficult to employ large sums in statistical bargains...

  • But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well. In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise.

The problem with the cigar-butt approach is twofold.

First, the original 'bargain' price probably will not turn out to be such a bargain after all. In a difficult business, no sooner is one problem solved than another surfaces. Or as Buffett puts it, 'Never is there just one cockroach in the kitchen.'

Second, any initial advantage you secure will be quickly eroded by low returns. As long-term investments go, these are poor bets. They will have low ROIC, which means the intrinsic value of the stock will grow very slowly, if at all.

Drive towards Quality

The 1970s were when the tide turned for Buffett. He found a friend, partner, and confidante in Charlie Munger. Charlie understood the importance of partnering with high quality businesses. He came up with a remarkable insight: Instead of frequently buying and selling three-puff cigar butts, one should look for cigars that never run out - companies with wonderful business and a durable moat.

Charlie knew that if you found a high-quality business and paid a fair price for it, it would work out even better than the statistical bargains:

  • It took Charlie Munger to break my cigar-butt habits and set the course for building a business that could combine huge size with satisfactory profits... From my perspective, though, Charlie's most important architectural feat was the design of today's Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.

Acquiring See's Candies

Let's hear from Buffett himself how he decided to adapt his investing philosophy to purchase See's Candies.

  1. Find an Outstanding Business

    See's was a legendary West Coast manufacturer and retailer of boxed chocolates, then annually earning about $4 million pre-tax while utilizing only $8 million of net tangible assets. Moreover, the company had a huge asset that did not appear on its balance sheet: a broad and durable competitive advantage that gave it significant pricing power. That strength was virtually certain to give See's major gains in earnings over time. Better yet, these would materialize with only minor amounts of incremental investment. In other words, See's could be expected to gush cash for decades to come.

  2. Pay a Fair Price

    The family controlling See's wanted $30 million for the business, and Charlie rightly said it was worth that much. But I didn't want to pay more than $25 million and wasn't all that enthusiastic even at that figure. (A price that was three times net tangible assets made me gulp.) My misguided caution could have scuttled a terrific purchase. But, luckily, the sellers decided to take our $25 million bid. To date, See's has earned $1.9 billion pre-tax, with its growth having required added investment of only $40 million. See's has thus been able to distribute huge sums that have helped Berkshire buy other businesses that, in turn, have themselves produced large distributable profits.

  3. The Power of Quality Businesses and Brands

    Additionally, through watching See's in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments. This becomes true because ordinary businesses take time to deliver extraordinary returns. They grow your wealth once in a while. On the other hand, wonderful companies compound your wealth year-after-year. These businesses withstand the test of time. And as you know, time itself has been very favorable to the stock market.

The acquisition of See's laid the foundation for present-day Berkshire Hathaway.

It all boils down to this: Rather than buying mediocre companies at bargain prices, it is better to partner with quality companies and pay a fair price.

Next time, we will look at Charlie Munger's contribution to the 2014 annual letter.

Stay tuned...

Rahul Shah

Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.

Equitymaster requests your view! Post a comment on "Lessons from Warren Buffett - LXV". Click here!

  

More Views on News

What They Forgot to Tell You About Sensex at One Lakh (Smart Contrarian)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

The Winning Formula in Stocks is Not What You Think... (Smart Contrarian)

Dec 15, 2017

You cannot beat a world champion at a game of chess with only a limited amount of practice. But as far as long-term investing is concerned, asking the right question can make you a champion investor in no time.

How the Fake Boom Ends (Vivek Kaul's Diary)

Dec 15, 2017

And so cometh, like the Grim Reaper, the end of the biggest fake boom ever.

For Every Achal Kumar Jyoti, there was a Navin Chawla (Vivek Kaul's Diary)

Dec 15, 2017

A narrative to have clearly emerged from the Gujarat elections is the Election Commission batting for the Bhartiya Janata Party (BJP), the party in power.

More Views on News

Most Popular

Buffett Style Investing

A detailed peek into how Warren Buffett identifies the value of a stock, his concept of margin of safety and more.

Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud(Vivek Kaul's Diary)

Dec 11, 2017

The Financial Resolution and Deposit Insurance(FRDI) Bill proposes to do just this.

If You're Not Looking for 'Excitement' but 'Big Returns' from Stocks, This Is for You(The 5 Minute Wrapup)

Dec 7, 2017

One does not have to necessarily invest only in 'exciting' stocks to become wealthy.

Beat Fund Managers at Their Own Game with These Stocks(Smart Contrarian)

Dec 6, 2017

The road to big investment gains passes through this universe.

NASA on Aliens and Bitcoin(The Honest Truth)

Dec 14, 2017

The most hilarious scam that aliens have ever planted on Planet Earth.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Dec 15, 2017 (Close)

MARKET STATS