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Lessons from Warren Buffett - II

Jun 28, 2007

Last week, we had started a series on the study of annual letters that legendary value investor Warren Buffett wrote every year to the shareholders of his investment vehicle, Berkshire Hathaway. We discussed some key points in the letter for the year 1977 in the previous write up. In this write up, let us see what the master has to say to his shareholders in the 1978 letter: "The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital. We hope we don't get into too many more businesses with such tough economic characteristics."

The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed.

While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Infact, the current downturn the sugar industry is facing has a lot to do with supply far exceeding demand and this in turn is having a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply.

"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices."

Those of you, who are regular readers of content on our website, the above paragraph must have rang a bell or two. Indeed, time and again, in countless articles, we have been highlighting the importance of investing in good quality businesses run by honest and ethical management. That the master himself has been looking at similar qualities does go a long way in further reinforcing our beliefs. Buffett then goes on to make a very important comment on valuations and says that no matter how good they are, there is a price to pay for businesses and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough.

Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it.

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