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  • OCTOBER 22, 2008

Lessons from Warren Buffett - LVIII

In the previous article based on Buffett's 2006 letter to shareholders, we covered his tribute to a fellow value investor Walter Schloss whereby he discussed the latter's value investing based investment strategy and how he (Schloss) had beaten the markets by a huge margin over a long investment horizon.

Let us now move to the letter from the year 2007 i.e., his most recent letter to the shareholders of Berkshire Hathaway and see the investment wisdom on offer therein.

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The Three Gs
Let us suppose that you are planning to lock away the surplus money with you in a bank savings account and three different banks approach you with three different offers:

  1. The first bank takes a one time deposit and pays you a very attractive interest rate, which will continue to increase as years pass by;
  2. The second bank pays a decent interest rate but also asks you to increase your yearly deposits at a fixed rate, which will also bear a decent interest rate; and
  3. The third banks pays you a very poor interest rate and also asks you to increase your deposits at a high rate, which in turn yield the same poor interest rate.

It is difficult to imagine a depositor choosing any other sequence than the one mentioned above if asked to rank his preferences. However, while investing in companies, the very same depositor fumbles quite often. He ends up investing in firms that exhibit the characteristics of deposit schemes similar to options b) and c) listed above.

Warren Buffett has mentioned that virtually all the businesses could be classified on the basis of three characteristics mentioned above and he has gone on to name these businesses as Good, Great and Gruesome. Needless to say businesses of the 'Great' kind are what excite him the most and he tends to avoid the businesses labeled 'Gruesome'.

Let us see what he has to say on the characteristics of each of these businesses:

The golden words
On 'Great' businesses, Buffett says, "Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There's no rule that you have to invest money where you've earned it. Indeed, it's often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can't for any extended period reinvest a large portion of their earnings internally at high rates of return."

Furthermore, Buffett likens 'Good' businesses to industries like the utilities where the companies will earn a lot more 10 years from now but will also have to invest a substantial amount to achieve the same. The returns though are likely to be satisfactory.

Let us now move on to businesses that Buffett has labeled as 'Gruesome' and he proffers the following view on them. He says, "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers."

Indeed, if investors stick to 'Great' and 'Good' businesses in their investment lifetimes and buy them at attractive prices, they are unlikely to end up poor.

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