Buffett (1991): Better to look for stable businesses run by competent people (the superstars) available at attractive prices.

Better to look for stable businesses run by competent people (the superstars) available at attractive prices than trying to look out for companies possessing the next revolutionary product or a service.




In his letter in 1991, Warren Buffett explained the difference between a 'business' and a 'franchise'. Continuing with the letter from the same year, let us see what other wisdom he has to offer.

With the kind of fortune that the master has amassed over the years, one could be forgiven for thinking him as rather infallible and the one fully capable of identifying the next big industry or the next big multi-bagger. However, this myth is easily demolished in the master's following comments from the 1991 letter.

"Typically, our most egregious mistakes fall in the omission, rather than the commission, category. That may spare Charlie and me some embarrassment, since you don't see these errors; but their invisibility does not reduce their cost. In this mea culpa, I am not talking about missing out on some company that depends upon an esoteric invention (such as Xerox), high-technology (Apple), or even brilliant merchandising (Wal-Mart). We will never develop the competence to spot such businesses early. Instead I refer to business situations that Charlie and I can understand and that seem clearly attractive - but in which we nevertheless end up sucking our thumbs rather than buying."

There are two things that clearly stand out from the master's above quote. 

• One is his ability to flawlessly identify his circle of competence and
• the second, his objectivity, from which comes his rare trait of accepting one's own mistake and working to eliminate it.

For those investors who believe that big fortune usually comes from identifying the next big thing or the next wave, they must have been surely forced to think again after coming face to face with the master's candid admission that he will never develop the competence to identify say the next 'Microsoft' or 'Pfizer' or how about the next 'Infosys' or the next 'Ranbaxy'. Indeed, outside one's industry of knowledge, it becomes very difficult to identify the next multi-bagger as it is just not high growth potential but a lot of other factors that go into making a highly successful company. In fact, even within one's industry of knowledge, it may prove to be a tough nut to crack.

So, if not the next multi-baggers, then how else can one become a successful long-term investor? The answer could lie in the master's quote from the same letter and given below.

"We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-oriented managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validate our assessment. But this investment approach - searching for the superstars - offers us our only chance for real success. Charlie and I are simply not smart enough, considering the large sums we work with, to get great results by adroitly buying and selling portions of far-from-great businesses. Nor do we think many others can achieve long-term investment success by flitting from flower to flower."

Thus, in investing as in other walks of life, easy does it. Hence, look around for stable businesses run by competent people and available at attractive prices. Trust us, it is much better than trying to look out for companies possessing the next revolutionary product or a service.

http://www.equitymaster.com/detail.asp?date=11/29/2007&story=3

Buffett (1989): We've never succeeded in making a good deal with a bad person.

Warren Buffett mentioned about his investment mistakes of the preceding 25 years in his 1989 letter to shareholders. Let us round off that list 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."

http://www.equitymaster.com/detail.asp?date=10/25/2007&story=3

When things go wrong: Human errors

Preventing errors by good decision making is not easy. Our brains aren't computeres; they are poor at calculating probabilities, thinking of different possible outcomes and holding lots of information. Situations that are complex, or constantly changing, confuse us even further.

Our 'natural' decison-making processes are often false friends in business. To help our brains get to grips with uncertainty, we have to create mathematical and logical structures. The fact that these are hard to understand indicates how 'unnatural' they are for us. Our brains are designed for self-preservation -taking decsions quickly, under pressure - to ensure survival. To do this, we take 'cognitive shortcuts' that allow us to cut through the information we're facing and reach a decison. The problem is that we often make the wrong choice.

It's the same story with error prevention. When things go wrong, many 'natural' responses, such as blaming others, are self-preservation impulses. They won't help us to learn from our mistakes or share learning with others. To do so, we have to overcome our 'natural' responses and adopt approaches that can, at first sight, seem counter-intuitive.

Every mistake is an opportunity to learn

Error is defined as an unintentional deviation from a goal, caused by an act or omission that is in principle avoidable.

Errors happen when we make decisions. 

• By improving the way we make decisions, we can try to prevent errors, or minimise their probability. 
• By improving the way we respond when things go wrong, we can try to manage errors, or minimise their impact. 
• We can also try to create positive impacts in negative situations, by taking the opportunities for learning that mistakes provide.