The stock market crash has prompted many to hunt for cheap shares. But Warren Buffett – arguably the world’s greatest investor – is on record as saying: “Buying cheap businesses is foolish.”
Indeed, he stopped buying cheap businesses almost 60 years ago. And he moved away from the so-called ‘cigar-butt’ style of investing that focused on ‘cheap’ and ignored ‘quality’.
Hunting (LON:HTG) for good value in the stock market crash These days, Warren Buffett doesn’t muddle up ’good value’ with ‘cheap’. And he was very clear about that in his 1989 letter to Berkshire Hathaway (NYSE:BRKa) shareholders. However, it’s true that he started off investing in purely cheap businesses. But his thinking started to evolve as long ago as 1965.
Berkshire Hathaway itself was a ‘cheap’ investment that went wrong. He bought the failing textile business because the indicators made it look cheap on the numbers. But the entire sector was in decline and no amount of reinvestment, cost-saving or efficiency improvements could save it.
Buffett reckons by the time he’d bought Berkshire Hathaway, he was becoming aware that the strategy of buying cheap was problematic. He said in that 1989 shareholder letter: “Unless you are a liquidator, that kind of approach to buying businesses is foolish.” Indeed, buying Berkshire Hathaway marked the end of his original approach to investment based on buying cheap.
The only way he managed to save his entire investment from going down the tubes was to reinvest Berkshire Hathaway’s cash flow into better, unrelated businesses and other stocks. He stopped reinvesting in the textile operations and, in the end, closed them all down.
Buffett’s cigar-butt approach to investing disappeared in its last puff of smoke almost six decades ago. And in the 2014 shareholder letter, he underlined the change, saying: “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”
Quality first So now he focuses on the quality of the business’s underlying shares. We can find initial indicators of quality by looking for high profit margins and decent returns against assets and capital employed. But I reckon relying purely on numbers is insufficient.
My guess is Buffett spends a lot of time thinking about the opportunities a business has in its market niche. He also talks a lot about economic moats, meaning that a business must have a sustainable competitive advantage that cannot be easily eroded by competitors.
To Warren Buffett, a wonderful business has all those quality attributes and when he’s found them he aims to buy their shares as cheaply as possible. In that way, he’s buying good value. Indeed, I reckon quality plus a fair price equals good value. And I’d follow Warren Buffett and buy good-value shares like that to make a million.
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Kevin Godbold has no position in any share mentioned. The Motley Fool UK owns shares of and has recommended Berkshire Hathaway (B shares) and recommends the following options: short September 2020 $200 calls on Berkshire Hathaway (B shares), long January 2021 $200 calls on Berkshire Hathaway (B shares), and short January 2021 $200 puts on Berkshire Hathaway (B shares). Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2020