Warren Buffett: “Buying cheap businesses is foolish!”

The majority of us think of Warren Buffett — the world’s richest investor — as a value hunter, and he is. However, the Sage of Omaha doesn’t confuse ‘good value’ with ‘cheap’.

The super-investor stopped habitually buying cheap business about 50 years ago — and he told us so 25 years ago, in his letter to Berkshire Hathaway shareholders for 1989.

No ‘backroom figures’ guy

If you think Mr Buffett hides away in a back office, comfortable only with piles of balance sheets and cash-flow statements, think again. He probably never has tried to reduce an investment decision down to numbers, such as the size of a discount to tangible net asset value, preferring instead to think hard about a firm’s prospects, management and industry dynamics before even attempting to calculate anything.

Proof came in the recent Berkshire Hathaway shareholder letter for 2014 where he owned up to the reason for dumping Tesco (LSE: TSCO)–he started selling Tesco shares because he “…soured somewhat on the company’s management”. That’s about as far away from a numbers-based approach to decision-making as it’s possible to get.

What about Benjamin Graham?

We can’t deny that Warren Buffett first became rich by buying cheap shares in the style of his old teacher, and major influence, the famous value investor Benjamin Graham. Buying shares in low-quality businesses at low prices gave the chance that some temporary blip in the fortunes of the business would provide an opportunity to dump the shares for a profit. Ben Graham did that, and Warren Buffett did that at first, but both men went off the idea over time as stock market conditions changed.

Buffett was changing his thinking as long ago as 1965. He reckons his first mistake when starting to build his Berkshire Hathaway conglomerate was buying the textile manufacturing business that started it off in the first place. He knew the sector was unpromising, but allowed a cheap valuation to entice him — just the sort of purchase that rewarded the young Buffett so handsomely early in his career.

Yet buying that dog of a textile business proved something of a watershed moment and Buffett said that by the time it came along, he was becoming aware that the strategy was not ideal. In fact, he reckons, unless you are a liquidator, that kind of approach to buying businesses is foolish (lower-case ‘f’!). Now that’s a big turnaround in his postion that we should all learn from, in my view, even if we might be 50 years late.

Why so?

In his 1989 shareholder letter, Buffett goes on to explain that the original “bargain” price of a cheap business will probably not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces. On top of that, any initial advantage you secure will be quickly eroded by the low return that the business earns.

That’s why it pays to be nimble if we find ourselves holding a pile of rubbish, I reckon. The longer we hang on to a business with poor economics, the lower our annualised returns are likely to be. Time, according to Buffett, is the friend of the wonderful business, the enemy of the mediocre. That’s why we’ve seen a string of strong businesses bought at reasonable prices in Buffett’s and Berkshire Hathaway’s portfolios over the last half-century.

Buffett’s cigar-butt mentality disappeared in its last puff of smoke more than half a lifetime ago. Indeed, in the most-recent shareholder letter for 2014, Buffett repeats the mantra: forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices. 

I reckon that if Warren Buffett weren't so constrained by the size of the capital he has to invest, he'd be taking a very close look at the wonderful businesses showcased in this Motley Fool wealth report. Our industry-leading analysts scoured the London market for firms operating with strong market positions and demonstrating powerful economic characteristics. To find out what they identified, click here.

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.