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Why Warren Buffett shuns cheap stocks and what he does buy

The world’s most well-known investor, Warren Buffett, once said “Buying cheap businesses is foolish,” and that was around 30 years ago. That may come as a surprise to those who know the so-called Sage of Omaha cut his teeth following the teachings of the grandfather of value investing, Benjamin Graham.

But Graham himself declared back in the 1970s that his value strategy had stopped working as a stock-picking system. And Buffett stopped buying so-called cheap ‘cigar-butt’ shares himself about 50 years ago.

Buffett’s evolving strategy

Around that time, Charlie Munger, Buffett’s sidekick and vice-chairman of Berkshire Hathaway — the conglomerate controlled by Buffett – allegedly convinced him that the quality of an enterprise was just as important as how cheap the share-price made it look. He also said something like, ‘Oh, and by the way, you really ought to hold onto your stocks for a very long while’. However, Buffett was ready by then to change his investing style anyway it seems.

But make no mistake, Buffett was already very rich having made a fortune trading cheap, generally low-quality value stocks in his twenties. And it was trading too. He’d take a position and wait for the value to ‘out’. Or simply sell because he’d made a lot of money already from the trade and didn’t want to give it all back because of some share-price reversal. Or he’d sell up without so much as a backwards glance because of a more compelling value investing opportunity elsewhere.

Indeed, there was no sign of the blend of Buffett/Munger strategy that we see today, which involves hunting for quality businesses selling at a cheap price and then holding for a long time. But Buffett’s thinking had been changing as far back as the mid-1960s. Then he realised he’d made a big mistake buying the struggling textile manufacturing business Berkshire Hathaway, which he later turned into the conglomerate he fronts today by investing the shrinking enterprise’s cash flow into other things rather than reinvesting in the poor-quality textile business.

Stubbing out the ‘cigar-butt’ mentality

In his 1989 shareholder letter to Berkshire Hathaway shareholders, Buffett put his previous ‘cigar-butt’ mentality to bed for the final time by explaining that a low price will probably not turn out to be good value after all. Because, in a business with poor trading economics, problems keep on coming as soon as one is fixed. And any initial advantage you secure by buying the cheap share price will likely be eroded by poor returns from the enterprise – which I reckon is another reason for his quick selling in his earlier investing career.

Fast-forwarding to Buffett’s 2014 shareholder letter and we find him driving the message home again by saying: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”

And that’s exactly what he does. Indeed, that’s why we’ve seen a long line of strong businesses bought at reasonable prices in Buffett’s and Berkshire Hathaway’s portfolios over the last 50 years or so, and he tends to hold onto his shares for a very long time.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.