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Don’t Commit This Warren Buffett Investing Mistake

Warren Buffett’s widely acknowledged as one of the best investors around – and for a good reason.

As the leader of Berkshire Hathaway, Buffett has helped the conglomerate grow its book-value per share (a good proxy for the true worth of the business) at an amazing rate of 19.4% annually from 1965 to 2014 (this equates to a total gain of 751,113%!), largely through astute acquisitions of whole companies and smart purchases of stocks.

But, Buffett’s also prone to making mistakes, as he has so readily acknowledged through the years. In his 1989 Berkshire annual shareholder’s letter, Buffett touched on a mistake that he committed which investors may also unknowingly make from time to time:

“My first mistake, of course, was in buying control of Berkshire. Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”

Buffett was aware that he was purchasing a lousy business when he first bought Berkshire – that was his mistake. But, investors may unwittingly fall prey to the same error by focusing on the “cheapness” of a stock without paying heed to the quality of its underlying business. As Buffett explained though, banking on a stock’s low valuation alone may result in unsatisfying returns or even losses. A cheap stock can easily become cheaper if its underlying business suffers.

Back at the start of 2009, Singapore’s market barometer, the Straits Times Index (SGX: ^STI), was valued at just six times its historical earnings. That’s already very cheap. But, there were some 279 shares back then (out of all the companies that are listed in Singapore as of 25 September 2015) that had an even lower price-to-earnings ratio.

What’s amazing though, was that 113 shares of that group of 279 had a lower price on 25 September 2015 as compared to the start of 2009. And of that group of 113, nearly all of them (111 to be precise) had seen their profits decline over the same period.

Of the 30 constituents of the Straits Times Index (SGX: ^STI), there are nine blue chips which are currently selling for lower than their tangible book values. They are namely:

The table below gives you a better idea of how their valuations look like. Golden Agri-Resources and Noble in particular, look really cheap with their shares priced at lower than 0.5 times their respective tangible book values.

Blue chips' tangible book value

Source: S&P Capital IQ

While the nine blue chips do appear to be bargains on the surface, some of them may turn out to be value traps. For any of us who are interested in them because of their low valuations, it’d pay for us to dig into their businesses carefully and consider their future growth before any investing decision is reached. As the quote from Buffett above had illustrated, a lousy business may not do us much good even when purchased at a cheap price.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway.