Warren Buffett’s track record makes him one of the investing community’s all-time greats. From 1965 to 2016, he generated an incredible annual return of 19%. But you may be surprised to know that even Buffett makes mistakes. In Buffett’s 1989 letter to his shareholders, he shared a number of investing mistakes he committed in his first 25 years of investing. It’s always valuable to learn from the mistakes of others. And given Buffett’s stature, learning from his errors is even more valuable. This article will be the first of a few articles that looks at the mistakes Buffett detailed in…
Warren Buffett’s track record makes him one of the investing community’s all-time greats. From 1965 to 2016, he generated an incredible annual return of 19%. But you may be surprised to know that even Buffett makes mistakes.
In Buffett’s 1989 letter to his shareholders, he shared a number of investing mistakes he committed in his first 25 years of investing. It’s always valuable to learn from the mistakes of others. And given Buffett’s stature, learning from his errors is even more valuable.
This article will be the first of a few articles that looks at the mistakes Buffett detailed in his 1989 letter. So, let’s get going. [Editor’s note: Three more articles on Buffett’s mistakes have been published. They can be found here, here, and here.]
A big mistake: Buying cheap stocks
A big mistake Buffett committed in his younger years as an investor was to invest in a textile manufacturing company simply because it was statistically cheap. Here’s how Buffett described his thought process when investing in it:
“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.”
In his younger days as an investor, Buffett applied an investing strategy that he called the “cigar butt” approach. In this strategy, Buffett would buy stocks that were priced sufficiently low in relation to their value, so that any uptick – however slight – in their business fortunes or the market environment would create an opportunity to unload the stocks at a decent profit.
He was very successful with cigar butt investing, but as he gained more experience, he quickly realized this strategy was not a good one. In describing his mistake of investing in the textile manufacturer in his 1989 letter, Buffett also wrote that “this kind of approach to buying businesses is foolish.”
Why it’s a mistake
One of the key risks with the cigar butt approach is that the company in question might end up going bust, or being a value trap. A value trap is an investment which looks promising based on its current price and earnings, but has poor prospects due to low expected future profits. In such a case, investors have little incentive to buy the stock at higher prices. Buffett also mentioned in his 1989 letter: “In difficult businesses, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.”
After purchasing the textile manufacturer, Buffett committed a similar mistake when he acquired department store operator Hochschild Kohn, because it was a cheap business. Luckily for Buffett, he managed to sell that business three years later at around the price he paid for it.
The investments Buffett made in the textile manufacturer and Hochschild Kohn, and probably numerous others, taught him a very important lesson: When investing, price should not be a determining factor. While not over-paying for a business is important, it is vital that investors also focus on the company’s long-term business prospects.
These experiences led Buffett to coin a phrase that is now famous: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
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