Berkshire's simple secrets to success

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Moving beyond cigar butts 

Buffett spent time recounting his evolution as an investor and the impact on Berkshire's philosophy. A student of Benjamin Graham, Buffett started his investing career in search of "cigar butts," ailing companies at ultra-cheap prices with one last "puff" in them, but he later realized the strategy wasn't scalable.

"My cigar-butt strategy worked very well while I was managing small sums," Buffett wrote. But it was "scalable only to a point.  ... Though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise."

Munger, whom Buffett met in 1957, began to lead him away from cigar butts and toward quality companies. Munger's blueprint for Berkshire, Buffett wrote, was "Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."

This is a good tonic for today's investing environment, which features very few outright bargains after a years-long market rally. Looking at the opportunity set (which features few 5-star, high-quality stocks), we'd say investors who need exposure to the stock market can do far worse than buying wide-most names--those with highly durable competitive advantages--at fair prices (3 stars) when better bargains are hard to come by.

Focus on moats

Such "wonderful business" tend to hold up better in downturns and provide meaningful long-term returns for investors to fund retirement or other big personal goals. In the case of Berkshire, they also meant cash flows to reinvest in even more wonderful businesses.

In 1972, Berkshire acquired See's Candy, which, Buffett wrote, "had a huge asset that did not appear on its balance sheet: a broad and durable competitive advantage that gave it significant pricing power. That strength was virtually certain to give See's major gains in earnings over time. Better yet, these would materialize with only minor amounts of incremental investment. In other words, See's could be expected to gush cash for decades to come."

The "value of powerful brands" continued to permeate Berkshire's investments over the years, with wide-moat companies such as Coca-Cola, American Express, and Wal-Mart dominating its investment portfolio.

The notion of a "circle of competence" and its importance to Berkshire's success in investment and operational decisions was also noted. Wrote Munger, "In particular, Buffett's decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis."

Buffett further quoted Tom Watson Sr. of IBM (another of Berkshire's big investment holdings): "I'm no genius, but I'm smart in spots and I stay around those spots."

A different kind of conglomerate

Buffett acknowledged the bad reputation of conglomerates, a lot of it earned due to past decades' "conglomerate mania," which was little more than accounting smoke and mirrors through which conglomerates would issue shares of overpriced stock to acquire mediocre firms trading a low multiples for good reasons.

But Berkshire's success as a conglomerate would seem to be the exception that proves the rule. Wrote Munger, "Did Berkshire suffer from being a diffuse conglomerate? No, its opportunities were usefully enlarged by a widened area for operation. And bad effects, common elsewhere, were prevented by Buffett's skills."

For instance, Buffett noted, Berkshire can "move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise" while avoiding all the related frictions that would otherwise accompany such moves--including taxes, egos ("if horses had controlled investment decisions, there would have been no auto industry"), and Wall Street bankers ("money-shufflers don't come cheap").

Referring again to See's cash flows, Buffett wrote, "We would have loved ... to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See's to help purchase other businesses. If See's had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs."

Another benefit to Berkshire's conglomerate structure has been established over the years: The firm is "now the home of choice for the owners and managers of many outstanding businesses" who don't want to sell to a competitor or a private equity firm. Berkshire's approach to acquiring great businesses, and then letting them continue to run themselves, means potential acquisitions are knocking on their door--a good position for a conglomerate to be in.

But mistakes were made

"The shares I used for the purchase are now worth about $5.7 billion. As a financial disaster, this one deserves a spot in the Guinness Book of World Records," Buffett wrote. "Trading shares of a wonderful business--which Berkshire most certainly is--for ownership of a so-so business irreparably destroys value."

But it's one thing to miscalculate the fundamental strength of a business, and another to acquire for acquisition's sake. "[Berkshire] never had the equivalent of a 'department of acquisitions' under pressure to buy," Munger noted.

"Patience" is another secret to success for the firm--waiting for the right opportunities and being content to sit on cash in their absence. But a patient approach also meant some so-called "fat pitches" sailed over the plate.

"While mistakes of commission were common," Munger wrote, "almost all huge errors were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well. The errors of omission were of much importance. Berkshire's net worth would now be at least $50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things."

The next CEO and the next 50 years