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Warren Buffett: Sage for the ages

I have recently been reading Warren Buffett’s famous annual Berkshire Hathaway (NYSE: BRK.B) letters, starting from 1977. The same Buffett quotes are frequently repeated – for good reason. However, I’ve been struck by just how much I have missed out on by reading only shortened quotes, without understanding the context in which they were written.

The below quotes are all from the 1980s. One point that features in every letter of that decade is the importance of companies achieving a good return on investment. This was the decade, after all, that he finally liquidated the textile business. I had a lot of difficulty selecting just three quotes, and if you have time to read some but not all of Buffett’s letters from the 80s, then I recommend 1987, 1989 and the appendix on goodwill and amortization in 1983.

Writing about businesses that can grow profits faster than inflation, Buffett described two characteristics of such companies:

“(1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.” (1981)

Fast-forward to 2013 and the software sector is one place to look for such companies. However, investors must note that yearly R&D and product stickiness depend on the specific software product.

Amongst my holdings, Energy Action (ASX: EAX), which sells software-based solutions and secures favourable electricity supply contracts for clients, best fits these criteria. This is because the company takes a percentage commission on contracts and will grow with the price of electricity (and inflation). Further, higher electricity prices further incentivize clients to retain the company’s services, allowing for a modicum of pricing power.

On the other hand, another of my favourite quotes counts against Energy Action. On the subject of management consultants, Buffett wrote:

“CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie and I have frequently observed the consequences of such ‘help.’ On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.” (1987)

I can’t say I was delighted to read that earlier this year Energy Action appointed Fort Street Advisers to help “assess growth opportunities in the market.” It truly is a pity for Energy Action shareholders that Valerie Duncan is retiring as Managing Director. If only she would continue.

This is something investors should consider when one of their companies announces it is paying for expensive external consultants. When the current management has proven to be wise capital allocators, external advisers have a difficult job adding value. However, as Buffett says, there are plenty of inadequate capital allocators who remain firmly in denial about their abilities – leading to what he calls “spurious accounting goodwill.”

Prospective investors in Coca-Cola Amatil (ASX: CCL) would be interested in this childhood anecdote pertaining to Berkshire’s investment in Coca-Cola (NYSE: KO).

“I believe I had my first Coca-Cola in either 1935 or 1936. Of a certainty, it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product.

I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I’m making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes.”

Foolish takeaway

Reading every Berkshire letter is more than a pastime; it’s part of an education I should have had at university. And what is investing, according to Mr Buffett? “When investing,” he says, “we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (1987)

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Motley Fool contributor Claude Walker owns shares in Energy Action. Find him on Twitter @claudedwalker.

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