Warren Buffett's Money-Making Brilliance Was Founded on a Mistake

For over a decade, Warren Buffett was convinced that the American economy would never shake the scourge of rapid inflation. Thankfully, he was wrong.

Jun 15, 2014 at 1:00PM


"Like virginity, a stable price level seems capable of maintenance, but not of restoration."

- Warren Buffett

For nearly a decade during the 1980s, Warren Buffett was convinced that the American economy would never be able to escape the scourge of high inflation.

He was wrong on this count, obviously.

But what he got right was his response, as this error in judgment accelerated Buffett's embrace of the investment philosophy he's known for today and made shareholders in Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) extremely rich.

Buffett and the scourge of inflation
If it's true that a person is the sum total of their experiences, then it seems impossible to deny that Buffett was deeply affected by the rapid price increases of the mid-1970s and early 1980s.

As you can see in the chart below, prices rocketed higher on two separate occasions. The first followed OPEC's 1973 oil embargo, which sent the price of oil from $3 per barrel to nearly $12 following the United States' decision to back Israel in the Yom Kippur War.

And the second, which topped out at nearly 15% in March of 1980, is generally attributed to an accumulation of imprudent monetary policy -- though, by the time it peaked, the Federal Reserve had already begun to aggressively counter the trend under the chairmanship of Paul Volker.


While high inflation is rarely good for business, it was particularly bad for Buffett given Berkshire's concentration in the insurance industry.

Insurance companies make money by collecting more in premiums today than they pay out in claims tomorrow. Consequently, because inflation weighs on the latter more than the former, it threatens to reverse this fundamental relationship.

On top of this, rapid inflation also erodes the return an insurance company earns from its investment portfolio -- which, oftentimes, is concentrated in fixed--income securities.

As Buffett observed in his 1979 letter to shareholders:

Just as the original 3% savings bond, a 5% passbook savings account or an 8% Treasury Note have been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives.

A mistake that didn't go to waste
It's with this as the backdrop that one begins to sense a transition in Buffett's investment philosophy from one focused almost exclusively on grossly undervalued securities to one that's equally cognizant of pricing power and competitive advantage.

Nowhere is this more apparent than in his 1981 letter to shareholders in which Buffett discussed the desire to buy businesses that "through design or accident . . . are particularly well adapted to an inflationary environment."

Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear or 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 in capital.

The line between these characteristics and Buffett's later investments in companies like Coca-Cola (NYSE:KO) and Gillette couldn't be clearer, as companies like this preside over enduring brands, scalable business models, and the ability to raise prices without igniting a fatal backlash from consumers.

Indeed, while alternative histories are speculative by nature, it isn't unreasonable to conclude that Berkshire Hathaway's portfolio of common stocks would look completely different today if it weren't for this epiphany coupled with Buffett's pessimism in the 1970s and 1980s that stable prices were forevermore a thing of the past.

"Like virginity, a stable price level seems capable of maintenance, but not of restoration," Buffett wrote in 1981.

In hindsight, he was mistaken on this point. But also in hindsight, it's clear that Berkshire Hathaway's shareholders have been greatly rewarded by his flawed forecast.

As Buffett went on to say nearly a decade later: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Warren Buffett just bought nearly 9 million inflation-proof stock
Imagine a company that rents a very specific and valuable piece of machinery for $41,000 per hour (That's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report details this company that already has over 50% market share. Just click HERE to discover more about this industry-leading stock... and join Buffett in his quest for a veritable landslide of profits!

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Coca-Cola. The Motley Fool owns shares of Berkshire Hathaway and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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