Warren Buffett: Why Being Cheap With Money Is a Big Mistake

People buy socks all the time. Warren Buffett thinks a simple lesson we can learn from them will teach us how we should buy stocks.

Jul 19, 2014 at 9:18AM


I hate buying socks. But according to Warren Buffett, the process can actually teach us how to be a successful investor.

This perspective has allowed him to turn Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B) from a small textile company that earned just $0.15 per share in 1965 into a $500 billion picture of American success that made $11,850 per share last year. 

The wisdom
Following the 2008 stock market collapse, Buffett penned the quote above in his letter to Berkshire Hathaway shareholders. This was by far the most tumultuous time Buffett has seen atop Berkshire, as the S&P 500 tumbled by nearly 40% on the year.

Buffett began his letter honestly and painted the dim picture of what the American economy was facing in February 2009, as the S&P 500 had officially been cut in half in just 14 months. Panic was on the mind of every investor at the time. Buffett revealed:

By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. -- and much of the world -- became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.

But the collapse of the market didn't deter Buffett as an investor. After he spoke about the troubles that characterized the country in 2008, the Berkshire chief said he believed, "America's best days lie ahead."

Buffett put his money where his mouth is. He poured more than $15 billion into the market in September and October 2008 by making massive investments in well-known titans. This encompassed $5 billion in Goldman Sachs (NYSE: GS), $3 billion in General Electric (NYSE: GE), and $6.5 billion into the Wrigley subsidiary of Mars.

Yet perhaps the greatest example of Buffett's wisdom -- which he learned from mentor Ben Graham -- is presented most clearly in his investment in Wells Fargo (NYSE:WFC).

The well of Wells
Buffett first began buying Wells Fargo in 1989. But as the new century approached Berkshire began to slowly unload its position, which dropped from $392 million at the end of 1998 to $306 million by 2001.

In 2003, Buffett boosted Berkshire Hathaway's holdings of Wells Fargo by more than 50%, to $463 million, but he didn't buy any in 2004. The big buying began in 2005, as the position grew by more than five times to sit at $2.8 billion. And it's been on an astounding run ever since:

Source: Company Investor Relations.

So why has Buffett aggressively added to his position of Wells Fargo during one of the most trying and difficult periods for the financial industry? Put simply, it -- like the socks Buffett buys -- was "marked down."

The bank worth buying
One key metric used by investors to gauge a bank's relative value is the price-to-tangible book value. Wells Fargo watched its fall as the decade progressed:

Source: S&P CapIQ.

On a relative basis, Wells Fargo was put on sale nearly 10 years ago, and its price has only improved as the years have progressed. But we must see this relative discount -- some banks are significantly less expensive than Wells Fargo -- as only part of the equation.

Consider Buffett's quote in 2005, when the first major purchase was made:

We substantially increased our holdings in Wells Fargo, a company that Dick Kovacevich runs brilliantly.


Source: S&P CapIQ

Even though the bank's multiple was trading well below where it had for the previous five years -- as shown in the chart to the right -- Buffett never mentioned the relative value. Instead, he highlighted the business and the underlying leadership.

But why has Buffett continued to buy Wells Fargo?

Sure, Wells Fargo's trading multiple has fallen in the nine years since Buffett began aggressively adding to his position. And although its profitability -- as measured by its return on assets, or ROA, and return on equity, or ROE -- has fallen as a result of the financial crisis, the gap isn't nearly as dramatic as the drop seen in its relative valuation.

Source: S&P CapIQ.

The drop in its value doesn't line up with the dip in its business operations. And while the bank's multiple is still often far above its peers, remember Buffett once said:

We try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.

With that in mind, consider Bank of America (NYSE:BAC), which Buffett stake a position in after the market overreacted and its stock cratered in the fall of 2011.

Why did he aggressively continue to buy Wells Fargo, but only make the one-time investment in Bank of America? The numbers don't lie:

Source: S&P CapIQ.

Bank of America saw its price-to-tangible book value plummet to just 0.5 in August 2011 when Buffett made his investment. So that chart doesn't tell the whole story.

But it does reveal why Buffett has continuously added to his stake in Wells Fargo, versus a one-time investment in Bank of America.

Put simply, there is perhaps no clearer picture of "a wonderful business at a fair price" than Wells Fargo over the last nine years.

The story of socks
So what does any of that have to do with socks? Let's revisit Buffett's quote:

Long ago, Ben Graham taught me that "Price is what you pay; value is what you get." Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down.

Let's say you see a pair of socks at the dollar store versus some at the neighborhood sports store. The sports store has a $25 three pack on sale for $15, while you could buy three pairs for $3 at the business next door.

Knowing one "investment" is five times more expensive, Buffett would tell you to pay $3 for the socks, right?


You'd have to consider so much about the socks beyond just the price. For example, what if the cheaper socks carried significant risk of injuries like blisters? Or what if they wore out after just a few months of use? And so on.

The $15 socks could in fact provide better value. If the $3 socks must be replaced every eight months -- their "quality" may be anything but  -- and you could hold onto the $15 socks for five years, you'd end up paying more over the long term for being cheap:


You may say over the short term cheaper socks provide more value, but when you take the long-term perspective with purchases -- years or perhaps decades -- the relative quality is incredibly important to consider.

In the same way, stocks shouldn't be held for days, weeks, or months, but years or decades. When Buffett announced in 2003 that he had added to his position in Wells Fargo, he also noted:

We bought some Wells Fargo shares last year. Otherwise, among our six largest holdings, we last changed our position in Coca-Cola in 1994, American Express in 1998, Gillette in 1989, Washington Post in 1973, and Moody's in 2000. Brokers don't love us.

Knowing he still holds massive positions in Coca-Cola and American Express, which cost him a little over $2.5 billion but at the end of 2013 were worth more than $30 billion, there is perhaps no clearer picture of the simple beauty of "buy-and-hold" investing.

The final thing to remember
In 2012, Buffett said:

More than 50 years ago, Charlie [Munger] told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible.

Investing shouldn't be a gauge of just the price as we look for bargains. Nor should it be a consideration of just the business, as Buffett has also argued that "a business with terrific economics can be a bad investment if the price paid is excessive."

Berkshire Hathaway has been so successful is because Buffett considers both the business and the price. Only by gauging the prospect of the business and the relative price can we determine the true value of the investment.

And when we do this, we'll inch closer to realizing the same success Warren Buffett has had.

Warren Buffett: This new technology is a "real threat"
Buffett has taught us so much through the years, and at the recent Berkshire Hathaway annual meeting, Warren Buffett admitted this emerging technology is threatening his biggest cash-cow. While Buffett shakes in his billionaire-boots, only a few investors are embracing this new market which experts say will be worth over $2 trillion. Find out how you can cash in on this technology before the crowd catches on, by jumping onto one company that could get you the biggest piece of the action. Click here to access a FREE investor alert on the company we're calling the "brains behind" the technology.

Patrick Morris owns shares of Bank of America, Berkshire Hathaway, and General Electric Company. The Motley Fool recommends Bank of America, Berkshire Hathaway, Goldman Sachs, and Wells Fargo. The Motley Fool owns shares of Bank of America, Berkshire Hathaway, General Electric Company, and Wells Fargo. 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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