A Simple Lesson From Buffett

The starting gun
Imagine you're a runner, looking for an edge in your race. Imagine you're allowed to wear your adult-sized Heelys and you can now shave a full minute off your 5K time. And they're a bargain at $150! How many races will you win next year owing to this great technological advance? Five? Ten? As many as you enter?

How about zero?

That's the correct answer, because if this miracle product can shave a minute off your time, it can do the same for your competitors. And you can bet that everyone will pony up the dough.

Warren Buffett, track star?
What's that got to do with the Oracle of Omaha? Well, as Jeremy Siegel explained in The Future for Investors, the Berkshire Hathaway we know today owes its existence to Buffett's recognition of this important concept, which economists might call the "fallacy of composition" or "the paradox of thrift."

Early on at Berkshire -- which was a fabric mill, for those who aren't familiar with ancient history -- Buffett's managers would bring him well-conceived plans for upgrading processes, machinery, you name it. These would, on paper at least, save the plant a lot of money, meaning bigger potential profits for the firm.

But Buffett soon realized that such capital expenditures were wasted: These advances were also available to every other fabric mill out there. That meant investing in such upgrades would benefit none of the manufacturers; with everyone generating similar cost savings and passing them onto the customers to try to boost sales, the only likely beneficiaries would be ... the customers!

To make the most of a tight situation, Buffett morphed Berkshire into an investment-driven holding company, and the rest, as we say, is history.

Simple lesson for value
The fallacy of composition is a particularly important concept for budding value investors, because so many of the rebound and turnaround stories out there hinge on comeback plans. When the chips are down, firms often aim to improve, restructuring themselves to embrace "best practices" whose benefits are fleeting, if not already gone.

A while back, I noted that General Motors was looking to streamline its part-sourcing strategies to be more like Toyota's. While that might plug a couple of holes in GM's leaky boat, by now you probably realize that it won't offer any long-term competitive advantage.

That's because even market-beating best practices can, over time, succumb to this inevitable process. I think much of the trouble that has plagued Dell derives from the erosion of one of its main competitive advantages. Other computer companies, from Hewlett-Packard to Lenovo, have caught up on lean manufacturing, which adds profit-sapping pricing pressure.

Yet time and time again, investors get sold on stories of the next big company that's going to cut costs and take over the competition. These days, we hear it a lot with the whole "Chinese solar panel" fairy tale. Think Suntech Power (NYSE: STP) has an advantage because of China? Take a look at all the companies, many of which are coming public now, that have the same "advantage." Think big players like BP (NYSE: BP) aren't looking for locations with similar, or even better, cost savings? Think again.

This plays out across every industry. Buying from low-cost Asian producers doesn't give Juniper Networks (Nasdaq: JNPR), Wal-Mart (NYSE: WMT), or Abercrombie & Fitch (NYSE: ANF) any advantage over the competition, because everyone's already doing the same thing.

That's not to say that a company like Dell might not be a bargain anyway -- my colleagues at Motley Fool Inside Value believe it is. It does mean that an estimate of Dell's worth needs to consider the erosion of past competitive advantages.

At the Foolish finish line ...
Decades of studies prove that buying stocks from the bargain bin is the best way to outperform the market. But identifying real bargains among potential values demands that we pay close attention to basic and -- yes -- boring concepts like the fallacy of composition. Think that flashy new customer-relationship-management system is going to turn the tide? Better find out if the competition is doing the same thing.

These are exactly the kinds of issues we ponder every day at Motley Fool Inside Value, where we comb the market for great stocks trading at great prices. If you'd like to take a look at the case for Dell, or any of the other past picks, a free guest pass is just a click away.

This article was originally published on Sept. 21, 2006. It has been updated.

At the time of publication, Seth Jayson had no positions in any company mentioned here. View his stock holdings and Fool profile here. Wal-Mart is a recommendation of Motley Fool Inside Value, along with Berkshire Hathaway. Dell and Berkshire are Stock Advisor recommendations. Suntech Power is a Rule Breakers pick. Fool rules are here.