Buffett Proclaims His Ignorance

The most surprising thing about Warren Buffett is that he can still surprise. After all, more ink has likely been spilled dissecting Buffett's strategies than those of any other investor. Buffett became the world's richest person while displaying both integrity and wit.

So it's natural that people listen when Buffett speaks. But he's been saying the same things since the 1960s. What more is there to learn from him?

Yet in the recent Berkshire Hathaway shareholder meeting, Buffett professed his ignorance about some of Berkshire Hathaway's investments.

An astounding answer
One questioner asked how Buffett values the pipelines of pharmaceutical companies -- a great query. When a drug loses patent protection, generic competition typically swoops in with cheap copies, potentially reducing sales of that drug by billions of dollars overnight. As a result, drug companies have to constantly nurture a pipeline of new drugs. From this pipeline, the next blockbuster must arise in order to maintain and grow the company's revenue.

What's more, Buffett clearly likes the pharmaceutical businesses. Berkshire has stakes in GlaxoSmithKline (NYSE: GSK  ) , Johnson & Johnson (NYSE: JNJ  ) , and Sanofi-Aventis (NYSE: SNY  ) -- three huge drug companies.

So Buffett's answer -- that he doesn't really know the potential of the pipelines of the drug companies in which he's invested -- was remarkable.

Ignorance is bliss?
It seems incredible -- almost irresponsible -- for Buffett to ignore the pipelines of these companies. Investment analysts in the sector spend a large portion of their time analyzing what's coming through the pipeline. Yet that doesn't even make the radar for Buffett?

However, if you take a step back and think about it, Buffett's blissful inattention actually makes sense. If you know anything about Buffett, you know that:

  1. He's a long-term investor.
  2. He likes to own excellent businesses.
  3. He wants easy decisions.

Taken together, these characteristics imply that he doesn't need to know the details of drug companies' pipelines.

Truly long-term
At the meeting, Buffett pointed out that in five years, the pipeline will change. Remember, this is a guy who's owned Wells Fargo (NYSE: WFC  ) and American Express (NYSE: AXP  ) for decades -- five years is nothing. Buffett meant that if you're buying a company simply for its pipeline, you're buying for short-term reasons.

Buffett is aiming to hold forever, not gamble on whether or not some drug in the pipeline will be approved. He's looking for excellent businesses with sustainable competitive positions. The question for Buffett isn't whether there's a great drug in the pipeline; it's whether huge pharmaceutical companies are excellent businesses in the first place.

Buffett thinks they are. Big drug firms have piles of cash that allow them to develop or buy new medications. They have the resources, expertise, and contacts to shepherd attractive drugs through trials and gain approval by the FDA. Once a drug is approved, a patent gives a company a monopoly on a product that can save someone's life. It's hard to imagine a business with greater pricing power. And that matters far more than pipelines.

One-foot hurdles
Finally, Buffett's looking for easy decisions, which leads to two key criteria.

First, he won't even consider investing in businesses that are too difficult to understand. For example, even though Yahoo! (Nasdaq: YHOO  ) president Susan Decker sits on Berkshire's board of directors, it's unlikely that Berkshire would ever consider investing in Yahoo!. Technology investing is just too hard. New competition arises every day, and it's too hard to know when a breakthrough will render a technology obsolete.

Second, Buffett is looking to buy businesses cheaply enough that a slight error in his estimate of their worth won't really matter. He's not looking to buy stocks at a 10% discount to their fair value. He's looking for a 30% or 40% discount, minimum. When he bought PetroChina (NYSE: PTR  ) , Buffett estimated that he was enjoying a 65% discount.

When buying at that sort of margin of safety, minor details are irrelevant. It doesn't matter whether PetroChina's oil fields will run dry in 2050 or 2055. Either way, the company's cheap. Similarly, it doesn't really matter whether any individual drug in the pipeline fails, as long as the pharmaceutical company you're buying is cheap, and as long as it has a great competitive position that will ensure its long-term success.

The most important takeaway for small investors
Valuation spreadsheets can encourage you to focus on details and provide false confidence. But the details are often trivial. Sure, it's worthwhile to know as much as possible about the companies in which you invest. But the most important parts to get right are the companies' competitive positions, and the price you're paying for the shares.

If you're a long-term investor buying excellent businesses at cheap prices, trivialities shouldn't matter. These are the types of opportunities on which our Inside Value team focuses. These days, we're finding some strong, growing businesses trading for 50% and 60% of what they're actually worth. If you want to check them out, we offer a 30-day free trial.

Fool contributor Richard Gibbons wants to be too difficult to understand, but is probably just trivially unimportant. He does not have a position in any of the stocks discussed in this article. The Motley Fool owns shares of Berkshire Hathaway. American Express and Berkshire Hathaway are Inside Value picks. Berkshire is also a Stock Advisor recommendation. GlaxoSmithKline and Johnson & Johnson are Income Investor selections. The Fool's disclosure policy is tasty with marmalade.

Read/Post Comments (5) | Recommend This Article (129)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 23, 2008, at 2:36 PM, dawtrey1 wrote:

    It seems that Richard Gibbons has a great insightg into the workings of Mr. Buffet's mind. He has no doubt studied Warren's value approach for years. The University of Oklahoma has a student investment fund that has studied and used the Graham, Buffet, Price value approach, and ran a $150,000 donation from alum Michael Price to $500,000 in a rather short period of time. Here are a group of kids that will some day be running the investment firms on wall street in the future. Or maybe Omaha.

  • Report this Comment On May 24, 2008, at 10:27 AM, Classof1964 wrote:

    This is a great article for small investors and buyers of individual stocks. Contrary to much of the short-term mentality of Wall Street, it suggests that individuals save and wait patiently for a favorable situation to develop, either in the general market or a sector or with an individual stock. It might be three or four years before a margin of safety and window of opportunity develop. But for the small, long term investor that time allows for the accumulation of funds to invest and becoming more familiar with the target stock and company. The focus on finding great businesses and following them while waiting for the margin of safety to develop frees one from getting lost in the overwhelming mass of details and facts available today for many companies.

  • Report this Comment On June 01, 2008, at 9:24 PM, journeywithme wrote:

    I think that Mr. Buffet's success demonstrates what can happen when sound investing principles are utilized faithfully and consistently over time. I am new on my journey into the stock market:

    I also want to focus on finding great businesses whose stock is currently selling at a discount. The challenge is learning how to quickly recognize these opportunities and not to get distracted by all the noise in the stock market.

    Be well.

  • Report this Comment On July 06, 2008, at 10:37 PM, rrecroc1 wrote:

    Mr. Buffett may personally have "ethics" but many of the companies he invests in do not ....... to me that invalidates his integrity.

    "Sugar water" has created the largest diabetes epidemic in the world in this country now even being seen in teenagers.

    As a pharmacist, I have dealt with the lying, bribing, corrupting, murdering, thieving brand name pharmaceutical companies for over two decades. They are literally the scum of the earth.

    Only the insurance companies rival them in their hypocrisy and lies.

    If you profit from the unethical behavior of a company you know to be ethically suspect, the "blood is on your hands" and you are a co-conspirator.

  • Report this Comment On October 03, 2008, at 4:23 PM, teslarules wrote:

    I respectfully disagree that WB “Buffett clearly likes the pharmaceutical businesses”. There are several arguments that there is nothing “clearly” about it. 1. Pharma is a small part of WB’s holdings 2. J&J can hardly be considered just a prototypical Pharma as its biz is very diverse 3. In his multi-decade investing career with ample opportunities to invest in Pharma, WB has clearly shown his aversion to Pharma. Even a superficial look at his investing philosophy offers clues. Pharma is probably one of the most complex industries, with multiple levels of risk (think pre-clinical + Phase I – IV and beyond). Even industry experts have trouble attaching values to Pharma. It was not an accident that an audience member asked about pipelines as they are the backbone of Pharma. After all, how can one know that a particular Pharma Co is a great business without understanding how successful a company is in developing drugs that not only make it to by stay on the market. Isn’t any of fellow Fools curious as to why there are no American Pharma (i.e., PFE) in WB portfolio (as mentioned, JJ is hardly a prototypical Pharma). Would be interested to get your feedback guys&gals!

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