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A Simple Lesson From Buffett

The starting gun
Imagine you're a sprinter, looking for an edge in your race. Imagine Nike designs a miracle shoe that can shave a full second off your 400-meter time. And it's a bargain at $150 a pair! How many races will you win next year because of this great technological advance? Five? Ten? As many as you enter?

How about zero?

That's the correct answer, because if this shoe can shave a second off your time, it can do the same for your competitors. And you can bet everyone will pony up the $150.

Warren Buffett, track star?
What does that have 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. Economists might call it the "fallacy of composition" or the "paradox of thrift."

Early on at Berkshire -- a fabric mill, for those unfamiliar 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 because the advances were also available to every other fabric mill out there. That, in turn, meant that investing in such upgrades would benefit none of the manufacturers. With everyone generating similar cost savings, and passing them on to the customers to try boosting 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 is history.

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

I recently noted that GM (NYSE: GM  ) was looking to streamline its parts-sourcing strategies to be more like Toyota's (NYSE: TM  ) . 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. GM is already late to the game, and you can bet that troubled Ford (NYSE: F  ) will be making the same efforts -- quite possibly too late to make a difference.

Even market-beating best practices can, over time, succumb to this inevitable process. I think much of the trouble plaguing Dell (NYSE: DELL  ) stems from the fact that one of its main competitive advantages is no longer such an advantage. Other computer companies, from Apple (Nasdaq: AAPL  ) to Hewlett-Packard (NYSE: HPQ  ) , and even Chinese competitors, caught up on lean manufacturing long ago, which adds profit-sapping pricing pressure.

That's not to say that 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 -- and even, in the wake of the accounting scandal -- whether certain of those "advantages" ever existed at all.

Foolish bottom 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 whether 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 look at the case for Dell, or any of the other past picks, a free guest pass is just a click away.

This article originally appeared Sept. 21, 2006. It has been updated.

At the time of publication, Seth Jayson had shares of Berkshire Hathaway, Ford, and Ford debt, but no positions in any other company mentioned here. View his stock holdings and Fool profile here. Berkshire Hathaway and Apple are Motley Fool Stock Advisor recommendations. Berkshire Hathaway and Dell are Inside Value choices. The Motley Fool owns shares of Berkshire Hathaway. Fool rules are here.

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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 October 28, 2008, at 11:00 AM, Paywhatever wrote:

    Am I missing something in this Buffett Lesson?

    Answer is ZERO? That does not seem to account for how many races you'll lose by not buying the $150 NIKE shoes - because you admit all competitors are sure to buy and use them.

    I see Buffett coming in 1-second late.

  • Report this Comment On October 28, 2008, at 3:48 PM, wuff3t wrote:

    "I see Buffett coming in 1-second late."

    Good luck. Let me know in 10 years time who has made the most money.

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