A Simple Lesson From Buffett

The starting gun
Imagine you're a street racer, looking for an edge in your game. Imagine Honda (NYSE: HMC) designs a new miracle motorcycle component that can shave a second off your quarter-mile. And it's a bargain at $150 a pop! How many races will you win next year, owing to this great technological advance? Five? Ten? As many as you enter? How much money will you scalp from the chumps on the sidelines?

How about zilch?

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

Warren Buffett, street racer?
What's that got to do with the Oracle of Omaha? Well, as Jeremy Siegel explained in The Future for Investors, the Berkshire Hathaway (NYSE: BRK-A) 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!

Making 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.

I recently 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, and help it compete less poorly than it has, 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 its troubled stateside peers are making the same efforts -- when they're not hoping for buyout help from private equity firms.

Even market-beating best practices can, over time, succumb to this inevitable process. Just look at the expensive and neverending race for faster, cheaper, more capacious memory from manufacturers like SanDisk (Nasdaq: SNDK), Qimonda (NYSE: QI), Samsung, and Micron (NYSE: MU) with its NAND partner, Intel.

I think much of the trouble that plagued Dell derived from the erosion of one of its main competitive advantages. And recent results from Lenovo -- which bought IBM's (NYSE: IBM) old PC business -- reinforce this point. Other computer companies, including Hewlett-Packard, Sony (NYSE: SNE), and a few no-name Chinese competitors, have and will continue to catch up on lean manufacturing, which adds profit-sapping pricing pressure.

That's not to say 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 will 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 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 shares of Berkshire Hathaway, but no positions in any company mentioned here. View his stock holdings and Fool profile here. Dell, Intel, and Berkshire Hathaway are Inside Value picks. The Motley Fool owns shares of Berkshire Hathaway and covered calls on Intel. Fool rules are here.