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 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 every other runner in those races. 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 explains in The Future for Investors, the Berkshire Hathaway of 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 company.
But Buffett soon realized that such capital expenditures were wasted: Those advances were also available to every other fabric mill. 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 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 modern 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, companies often aim to improve, restructuring themselves to embrace "best practices" whose benefits are fleeting, if not already gone.
Awhile 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. 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 are sold on stories of the next big company that will cut costs and smoke the competition. We hear it a lot with the "Chinese solar panel" fairy tale. Think Suntech Power
This plays out across every industry. Buying from low-cost Asian producers doesn't give Juniper Networks
So a company like Dell might be a bargain anyway -- my colleagues at Motley Fool Inside Value have recommended it. It does mean that an estimate of Dell's worth needs to include calculations for the erosion of past competitive advantages.
At the Foolish finish line
Decades of studies show that buying stocks from the bargain bin is the best way to outperform the market. But identifying those bona fide bargains 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 first if the competition is doing the same thing.
These are the topics we ponder every day at Motley Fool Inside Value, as we comb the market for great stocks trading at great prices. I urge you 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 Sept. 21, 2006. It has been updated.
At the time of this publication, Seth Jayson had no positions in any company mentioned here. View his stock holdings and Fool profile. Wal-Mart is a recommendation of Motley Fool Inside Value, along with Berkshire Hathaway. Berkshire and Dell are also recommendations of Stock Advisor. Suntech Power is a Motley Fool Rule Breakers recommendation. The Motley Fool owns shares of Berkshire Hathaway. Fool rules are here.
