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 owing to this great technologicial 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'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. 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 investing in such upgrades would benefit none of the manufacturers: With everyone generating similar cost savings, and passing them onto the customers in order to try and boost sales, the only likely beneficiaries would be ... the customers!
In order 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 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, firms often aim to improve, restructuring themselves to embrace "best practices" with benefits that are fleeting, if not already gone.
I recently noted that GM
Even market-beating best practices can, over time, succumb to this inevitable process. I think much of the trouble plaguing Dell
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 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 originally appeared Sept. 21, 2006. It has been updated.
At the time of publication, Seth Jayson had shares of Ford, Ford debt, and Ford calls, but no positions in any other company mentioned here. View his stock holdings and Fool profile here. Dell, Apple, and Berkshire Hathaway are recommendations of Motley Fool Stock Advisor. Dell and Berkshire are also Inside Value picks. The Fool owns shares of Berkshire. Fool rules are here.