One big reason the Berkshire Hathaway annual meeting attracts 30,000-plus shareholders and fans is that anyone who stands in line has a shot at asking the master investor a question. Want to know why Buffett has never purchased shares of his good friend Bill Gates' company? Go ahead and ask him. Want to know what he thinks of the presidential candidates? He'll answer it.
Simple question, important lesson
This year, the most interesting Q&A concerned Berkshire's big purchase of PetroChina awhile back. According to an article in Forbes, Buffett bought the shares after minimal due diligence. And I mean minimal. In fact, it was reported that all he did was read a couple of annual reports.
A shareholder stood to ask him -- and I'm paraphrasing here -- "Dude! What's the deal with that? How could you make such a large purchase with only the annual reports, without seeing the operations or meeting management?"
That's a fair question. How could Buffett, a man who has spoken at length many times about the vital importance of good management, buy a major chunk of this Chinese national company, sight unseen?
Stories are simple when the price is right
Buffett replied that the oil business is "not that hard to understand." So, once he came to the conclusion that PetroChina was worth about $100 billion but was selling for only $35 billion, the decision pretty much made itself without the need for details. It would have been a lot different, he said, if he thought it was worth $35 billion but was selling for $40 billion.
He explained that he's looking for precisely these kinds of investments all the time. If ConocoPhillips were trading at what looked like half-price, the response would be immediate. But at the time Buffett was watching PetroChina, China Fever had yet to take hold with the world's stock buyers, and that explained much of the discount. For Buffett, it was a no-brainer. "It should hit you between the eyes," he said, adding that if your investment thesis requires you to carry an analysis out to three decimal places, it's not a good idea. Since all stocks Asian and oil have been shattered lately, many of these have come back to no-brainer land.
Back to basics
Buffett was referring to the "margin of safety." Most commonly, it describes a percentage difference between what a company is selling for on the market and what you think it's actually worth. If you're buying stocks that look only moderately underpriced, say 5%-10%, then you have to be very, very certain that your numbers are correct. You also need to know a lot about management, competition, and whether the company HQ sits in an asteroid's path.
Unfortunately, no matter how diligent you are, you will never know it all, and you'll inevitably make mistakes. That's why the margin of safety is so important, and the fatter that margin of safety is, the less you need to worry about getting the details precisely right or wrong. Interested in a fallen financial. You'd better know everything about its balance sheet, management, and future prospects -- and that's an impossible task these days. The guys running these banks have no idea what their assets are worth.
That's why Buffett likes the simpler stories, and you should, too.
One way Buffett ensures that he's got a good margin of safety on a simple story is to concentrate on industries in which some players have big competitive advantages. Protected national champions like PetroChina fit that bill. We don’t quite have those on our shores, but the government seems to have designated several banks as too big to fail, such as Goldman Sachs
They’re no longer national champions, but railroads have considerable moats and bright long-term futures, and we know Buffett has already been taking positions in operators like Burlington Northern Santa Fe
Buffett also likes strong brand names with deep moats. His big score with Coca-Cola came at a time when the entire world thought "New Coke" had killed the brand, but he knew consumers would come back to what they'd trusted for years. Strong brands like those at Coke usually weather storms well, even the ones we're seeing today. So when such stocks do break down, it's a simple decision to buy. Investors today would do well to watch for market-panic-induced bargains in brand-heavy cash producers further up the food chain, such as cheap eateries like Yum! Brands
Foolish final thought
How did PetroChina work out for Buffett? Pretty well, but let's not do that math. Let's forget the winnings of the super-investors for a second and look at what it did for simple, nonbillionaire geniuses like you and me.
I came to a similar conclusion on PetroChina awhile after Buffett did, and I got my shares for about $90 each. A year and a half later, they were selling for nearly $250, a good deal more than I figured the company was worth. I sold, pocketing a 180% gain, and looked elsewhere for simple stories with similar margins of safety. I wasn't aiming to emulate Buffett, but I'm pretty sure remembering this lesson will make me a better investor. You don't have to sweat the details when the discount is big enough, and in today's market, there are plenty of bargains. Buffett has said so himself, in a recent New York Times editorial.
Finding margins of safety like these is the primary goal of my colleagues at Motley Fool Inside Value. Like Buffett, advisors Philip Durell and Ron Gross aren't afraid to wade into the panicky market and hold businesses. In fact, Philip attended the Berkshire annual meeting this year and has his own tales to tell. To take a look at what he learned, and how it informs his investing decisions, a free trial of Inside Value is just a click away.
This article was first published May 13, 2008. It has been updated.
At the time of publication, Seth Jayson had shares of Berkshire Hathaway, but no position in any other company mentioned here. Berkshire Hathaway and Coca-Cola are Inside Value recommendations. Berkshire Hathaway is also a Stock Advisor selection. The Motley Fool owns shares of Berkshire Hathaway and has a disclosure policy.