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.
Simple question, important lesson
This year, the most interesting Q&A concerned Berkshire's big purchase of PetroChina a while 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. "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.
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. That's not the case at many of the high-fliers that were Wall Street darlings only two years back. Investors who thought they were getting the deal of a century after the first drop in famous financials like Barclays (NYSE:BCS), UBS (NYSE:UBS), Wachovia (NYSE:WB), or Lehman Brothers (RIP) learned a brutal lesson to the contrary. There was simply no way for any of them to know enough about their balance sheets (loaded with inscrutable junk), let alone management, and future prospects.
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 Aluminum Corp. of China (NYSE:ACH) or China Mobile (NYSE:CHL) fit that bill. So do 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.
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 nongeniuses like you and me.
I came to a similar conclusion on PetroChina a while 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 lot 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.
Finding margins of safety like these is the primary goal of my colleagues at Motley Fool Inside Value. Like Buffett, advisor Philip Durell isn't afraid to wade into the panicky market and hold businesses. In fact, Inside Value recently tapped construction materials provider Vulcan Materials (NYSE:VMC), a fairly simple business, and one that is likely to take lumps during the coming economic slump, but that was priced for far worse. And it has returned an unusual (but welcome) 20% since then -- beating the S&P 500 handily.
To take a look at all the Inside Value picks, and to see what Philip learned at this year's Berkshire meeting 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, Vulcan Materials, and Coca-Cola are Inside Value recommendations. Berkshire is also a Stock Advisor selection and Motley Fool holding. The Fool has a disclosure policy.
