Buffett vs. Buffett on Company Quality

Perhaps Buffett’s most misused quote is “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

Perhaps Buffett’s most misused quote is:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

-1989 Berkshire Hathaway annual letter

The quoter is usually trying to show how evolved their approach has become toward quality companies or justify paying fancy prices for good businesses because they lack the discipline to wait for real mispricings.

It is completely true that Buffett’s approach has evolved both from the Partnership days to the early Berkshire Hathaway days and from the early Berkshire days to his current approach. Some of the evolution was driven by the changes in the markets over that time, but a significant driver of the change in Buffett’s approach was his improvement in investing understanding driven by both experience and the influence of his partner, Charlie Munger.

However, those throwing around the quote about buying wonderful companies at a fair price are missing a couple of things. First, let’s go to no lesser authority than… Warren Buffett:

Our partial-ownership approach can be continued soundly only as long as portions of attractive businesses can be acquired at attractive prices. We need a moderately-priced stock market to assist us in this endeavor. […] For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.

– 1982 Berkshire Hathaway annual letter

In the same letter Buffett then goes on to reflect on how little they owned in public equities during the height of Nifty Fifty bubble:

There were as many good businesses around in 1972 as in 1982, but the prices the stock market placed upon those businesses in 1972 looked absurd. While high stock prices in the future would make our performance look good temporarily, they would hurt our long-term business prospects rather than help them. We currently are seeing early traces of this problem.

Now, you might be thinking “But Gary, the first quote was from 1989, that’s seven years after the earlier quote from 1982. Maybe Buffett just evolved some more over that time?”

Perhaps, but that view is not supported by the facts.

Buffett has continued to stress the importance of the purchase price of any investment throughout his writings and his answers to questions during the Berkshire Hathaway Annual Meetings. More importantly, since actions speak louder than words, look at how he is investing right now.

Just like in 1972, it’s very likely that Buffett knows many good businesses today. However, Berkshire Hathaway’s cash hoard keeps rising. There is only one reason why that might be – because nothing meets his criteria. The only logical implication is that his criteria includes a heavy emphasis on price.

So let’s return to that famous 1989 quote. The great investor said “fair price.” He did not say “any price,” “full price” or any other term. Now, what might “fair” mean to him?

In some sense, “fair” has no absolute meaning in this context. Selling a stock is giving up partial ownership in a business just like buying a stock is acquiring such an interest. If the company’s prospects remain unchanged, the seller foregoes the same Internal Rate of Return (IRR) the buyer gains.

I believe Buffett means something like this: “Look, you don’t need to insist on paying a single-digit P/E for a stock. Even if you pay the typical market multiple of 15X or perhaps slightly more, if you have identified a really wonderful company your IRR will be pretty darn good – well into the double digits. What’s more, a wonderful company is more likely to surprise you to the upside and deliver higher returns than what you bargained for, while the company behind a dirt-cheap stock is likely to surprise to the downside.”

Disagree? I challenge you to give me three examples of major Berkshire Hathaway investments made at much more than 20X earnings. BYD, an incredibly successful Berkshire investment made at Munger’s insistence, was a very small position at the time of purchase.

Perhaps you are thinking about See’s Candies, frequently (and correctly) thought of as the milestone investment which reflected Buffett’s pivot towards quality? Not quite. That one was made at just under 10X earnings.

The reason that Buffett is such a concentrated investor is his insistence on a combination of a quality company, an honest and capable management and an attractive price. Whether you label it “fair” or use some other term, he is certainly not paying up very much even for quality companies, nor is he telling you to.

The next time you are tempted to pay 30X+ earnings because you think you are such a hotshot business analyst and seer of the future, just remember: you are doing it because you want to, not because that’s what Buffett taught you to.

About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.