A Simple Lesson From Buffett

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By Seth Jayson

The starting gun
Imagine you're a runner, looking for an edge in your race. Imagine Under Armour designs a miracle skinsuit that can shave a full minute off your 5K time. And it's 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 your competitors. And you can bet that 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, 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 firm.

But Buffett soon realized that such capital expenditures were wasted: These advances were also available to every other fabric mill out there. That meant investing in such upgrades would benefit none of the manufacturers; with everyone generating similar cost savings and passing them onto 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 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, firms often aim to improve, restructuring themselves to embrace "best practices" whose benefits are fleeting, if not already gone.

I recently 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. Moving up the size chart a notch, this effect is one of the reasons I'm often cautious on admittedly great manufacturers like Caterpillar (NYSE: CAT) and Deere (NYSE: DE).

That's because even market-beating best practices can, over time, succumb to this inevitable process.

I think much of the trouble plaguing 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 -- even though some of this competition must contend with old-fashioned retail sales environments and hawk machines through frugal front-ends like Best Buy (NYSE: BBY). (I'd argue that we're seeing the same story play out at other former tech untouchables, like Nokia (NYSE: NOK) with its water-torture margins.)

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.

At the Foolish finish 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.

Source: http://www.fool.com/investing/value/2007/12/27/a-simple-lesson-from-buffett.aspx?source=ihpcsphlb0000001

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