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Escaping Our Old Ideas Is Difficult

"The difficulty lies not in the new ideas but in escaping from the old ones."                                                                                                                                         -John Maynard Keynes

I found this quote not in one of John Maynard Keynes' books, but in The Essays of Warren Buffett: Lessons for Corporate America by Lawrence Cuningham.  Warren Buffett was a disciple of one of the first hedge fund managers, Ben Graham, who would look for companies that traded at cheap multiples of earnings and had lots of tangible assets (equipment, buildings, etc.) on its books.

Ben Graham would then buy these cheap companies when the company was trading at a price below what the value of the underlying tangible assets were worth.  Let's use a simple example to get an idea of what he was doing.

Let's say you have a company trading on the stock market called Trendy Watches Inc. and they sell old fashioned watches. Here is what the balance sheet may look like:

Cash:  $10,000

Accounts Receivable (money owed to you from customers):  $10,000

Inventory:  $10,000

Property, Plant, and Equipment:  $100,000

Total Assets:  $130,000

Accounts Payable (money you owe to suppliers): $5,000

Short term Debt:  $0

Long Term Debt:  $0

Total Liabilities:  $5,000

Total Equity:  $125,000 (Total Assets minus Total Liabilities)

For simplicity, let's say that the company is earning $6,000 in net income and that this company has been trading on the the stock market for decades, but all of a sudden smart watches are becoming more and more popular.  This is making the old fashioned watches that Trendy Watches Inc.'s sells less trendy and now consumers are demanding more watches that sync with smart phones.  The market cap is now trading at $60,000 because no one thinks the company has a bright future ahead of it.

Ben Graham might understand that this company doesn't have a bright future ahead of it, and that it may not be around for 10 or 20 years, but when he looks at the balance sheet he knows that this company has no debt and they have property, plant, and equipment that exceeds the market cap alone by $40,000.  The property, plant, and equipment may consist of an office building that could be rented out or a manufacturing plant that could possibly be sold for what the whole company is selling for ($60,000 market cap).

This was known as "cigar butt" investing because it is just as if you are walking down the street and you find a cigarette with one puff left on the sidewalk.  You can pick this cigarette up and get one puff for free, but it wouldn't give you anything else.  Just like our example above, buying Trendy Watches Inc. won't give you long term returns because it is very likely that their product will be out of fashion as smart watches take over the market, similar to how iPods took over CD players, but in this case you can buy the whole company and liquidate the assets.  This is a case where Ben Graham would look for companies that are worth more dead than alive because he could buy the whole company, sell the underlying assets, and make a profit.

Warren Buffett used this technique a lot when he was much younger since he was a student of Ben Graham's at the University of Columbia Business School, and then he worked for Ben Graham at his investment partnership.  It worked out pretty well, but eventually Warren Buffett learned that there are better ways to earn higher returns in the market.

He learned from Phil Fisher and Charlie Munger that it is better to buy "Good Businesses at Fair prices" as opposed to "Fair Businesses at Good Prices".  Our example above of Trendy Watches Inc. would be an example of buying a fair business at a good price.  Warren Buffett admits that it took him a long time to realize this, but it has been one of the best changes he made for his career.

Here is a quote from one of Buffett's shareholder letters where he explains the troubles of buying companies with no long term business economics as opposed to companies that possess long term business economics:

"My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic goodwill.  This bias caused me to make many important business mistakes of omission, although relatively few of commission."

So this is a great example of Warren Buffett being able to adapt to a constantly evolving world by being able to escape his old (outdated) ideas, and switching to new ideas that are more successful.

For other reading check out the links below:

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