Don't Buy A Stock Just Because It Is Cheap

Excerpted from Warren Buffet's 1989 letter to Berkshire shareholders

Let's take a quick look at the past 25 years. My first mistake, of course was in buying control of Berkshire. Though I knew its business textile manufacturing to be unpromising, I was enticed to buy because the price looked cheap.

I called this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left may be not offer much of a smoke, but the "bargain purchase" will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.

First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockcroach in the kitchen. Second, any initial adavantage will be eroded quickly by the low return the business earns.

Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had learn it the hard way - infact, I had to learn it several times over.

Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn. I bought it at a substantial discount to its book value, the people were first-class, and the deal included some extras. Three years later, I was lucky to sell the business for what I had paid.

After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, My Wife Ran Away With My Best Friend And I Still Miss Him A Lot.

I could give you other personal examples of "bargain-purchase" folly, but I am sure you get the picture: It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class management.

Ambition