Nocera: How Warren Buffett does it

Fifty years ago, a young investor named Warren Buffett took control of a failing textile company, Berkshire Hathaway. “I found myself … invested in a terrible business about which I knew very little,” Buffett relates in his annual letter to shareholders, which was released over the weekend. “I became the dog who caught the car.”

Buffett describes his approach in those days as “cigar butt” investing; buying shares of troubled companies with underpriced stocks was “like picking up a discarded cigar butt that had one puff remaining in it,” he writes. “Though the stub might be ugly and soggy, the puff would be free.” He continues: “Most of my gains in those early years … came from investments in mediocre companies that traded at bargain prices.”

But that approach had limits. It took Charlie Munger, the Los Angeles lawyer who has been his longtime sidekick, to show him that there was another way to win at the investing game: “Forget what you know about buying fair businesses at wonderful prices,” Munger told him. “Instead, buy wonderful businesses at fair prices.” Which is what Buffett’s been doing ever since.

He has done it in two ways. First - and this is what he is renowned for - he has bought stock in some of the great American companies of our time, stock that he has held not just for years, but for decades. Second, he has turned Berkshire Hathaway into a true conglomerate, which owns not just stocks but entire companies. Although Berkshire’s front office employs only 25 people, its companies have, in total, some 340,500 employees.

How successful has the Buffett-Munger approach been? In the 50 years since Buffett took over Berkshire, its stock has appreciated by 1,826,163 percent. That is an astounding number.

You would think, given Buffett’s success, that more people would try to emulate his approach to investing. It is not as if he hasn’t tried to explain how he does it. Every year, you can find a Buffett tutorial in his annual letter that the rest of us would do well to absorb - and practice.

In the current letter, for instance, he makes the case - which has been made many times before - that a diversified portfolio of stocks “that are bought over time and that are owned in a manner invoking only token fees and commissions” are less risky over the long term than other investment vehicles that are tied to the dollar. Clearly, that’s been his approach. He then goes on to bemoan the fact that too many investors - both little guys and investment professionals - do things that add risk: “Active trading, attempts to ‘time’ market movements, inadequate diversification, the payment of high and unnecessary fees … and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy.”

Another thing about Buffett is that he has never gotten caught up in fads. He only buys businesses that he understands and can predict where the business will be in a decade. He teaches this point in the current letter with a discussion of the conglomerates that sprung up in the 1960s and became the hot stocks of the moment. Jimmy Ling, who ran one such company, LTV, used to say that he looked for acquisitions where “2 plus 2 equals 5.”

LTV, as conceived by Ling, of course, ceased to exist decades ago (though the company would go through several transformations and bankruptcy court before shuttering its last vestige in 2002). “Never forget that 2 + 2 will always equal 4,” writes Buffett. “And when someone tells you how old-fashioned that math is - zip up your wallet, take a vacation and come back in a few years to buy stocks at cheap prices.”

If it’s really this simple, why don’t more people try to invest like Buffett? One reason, I think, is that sound investing - buying when others are selling, holding for the long term, avoiding the hot stocks - requires a stronger stomach than most people have. When a stock is plummeting, it takes a certain strength to buy even more instead of selling in a panic. Most of us lack the temperament required for smart investing. The fundamental equanimity required to be a great investor is a rare thing.

The second reason is that investing the Warren Buffett way is a lot more complicated than he makes it sound. Can you predict where a business will be in 10 years? Of course not. But he can - and does.

In a few months, the faithful will flock to Omaha, Nebraska, to attend Berkshire’s annual meeting - “Woodstock for capitalists,” Buffett likes to call it. For six hours, Buffett and Munger will be on stage, before some 40,000 people, cracking wise, while making their investment decisions sound like simplicity itself.

But, in coming to pay their annual homage, the throngs will not be acknowledging the simplicity of Buffett’s approach, but the genius behind it.

Joe Nocera is a columnist for the New York Times.