1989
Click here to read the letter.🧠 Key Takeaways
While a company can forego capex for a short period without immediate consequences, doing so habitually can lead to a gradual deterioration of the business's core operations. Over time, neglecting necessary investments into the business can weaken it, impair its ability to increase sales, and ultimately lead to its decline.
Rather than chasing low-quality businesses just because they're cheap, investors should prioritize high-quality companies with strong, sustainable, and growing earnings. These businesses are more likely to generate consistent returns throughout the years, which reduces the need for activity and churn in your portfolio.
In investing, it's usually more profitable to invest in businesses or industries that are easy to understand and evaluate. These are companies with clear business models, transparent and straight-forward financials, and a predictable path to earnings growth.
The "institutional imperative" can manifest in business as resistance to change, unnecessary spending, rationalizing poor decisions, and imitating competitors. Similarly, investors can fall into these traps by holding onto poor investments, over-tweaking their portfolios, justifying bad decisions, and following the crowd instead of making independent, rational choices. In both cases, you should avoid the institutional imperative at all costs.
✍️ Memorable Quotes
“Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures.”
While a company can forego capex for a short period without immediate consequences, doing so habitually can lead to a gradual deterioration of the business's core operations. Over time, neglecting necessary investments into the business can weaken it, impair its ability to increase sales, and ultimately lead to its decline.
Warren Buffett and Charlie Munger actually love it when their competitors skimp on capex because it means those companies are likely to become less competitive and innovative as time goes on. That opens up opportunities for well-capitalized companies—those who keep investing in their business—to step in, grab market share, and strengthen their position.
“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may 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 cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.”
Early in his investment career, Warren Buffett found success using the "cigar butt" approach to investing, a strategy he learned from his mentor, Ben Graham.
The idea behind the "cigar butt" approach is simple: buying a beaten-down stock at a bargain price can still yield some profit if the stock's price rises temporarily, even if the business has long-term issues.
It's like finding a discarded cigar butt on the street with just one puff left. It's not much, but it's free, so you take that last puff.
However, Warren later realized this strategy isn't sustainable. These "cigar butt" businesses often face continuous problems; solve one, and another pops up.
Even if you buy a "cigar butt" business at a bargain and can theoretically sell it for more, the low returns from its operations can erode your gains over time.
For instance, buying a company for $8 million that can be sold for $10 million might sound like a good deal. But if the company only generates small annual returns in the meantime, those returns won't compensate for the time and capital invested, especially if you hold the stock for several years.
This "cigar butt" approach is the antithesis of Warren's evolved (and current) investing philosophy, which was heavily influenced by Charlie Munger. This is the idea that it's better to buy a wonderful business at a fair price than a fair business at a wonderful price.
Unlike "cigar butt" stocks, wonderful businesses are compounding machines, and time is their friend. Buying and holding these businesses can compound your wealth over the long-term.
In saying that, rather than chasing low-quality businesses just because they're cheap, investors should prioritize high-quality companies with strong, sustainable, and growing earnings. These businesses are more likely to generate consistent returns throughout the years, which reduces the need for activity and churn in your portfolio.
Ultimately, this “Quality Investing” approach isn't just about buying low and selling high. It's about finding businesses that can deliver sustained growth, ideally so that you never have to sell.
“The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.”
In investing, it's usually more profitable to invest in businesses or industries that are easy to understand and evaluate. These are companies with clear business models, transparent and straight-forward financials, and a predictable path to earnings growth.
Complex or difficult investments, such as highly speculative ventures, businesses in declining industries, businesses you don’t understand, or companies with confusing accounting practices, can be much harder to assess. They can involve more risk and uncertainty, which might lead to worse returns.
“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated. Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.”
The "institutional imperative" refers to the tendency of organizations to conform to certain patterns of decision-making, often to their detriment. Warren provides a few key examples of its occurrence:
First, much like Newton's First Law of Motion, businesses often resist changing their current direction, even when it's clearly necessary. Old dogs don’t like new tricks. Still, this resistance can prevent them from adapting to new challenges or opportunities, which can negatively impact the business.
Second, in the same way that work expands to fill the time available, companies often find ways to spend available funds. This might manifest as unnecessary projects or acquisitions, driven by internal or external pressures. The thinking is that any activity is better than appearing inactive, but this can lead to inefficient uses of invested capital and poor returns.
Third, employees and executives may go to great lengths to rationalize the whims of the company's leadership, even if they don’t make sense. This can involve creating detailed analyses and using whatever supporting evidence available to reinforce the poor decisions and misguided ambitions.
Fourth, businesses often mindlessly mimic the actions of their competitors, such as making acquisitions or setting executive compensation. This herd mentality can lead to decisions that are not based on logic or rationale, but rather on what everyone else is doing.
In any of these four examples, the institutional imperative at play can lead to poor business decisions. These decisions are not necessarily due to incompetence or malice, but are driven by the internal/external dynamics of the business and the pressure to conform to norms and expectations (quarterly earnings results, public opinion, etc.).
Similar instances of the institutional imperatives exists for investors as well.
First, investors might hold onto a low-quality investment out of loyalty or stubbornness. Either way, this resistance to change can prevent them from making necessary adjustments to their portfolio, and can negatively impact their returns.
Second, investors can be tempted to tweak their portfolio too excessively, simply because they have available capital or get bored and feel the need to actively do something (any activity is better than no activity — same mindset). This can result in making impulsive investments, over-diversifying their portfolio, and buying into lower-quality companies.
Third, investors might find themselves justifying their position in these lower-quality companies with flawed logic, such as "it will recover eventually" or "I've already lost so much, I might as well wait it out." This is what’s referred to as the “Sunk Cost Fallacy”, which manifests as a reluctance to cut losses and move on to better opportunities.
Lastly, it’s no surprise that investors frequently follow the crowd, buying into popular stocks or trends because "everyone else is doing it" and they feel the fear of missing out. This herd mentality can cause investors to buy overpriced companies during market bubbles and panic-sell during downturns, rather than making decisions based on their own individual analysis and beliefs.
“Some of my worst mistakes were not publicly visible. These were stock and business purchases whose virtues I understood and yet didn’t make. It’s no sin to miss a great opportunity outside one’s area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire’s shareholders, myself included, the cost of this thumb-sucking has been huge.”
Sometimes, the biggest mistakes aren't from doing the wrong things (commissions), but from not doing the right things (omissions). In investing, good opportunities can disappear as quickly as they appear, so you have to be ready to jump on them when they present themselves.
Although, as Warren would say, investing is a "no-strike game," which means that you also don't have to swing at every pitch. Even if you do miss some good opportunities, there will always be others down the line.
The key is to stay ready (do your research and ear-mark some cash), so you can have the option to seize the opportunities when they come.