valueandprices
warren buffett

Warren Buffett, Partnership Letter, 1967

“The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors. At the one extreme, the analyst exclusively oriented to qualitative factors would say, “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.” On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself”.

Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess – I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight.” This is what causes the cash register to sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side – the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions, but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

“In a cruel irony, most good businesses earning high returns on invested capital can’t absorb much incremental capital without reducing those high returns, while most bad businesses earning low returns on invested capital require all earnings be reinvested simply to keep up with inflation. Bad businesses that can only earn sub-par returns destroy capital until they are liquidated. The sooner the business is liquidated, the more value that can be salvaged. The longer the good business can maintain a high return on invested capital, the more valuable the business.”

“Where Graham had warned against relying on qualitative matters, Buffett embraced them. Not only that, he embraced two particular factors that Graham had explicitly warned against – the nature of the business and the ability of the management. Graham believed that it was impossible to separate out unusually good returns on capital or uncommonly adept management from a stock enjoying favorable business conditions. “Corrective forces” Graham warned, “are usually set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital.” Buffett acknowledged Graham’s caveat, but believed that there existed some businesses earning high returns on invested capital able to resist Graham’s corrective forces due to their extraordinary economics. Able management would only prosper on such high-quality businesses, but was essential in managing the capital tied up in the business and maintaining the competitive advantage.”

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