Regular readers of this blog will have to forgive me for writing about Warren Buffett so much recently, but I recently read his excellent biography by Roger Lowenstein, and so I have Buffett on the brain. One Buffett anecdote that resonated with me was his comment that on his desk he had an “In” box and an “Out” box and also a “Too Hard” box. This is for investment ideas that are too complex or uncertain. This is an important point because many people think (understandably) that if you want to be a great investor, you must tackle the most obscure and complex investment ideas. There are no doubt some investors out there who are successful this way, but Buffett’s approach has always been to only swing at the really good pitches as he says. He waits until he finds really great investment ideas that are not overly complex, where he can clearly find the hidden value.
During an interview with CNN Money in 2012 Buffett showed off his “Too Hard” box below.
Some might ask if this is a case of false modesty from the brilliant investor. It’s true, sometimes Buffett’s folksy Midwestern persona leads him to downplay the tremendous effort that goes into operating Berkshire Hathaway, but looking closely at his record I think it’s clear that for the most part Buffett has followed the “Too Hard” box discipline. If you scrutinize Buffett’s many past investments you will likely find some complex transactions, including perhaps his more recent dabbling in partnerships with a private equity firm, but these are exceptions that prove the rule.
But what exactly is it that makes an investment too hard? Buffett doesn’t describe his criteria explicitly, but judging from his record and his writings you can start to get a picture of what he means. One thing that might consign a stock to the Too Hard bin would be an esoteric business. Buffett has always steered clear of most technology stocks and has not invested widely in pharmaceuticals, two industries that often require specialty knowledge. Technology companies are dogged by the rapid innovation and fierce competition that quickly chip away at any competitive advantage. Pharmaceuticals often involve a lot of big bets on the uncertain prospects of particular drugs that are subject to intense regulation and government reimbursement issues. Finance is another possibly esoteric business, however, Buffett’s long experience with that sector has given him a pretty good grasp of the financial industry, especially banking and insurance.
Another factor that makes a business too hard is a lack of visibility of earnings or lack of transparency in the financial statements and other company communications. Ideally, a good company would have dependable annuity-like earnings that are fairly certain to continue in the future. This often comes from long-term contracts or when a company makes a product that is essential or has high switching costs and low bargaining power of customers and suppliers. This would explain Buffett’s fondness for consumer staples stocks like Coke, Heinz, and Proctor and Gamble.
If it is clear what is going on with the company, what the moving parts are and what the drivers of growth are, this is a major benefit to investors. If a company is more a “black box” whose inner workings are obscure, it is probably a candidate for the Too Hard box, and even strong earnings and a low price wouldn’t overcome the risks involved with a lack of transparency.
During the internet Bubble in the late 1990’s, many influential voices in the financial media said that Buffett lost his touch when he abstained from investing in technology stocks. Of course, after the crash, the black box nature of these stocks whose soaring prices were driven entirely by imaginary future earnings ended up proving Buffett right.
An example of two companies that I have been researching recently will illustrate the point. They are Wal-Mart and Gilead. Despite its vast scale, Wal-Mart is a relatively straightforward company. There is a vast amount of information available about it. It has only three operating divisions: Wal-Mart U.S., Wal-Mart International and Sam’s Club. The company’s “everyday low price” and “everyday low cost” models are enabled by its huge scale. You can visit Wal-Mart stores and see for yourself what the consumer experience is like. This does not guarantee Wal-Mart is a great investment, but the increased transparency and understanding, I would argue, increases your odds that you are making a good investment rather than a lucky (or unlucky) guess. Berkshire Hathaway, as it turns out, is one of the largest shareholders in Wal-Mart.
Gilead on the other hand appears very attractive with enormous earnings growth based on its “miracle” drug that cures Hepatitis C. Without a medicine or science background or a special expertise in biotech stocks, however, Gilead is very difficult to evaluate. There is no question that the Hepatitis drug is an amazingly profitable blockbuster drug, but its success has brought the company enormous scrutiny from insurance companies, regulators, government programs and pharmacy benefits managers. All of these groups are questioning whether the drug should be covered or whether the company can charge the amount that it believes the drug is worth. (Each pill can cost $1000).
Then there is the question of whether Gilead will be able to duplicate this blockbuster success in the future with other drugs. All of this brings a great deal of uncertainty. The price might be low enough now at 12 times earnings that we might decide to buy the stock after doing more research. However, many aspects of Gilead’s story would place it in the Too Hard bin, and that’s why we’ve steered clear of most high-flying biotechs with the exception of the more mature, dividend-paying stalwart Amgen.
You may miss out on some big gains by rejecting Too Hard stocks, but the success of Buffett and many of his followers indicates that there are great profits to be made among the relatively “easy” stocks.