Buffetts simple propositions

Degree of difficulty doesn't count

Men rush towards complexity, but they yearn towards simplicity. They try to be kings; but they dream of being shepherds.

G.K. Chesterton

Tony Zukas and Frank Foster diving at Hotel Floridian pool in 1937

Before I explain Buffett’s simple propositions, I want to tell a business story that taught me a few lessons that I think are relevant for investing. After all, Buffett famously said he’s a better investor because he’s a businessman, and a better businessman because he’s an investor. I find this to be true in my life as well. 

I wanted the money

Several years ago, my construction business ran into financial trouble after taking on a large, fancy home remodel. The customer was wealthy and requested many complex and luxury things be done to the home. It was an opportunity to make a lot of money, and my partners and I were excited about it.

Unfortunately, this excitement clouded our judgment, especially mine as I undertook the bidding process. I underestimated the difficulties involved and gave very competitive pricing in order to assure that we won the bidding war.

As an investor, you may have experienced something similar if you’ve ever valued a business that you really wanted to own. You may have found yourself subconsciously justifying rosy assumptions about the business in order to make the model say what you want it to say. This is what exactly I did with the bid proposal.

My partners and I submitted the bid proposal and it was accepted. I vaguely sensed that I wasn’t being very smart, but ignoring my intuition, I proceeded because I wanted the money and I wanted the project in our work portfolio.

The project worked out well for the customer but not so well for us, as the project faced one problem after another. It ended up taking more than twice as long as we had anticipated, and we were running low on cash flow halfway through the project. I was extremely bitter and disappointed for a few months, but there was no one to blame but myself.

Humans have a built-in forgetter

Most of us were given basic instructions by parents, mentors, and wise people before us. We were taught basic things such as

1. Don’t be reckless

2. Stick to what you’re good at, go with your strengths

3. Keep it simple, don’t over complicate things

4. Be humble, be patient

But many of us, including me, exile these lessons to an obscure place in the back of our minds, of course, until something bad happens. Then they seem to come hurling back into our consciousness once again.

The reality is, sometimes it just takes a good old-fashioned shellacking to make sure a lesson sticks. And when it sticks, it really sticks because pain is the greatest teacher.

Buffett’s zinc venture

Buffett himself has a handful of battle scars.

In his 2004 shareholder letter, Buffett talked about a large write-off from an investment in a failed zinc project. The zinc was found in the brine of one of Berkshire’s geothermal energy operations, and Buffett figured he could extract it and turn a profit. Seems simple enough, right?

Not quite. Instead, Buffett ran into one problem after another and ultimately decided to scrap the entire project after a few years.

Buffett then went on to explain the importance of simple business propositions.

“Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.” 

Whether you’re running a business or analyzing an investment, this principle remains the same. The more complex an operation is, the greater chance that at least a few independent variables will negatively affect the overall outcome.

Buffett’s example can be expressed mathematically like this

0.90 * 0.90 * 0.90 * 0.90 * 0.90 * 0.90 * 0.90 * 0.90 * 0.90 * 0.90 = 0.35

The point is that independent variables interact with each other and impact the dependent variable (the outcome).

The Payoff is the same

In his 1994 shareholder letter, Buffett also expressed the same thing, although he underlined something else that is important.

"Our investments continue to be few in number and simple in 
concept:  The truly big investment idea can usually be explained in 
a short paragraph."

"Investors should remember that their scorecard is not computed 
using Olympic-diving methods:  Degree-of-difficulty doesn't count. 
If you are right about a business whose value is largely dependent 
on a single key factor that is both easy to understand and 
enduring, the payoff is the same as if you had correctly analyzed 
an investment alternative characterized by many constantly shifting 
and complex variables."

Warren Buffett

1994 letter to shareholders

The point Buffett is making here is that if an easy thing and hard thing produce the same result, the hard thing is the wrong choice. But if you are familiar with Buffett’s rhetoric, you’ll know that he’s also alluding to something else when he says “degree of difficulty doesn’t count.”

This is a classic Buffett polemic, and it’s connected to his broader philosophy of simplicity and his aversion to unnecessary complexity. Let me try to explain a bit more on this.

There is a kind of arrogance and intellectual snobbery that tempts people in the business world. They may be investors, professors, or businessmen. The temptation is to overcomplicate things for the sake of looking smart or making a name for oneself.

Ironically, Buffett and Munger, being some of the most brilliant, have been very critical of this sort of thing, particularly in the business world and the contemporary theories taught at modern business schools.

Instead, Buffett and Munger resolved to be simple practitioners who are grounded in pragmatism— focusing on simple, understandable propositions with a high probability of success. And their track record speaks volumes about their approach to investing and business.

Stewart Horejsi vs Albert Einstein

A lot of money has been lost in the stock market by very intelligent and capable people. Albert Einstein, Isaac Newton, and John Maynard Keynes are some of the most brilliant men who have ever lived, and yet they all lost fortunes in the stock market. My guess is that their IQ gave them a false sense of confidence. 

At the same time many unassuming men have created a ton of wealth by keeping it simple. For example, Stewart Horejsi is a billionaire who is worth around $3.8 billion, and yet he didn’t graduate from a prestigious university, nor did he found a successful public company, neither does he appear to have an exceptionally high IQ at all. In fact, Stuart graduated from the University of Kansas and ran a struggling family welding-supply company.

All that Stuart did was pile money into Berkshire Hathaway Class A stock. He had confidence in what Buffett was doing, and he just kept buying more Berkshire stock until he amassed around 6,000 shares. There are many lessons to be learned from Stuart’s story, but one famous Munger quote comes to mind.

“take a simple idea and take it seriously.”

Charlie Munger

Buffett and Munger constantly remind us that one doesn’t need to have a PhD in order to be a successful investor; one just needs to be reasonable, disciplined, patient, and make a handful of good decisions.

Of course, we shouldn’t neglect the hard work of learning accounting, corporate finance, and statistics. I am not against higher education at all.

By all means, go to school, take online courses, and read plenty of books on all of these core disciplines. But none of these can teach us the most important things, such as how to hold (or buy) when everyone else is selling, or how to consistently save 20% of your income, or how to be objective and use sound reasoning. These things are learned through practical application and occasionally a few big mistakes.

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Disclaimer: Nothing from Kairos research should be taken as financial advice. It is for educational and entertainment purposes only. Consult a financial advisor before buying or selling any securities mentioned.