Investing in Cyclical Businesses: Lessons from Warren Buffett and Charlie Munger
We have recently focused on the incredible deep-value opportunities we see in metals and mining stocks. However, many value investors shy away from these types of businesses because of their cyclicality and poor economics, with Warren Buffett being the most famous example.
Buffett is well known for preferring high-quality brands over commodity-type businesses, even though he does sometimes invest in commodity companies, such as oil companies, when they present good value.
After having recently relistened to the excellent book "The Complete Financial History of Berkshire Hathaway," I realized just how large a part of Berkshire Hathaway's success over the years comes from a cyclical, commodity-type business with manageable barriers to entry for well-capitalized players: insurance. I found it fascinating to learn how Buffett navigated the cyclical insurance business over the years, and it resembles, in many respects, how great mining investors operate. There are numerous valuable lessons for mining investors to learn.
But before we go any further, I want to acknowledge that even though insurance and mining are cyclical, commodity-type businesses, insurance generally has much better economics, making it a better business overall. And while the reasons for the cyclicality are different, insurance, much like mining, experiences years of high prices followed by years of low prices.
I realized when listening to the book that Warren Buffett and the late Charlie Munger were great contrarian investors in cyclical industries. In insurance, they took a long-term view and were perfectly fine with good but lumpy long-term results instead of feeling compelled to participate in all parts of the insurance cycles. Instead, they encouraged their insurance companies to be active when they could underwrite at good prices and inactive during times when they could not.
Their focus was on profitable underwriting first and foremost, not volume. That meant there were years when Berkshire’s insurance companies wrote much less insurance than the rest of the market, which underwrote insurance premiums at bad terms, eventually leading to poor financial results. Buffett and Munger waited patiently until they could get good prices, then allocated massively during those years. Berkshire even implemented a “no layoff” policy at its insurance businesses to disincentivize employees from writing bad insurance just to keep busy during years of bad prices.
I think there are numerous lessons here for mining investors. Many multimillionaires and billionaires in the mining sector operate very much like Buffett and Munger through the cycles that mining markets go through. During bull markets, they are typically inactive buyers of assets and primarily hold assets and build companies organically, but during bear markets, they load up when assets can be bought cheaply. Over the last half-year or so, we have seen smart money in mining being very active as equities were (and still are) dirt cheap at a cyclical low.
So, what are the key lessons investors can learn from Warren Buffett and Charlie Munger on investing in cyclical businesses? In my opinion, they are:
Focus on profitability: Invest in cyclical companies and their operations only when the potential profits are high enough to compensate for the risk involved, typically close to a cyclical low in that market.
Invest with good capital allocators: Invest in companies with management teams that are good capital allocators, understand the inherent cyclicality of the market they operate in, and can take advantage of it much like Buffett and Munger did in insurance over the years.
Our goal here at Value Discovery Media is, among other things, to identify long-term trends and invest at an opportune time in them. We believe we are still at the point in the mining cycle where we should take note of the lessons learned from Warren Buffett and Charlie Munger outlined above and aggressively allocate capital to commodity equities while large potential profits are on offer.
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Disclaimer: This article is for informational purposes only and does not constitute investing advice. Please consult with a qualified financial advisor before making any investment decisions.
