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Warren Buffett: It Is Not Always Worth Chasing After Growth

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Is it always a good idea to chase companies with the fastest growth rates? Is it rational to pay any price to get your hands on the hottest tech stock of the moment?

Some investors and analysts would argue the answer to both of these questions is yes. Earnings growth should lead to higher stock prices, which is excellent news for investors.

However, anyone who follows Warren Buffett (Trades, Portfolio) will know that he has spent a lot of money and time chasing businesses that do not have fantastic growth prospects. For example, his last significant acquisition, Precision Castparts, had a mixed growth outlook.

Perhaps Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) most important purchase of all time, See's Candies, has only seen sales growth of around 10% per annum historically, according to the limited financial data available on the business.

However, the Oracle of Omaha is not particularly interested in growth. While he does want to own businesses that have pricing power, he's more interested in the cash that these companies generate and the predictability of their cash flows than the potential for growth.

He explained his thoughts behind these ideas at the 1994 Berkshire Hathaway annual meeting of shareholders. Responding to one shareholder who asked Buffett for some insight into his process for valuing high growth stocks, he said:

You can certainly have a situation where there's absolutely no growth in the business, and it's a much better investment than some company that's going to grow at very substantial rates, particularly if they're going to need capital in order to grow.

There's a huge difference in the business that grows and requires a lot of capital to do so, and the business that grows, and doesn't require capital.

And I would say that, generally, financial analysts do not give adequate weight to the difference in those. In fact, it's amazing how little attention is paid to that. Believe me, if you're investing, you should pay a lot of attention to it.

After a few comments from his right hand man, Charlie Munger (Trades, Portfolio), Buffett went on to add:

Some of our best businesses that we own outright don't grow. But they throw off lots of money, which we can use to buy something else. And therefore, our capital is growing, without physical growth being in the business. And we are much better off being in that kind of situation [than] being in some business that, itself, is growing, but that takes up all the money in order to grow, and doesn't produce at high returns as we go along. A lot of managements don't understand that very well, actually.

As most public stockholders do not have direct access to the cash flows of the companies they invest in, this advice is only really suitable for business managers and business owners.

However, it also gives us a great insight into the way the Oracle of Omaha has been running Berkshire over the years.

The conglomerate has attracted some criticism for owning a lot of businesses that are not growing, including distribution companies. As these quotes explain, growth is not the only metric investors should be chasing. If a company can produce stable, healthy cash flows, the ability to reinvest this cash in equally productive businesses is probably more valuable than it would be if it were reinvested back into the business at lower rates of return.

This understanding of capital allocation is undoubtedly one of Buffett's top skills. Berkshire's investors have benefited substantially from his decisions and focus on free cash flow over the years.

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here:

  • Warren Buffett: Risk Is 'Inextricably' Tied to Time

  • Charlie Munger: Extrapolating the Past Is 'Massively Stupid'

  • Warren Buffett: Gold Has No Practical Use

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This article first appeared on GuruFocus.