Case StudiesSuperinvestorsWarren Buffett

Comments on Mistakes and Buffett’s Original Berkshire Purchase

I was reading through the 2014 (last year’s) Berkshire Hathaway annual report and 10-K looking for a few things, and happened to reread Buffett’s letter from last year. I wrote a post a couple weeks ago concerning buybacks and Outerwall, and how a company that is buying back stock of a dying business is not a good use of capital.

I noticed a passage in last year’s letter that is relevant to the topic—Buffett himself was attracted to buybacks on a dying business—Berkshire Hathaway in the early 1960’s. Berkshire was a Ben Graham cigar butt—it was trading at around $7 and had net working capital of $10, and book value of $20. Berkshire was a classic “net net”—a stock trading for less than the value of its cash, receivables, and inventory less all liabilities. Buffett liked the fact that Berkshire was a) trading at a cheap price relative to liquidation value, and b) using proceeds from the sale of plants to buy back shares—effectively liquidating the company through share repurchases.

Here is what Buffett was looking at when he originally bought shares in this company in the early 1960’s:

BRK 1964

Like Outerwall, Berkshire’s business was in secular decline. In fact, it had been dying a long time, as the meeting notes from a 1954 Berkshire board meeting stated: “The textile industry in New England started going out of business forty years ago“.

Also like Outerwall, Berkshire was buying back stock. One difference (among many of course) between Berkshire then and Outerwall now is that Berkshire was closing plants and using proceeds to buy back shares. From the 1964 Berkshire report (which can be found on page 130):

“Our policy of closing plants which could not be operated profitabily was continued, and, as a result, the Berkshire King Philip Plants A and E in Fall River, Mass. were permanently closed during the year. The land and buildings of Plant A have been sold and those of Pant E offered for sale…. Berkshire Hathaway has maintained its strong financial positiona nd it would seem constructive to authorize the Directors, at their discretion, to purchase additional shares for retirement.”

Outerwall, on the other hand, is producing huge amounts of cash flow from its operations, not from the sale of fixed assets.

Liquidation vs. Leveraged Buyout

Another difference is that Berkshire was in liquidation mode and was buying out shareholders (through buybacks and tender offers) from cash proceeds it received from selling off plants. Outerwall hasn’t been liquidating itself through buybacks—instead it has leveraged the balance sheet by issuing large amounts of debt, using the proceeds to buy back stock, which has reduced the share count, but not the size of the balance sheet or the amount of capital employed.

Outerwall had total assets of around $1.3 billion five years ago, roughly the same as it does now (goodwill however has doubled due to acquisitions). These assets were financed in part by $400 million of debt and $400 million of equity in 2010. Today, the company’s assets are financed by roughly $900 million of debt, and shareholder equity is now negative. Outerwall has historically produced high returns on capital, and it’s a business that doesn’t need much tangible capital to produce huge amounts of cash flow (an attractive business), but it has been run similar to companies that get purchased by private equity firms—leverage up the balance sheet, issue a dividend (or buyout some shareholders), thus keeping very little equity “at risk”. It’s a gamble with other people’s money, and sometimes it results in a home run (sometimes, of course, it doesn’t).

So Berkshire in the 1960’s was more of a slow liquidation. Outerwall is basically a publicly traded leveraged buyout.

In the case of BRK, shareholders who purchased at $7 were rewarded with a tender offer of just over $11 a few years later. But that’s the nature of cigar butt investing—sometimes at the right price, there is a puff or two left that allows you to reap an outstanding IRR on your investment—in Buffett’s case, had he taken the tender offer from Seabury Stanton, his IRR on the BRK cigar butt investment would have been around 40%.

He didn’t though, and the rest is history. It’s interesting to note another mistake that he points out in last year’s letter, one that I think is rarely mentioned but was very costly. Instead of putting National Indemnity in his partnership, which would have meant it was 100% owned by Buffett and his partners, he put it into Berkshire Hathaway, which meant that he and his partners only got 61% interest in it (the size of the stake that Buffett had in BRK at the time).

I think this could have been Buffett’s way of doubling down on Berkshire (then, a dying business with terrible returns on capital). He thought he could save it (not the textile mills, but the entity itself) by adding a good business with solid cash flow and attractive returns to a bad business that was destroying capital. Obviously, as Buffett points out, he should have shut down the textile mills sooner, and just used National Indemnity to build what is now the company we know as Berkshire Hathaway.

Two Mistakes to Avoid

Two takeaways from this, which in Buffett’s own words were two of his greatest mistakes:

  • It’s usually not a good idea to buy into bad businesses, even at a price that looks attractive
  • If you are in a bad business, it probably doesn’t make sense to “double down”—for most of us, this could mean averaging down and buying more shares. In Buffett’s case, it was already a 25% position in his portfolio and he “doubled down” by throwing good money after bad (putting National Indemnity—a good business—inside a textile manufacturer instead of just a wholly owned company inside of Buffett’s partnership.

The good news—things have worked out just fine for Buffett and for Berkshire. Although the textile mills unfortunately had to finally shut down for good, National Indemnity has come a long way since Buffett purchased it for $8.6 million in 1967 (see the original 2-page purchase contract here, no big Wall Street M&A fees on this deal). National Indemnity now has over $80 billion of float, and over $110 billion of net worth, making it the most valuable insurance company in the world. The insurance business that started with National Indemnity paid dividends to Berkshire last year of $6.4 billion and holds a massive portfolio of stocks, bonds, and cash worth $193 billion at year end.

Buffett estimated his decision to put National Indemnity inside of Berkshire instead of in his partnership ended up costing Berkshire around $100 billion.

It’s refreshing when the world’s best investor humbly lays out two of his largest mistakes, his original thesis, and the thought processes he subsequently had in regards to those investments. It’s also nice to note that despite two large mistakes, things worked out okay.

I own shares in Berkshire, purchased for the first time ever just recently, and I’ll write a post with a few comments on the recent 10-K and annual report soon.

Have a great week,

John

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com

11 thoughts on “Comments on Mistakes and Buffett’s Original Berkshire Purchase

  1. It depends. Distressed debt investors do broken capital structures and bad businesses. That’s a big group of invesors What is probably true though is that you’re better off taking time to learn about better businesses than allocate a similar amount of time to hairy situations. Like Munger said, it’s not like gymnastics; you don’t get points for difficulty.

  2. John, great post and research with this old school data…very interesting. It always is when reviewing Buffett’s early years. I’ve followed your site for a few years now. Keep up the interesting work. There are plenty of us value investing nerds that both, enjoy it, and learn from it.

  3. Great article. Agree that the risk is higher to buy a bad business. It may work if the investor can buy the whole company but it is not the case most of the time.

    1. Thanks Anthony, yeah that’s a good point. If you can control the capital allocation (i.e. if you owned 100% of Outerwall and could just run off all of the cash flow), maybe it can produce a decent IRR. But even then, as was the case with BRK, it is challenging. Thanks for reading.

  4. Any time I think of the Berkshire situation– savvy outside investor targets a company in a dying industry in a small New England town– I can never help thinking of Other People’s Money, with Danny DeVito’s “Ben Graham” style value-investing analysis to the company’s management and his Prayer-for-the-Dead speech at the end to the shareholders. Of course, Larry the Liquidator wasn’t out to keep New England Wire & Cable and transform it into a more profitable kind of business, but still…

    By the way, John– did you get a copy of that history-of-Berkshire souvenir book from last year’s meeting? One of the pages was a detail of one of Buffett’s ledgers from the early days, and I remembered thinking it would be interesting to look those stocks up in the Moody’s manuals of the era and see what his thinking might have been.

    1. No, unfortunately I wasn’t able to get a copy of that book, but I’d love to take a look at those ledgers. Thanks for the comment Matt.

  5. Great post John! I would love to see Buffett’s Coke first acquisition at 5x bv case to get a sense of what he was buying into at that time. Anyway I am 100pct agree with Anthony thaat unless we are controliing investor that can liquidate a company it doesnt make sense to have a cheap value to a bad net asset business.

    1. Christopher K, have you analyzed MNST? Ironically, it’s selling for around 5-6x book last time I checked recently, and KO has a big position in it. Caffeinated water looks like it is proving to be just as profitable and cash-generating as sugar water, and MNST is controlling costs well too, with those probably headed even lower given access to KO’s distribution network in their new partnership.

      1. Hi Ross, i think its kinda common to see strategic players acquiring other players at high pb. But its a super curious case when Buffett acquired KO outside his cigar butt habit. Im curious what kind of owner earnings he projected and his multiple exit justification in ‘forever’ holding perjod.

        1. Christopher, I absolutely agree. If an acquirer knows the assets are solid and have long-term cash-generating potential, it makes sense to me to acquire at a high p/b ratio. It’s akin to buying attractive real estate in a great location at a low cap rate. However, I don’t believe Buffett/Munger have that quantitative justification in terms of a multiple exit justification for a ‘forever’ holding. I think they factor in a lot of very wise, subjective conclusions regarding franchise dominance in the market, pricing power in future decades, moat characteristics, etc. Pricing power in particular is so important and I think fools a lot of financial projections because growth rates often do not incorporate the immense power in the ability to raise prices, which raises revenue, which raises earnings, without having to increase customer growth. This can mask a low p/e ratio as a very high p/e in reality, which may be the case with MNST. The compounding characteristics of significant pricing power advantages lasts for decades. How much will we be paying for coke in 2044?

          Munger has said many times that liabilities are not what an investor should be concerned about when acquiring a business because balance sheet liabilities are 100% owed (unless some type of debt-restructuring occurs). It’s the assets that the investor needs to be worried about because certain items can be deceiving (i.e. a/r, inventory, intangibles, etc.) and on a more important level, not have the franchise and competitive qualities to perform as well in the future.

          I am not an energy beverage drinker, but with the exception of 5-hour energy that is privately held and hard to compare without financial disclosures, MNST may be approaching a justification for a long, long-term holding (I’m cautious using ‘forever’). The ‘forever’ holdings seem so rare that it’s tough to know when you have found one. KO, WFC, MTB, and WMT appear the only true ‘forever’ public security holdings at this point in time in the Berkshire portfolio…Buffett has expressed that AMEX is not what it once was similar to PG. Thus, I feel ‘forever’ is more of a rational way of wording it to justify not having to worry about selling for awhile (>10 years). Is AB Inbev a ‘forever’ holding? The railroad ‘forever’ qualities seem logical: are CP and KSU ‘forevers’? If you hold any of these securities for a long time horizon, you probably will not lose money and they all compound earnings north of ~20% or higher with sound capital allocation, moat characteristics, pricing power, etc. Thus, are their P/B values are justifiably expensive or inexpensive? What would it take to make you want to liquidate a long-term position in one of these businesses? Would it be based on a multiple or financial metric justification or a qualitative, competitive factor? The owner earnings are there and appear to be there for the foreseeable future. I believe it’s the change in subjective, competitive qualities that justifies the exit for Munger and Buffett to relinquish ownership, such was the case with PG, AMEX, and maybe eventually WMT as well. It would be a great question at the next Berkshire meeting.

Leave a Reply

Your email address will not be published. Required fields are marked *