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:
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 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 firstname.lastname@example.org.