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Comments On Mistakes And Buffett’s Original Berkshire Purchase

I was reading through the 2014 (last year’s) Berkshire Hathaway ( BRK.A , BRK.B ) 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 (NASDAQ: OUTR ), 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 1960s. 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. It 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 1960s: 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 versus 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 has been run similar to companies that get purchased by private equity firms – leverage up the balance sheet, issue a dividend (or buy out 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 1960s 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 regard 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.

Why There Will Never Be Another Warren Buffett

Summary Increasing numbers of highly intelligent people have been drawn to the stock market over the past several decades. As a result, it has become extremely difficult for individual investors to gain an “edge” over the competition. This explains why it’s so hard to produce the kind of “outlier” returns investing legends like Warren Buffett achieved. In an interview in the late 1990s, Warren Buffett famously said that he could “guarantee” 50% annual returns if he was managing less money. He explained that compounding large sums of money at high rates becomes increasingly difficult over time, because it limits the investable universe to only the largest companies. A smaller portfolio would allow him to invest in smaller companies, which have historically produced slightly better returns than their larger counterparts. He further pointed out that today’s easy access to information makes it easier than ever to find such companies selling cheaply. Unfortunately, Buffett’s argument has a major flaw. It’s certainly possible that his performance would improve (marginally) if he was managing millions, rather than billions, of dollars; but to claim that faster access to more information makes it easier to find attractive investment opportunities is illogical. In reality, this actually makes the stock market more efficient (not less), which makes it harder (not easier) to find and exploit pricing inefficiencies. But there’s another equally important factor driving market efficiency: skill. Today’s investors are much better than those of earlier decades, and the difference between the best and the average investor is less pronounced. This is often called the “paradox of skill.” This phenomenon was famously observed by evolutionary biologist Stephen Jay Gould. He wanted to know why no hitter in Major League Baseball has had a batting average over .400 since Ted Williams hit .406 in 1941. He discovered that, while the league batting average has remained roughly the same throughout baseball’s history, the variation around that average has declined steadily. To put that in plain English, it means that skill of modern baseball players is better than ever, which makes outliers like Ted Williams less likely to occur. The paradox of skill is evident in other competitive sports as well. Today’s elite athletes have superior coaching, training, nutrition, and drugs/supplements. Which is why they’re running faster, jumping higher, throwing farther, and lifting heavier than ever before. But as athletes approach the biological limits of human performance, it makes it harder and harder for individuals to stand out from the competition. A perfect example of this is the men’s Olympic marathon. The winning time has dropped by more than 23 minutes from 1932 to 2012; however, the difference between the time for the winner and the man who came in 20th shrunk from 39 minutes to 7.5 minutes over the same period. In other words, the overall skill of Olympic marathoners is improving on an absolute basis but shrinking on a relative basis. We can see the same thing happening in the game of investing. Growing numbers of today’s investors (both retail and institutional) are far more sophisticated and knowledgeable than their predecessors. As a result, just as we’ve seen the disappearance of .400 hitters in baseball, we’re also seeing the disappearance of superstar investors who were once able to persistently outperform the market by large margins. The table below shows that the standard deviation of excess returns (a proxy for investment skill) has trended lower for U.S. large-cap mutual funds over the past several decades. This means that the variation in stock-picking skill has narrowed as everyone got better and the market became more efficient. Decline in Standard Deviation of Excess Returns (Mutual Funds) Note: The table shows the five-year, rolling standard deviation of excess returns for all U.S. large-cap mutual funds. The benchmark index is the S&P 500 (NYSEARCA: SPY ). Source: A North Investments, Credit Suisse (Dan Callahan, CFA and Michael J. Mauboussin) Now consider Buffett’s track record. What do we see? The same exact story as above! During the early part of his career, when the market was underdeveloped and there was less competition, Buffett was the Ted Williams of investing. He had a huge edge over the less-skilled competition. But as more and more intelligent people were drawn to the market over the years, the variation in skill narrowed, shrinking his margin of outperformance. Ironically, even Buffett’s own teacher and mentor, Benjamin Graham, realized that outperforming the market was becoming increasingly difficult over time. In one of his last interviews before he died, he recommended passive (index fund-style) investing and said that it may no longer be possible to identify individual stocks that will outperform. In recent years, Buffett has also become a fan of index funds – not surprising, considering that he’s underperformed the market four out of the last five years. Decline in Standard Deviation of Excess Returns (Warren Buffett) Note: The table shows the five-year, rolling standard deviation of excess returns for Warren Buffett’s Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). The benchmark index is the S&P 500. Source: A North Investments, Berkshire Hathaway 2014 Annual Report The bottom line is that beating the market is becoming tougher, even for the best of the best. If Buffett started investing today with a smaller portfolio, it’s highly unlikely that he would come anywhere near the 50% annualized returns he claims he could get. In fact, over the course of his entire professional career, Buffett only accomplished this amazing feat twice (in 1968 and 1976). It should also be pointed out that even Renaissance Technologies’ legendary Medallion Fund, the most successful hedge fund ever, only managed to deliver annualized returns of 35% (that’s after a 5% management fee and a 44% performance fee). Renaissance employs scores of top PhDs who build elaborate algorithms that identify and profit from various market anomalies. If there really was a simple way to consistently earn 50% annualized returns, they would have found it by now. The reality is, as in baseball, the best hitters in money management can no longer bat .400. It’s extremely difficult to outsmart a market in which so many people have become just as smart as you are.