A contributor, Sid Berger, generously provided us with a concise case study. Thank you Sid.
Berkshire Hathaway, Inc. Case Study – Avoiding Value Traps
“All I want to know is where I’m going to die so I’ll never go there.” – Charlie Munger
This article is the first in a series of case studies highlighting mistakes by famous value investors. This concept was unashamedly stolen from Mohnish Pabrai. See here for the article http://www.gurufocus.com/news/137071/mohnish-pabrai–his-project-to-learn-from-other-successful-investors-includes-comments-on-dell-and-aig.
In 1962, Warren Buffet came across a struggling textile manufacturer named Berkshire Hathaway. By any measure, the company was cheap. He bought shares from 1962-1965 at an average price of $14.86. This price was 22% below its December 31, 1965 net working capital of $19 per share.
It looked like a classic Grahamian purchase of a company for less than liquidation value. Buffett recognized that the business was unexciting but likely to generate a couple of good quarters which would give the stock price a temporary boost. Yet, Buffett let emotion rule and held on to the business and continued to plow more money into it. He finally pulled the plug in 1985.
What was wrong with Buffet’s investment process that led him to make this mistake? Could it have been avoided?
Buffett himself did a great post-mortem analysis in his 1985 letter to shareholders http://www.berkshirehathaway.com/letters/1985.html. I will draw upon that letter here but will expand upon some of the concepts and highlight their broader applicability.
First off, the company had absolutely no moat. That is, it had no durable competitive advantages such as brand name. To paraphrase Buffet, they couldn’t charge two cents more than their competitors because consumers had to have a Berkshire lining in their suit.
Second, textiles are an industry with no or low barriers to entry. As a result, any capex was simply wasted as all market participants countered with investments of their own. Standing on its own, Berkshire was presented with investment choices that would produce great returns. But, the investments were neutralized by each of the competitors making investments of their own. As Buffet stated, such a situation is like spectators at a parade all standing on their tiptoes to catch a better view – not much is actually accomplished.
Buffet also seems to have missed or at least minimized the threat of low-cost overseas competition. There were non-US textile mills where employees were willing to work for a fraction of Berkshire’s workers. Could Buffet have seen this coming? It’s difficult for me determine as I am not an expert on the textile industry of the mid-Sixties. He does note in his 1985 letter to Berkshire Shareholders that manufacturers in the Southern part of the US were thought to have an advantage over Berkshire because of their non-unionized workforce. So, he was at least aware that labor costs could be an issue.
More broadly, turnarounds seldom turn. Even the most gifted manager will have difficulty turning around a struggling company in a declining industry. As Buffet stated, “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Buffet convinced himself that new management could turn around the Berkshire business, but the secular decline in the US textile industry was too much for anyone to defeat.
Also, if you’re producing a commodity, you better be the lowest cost producer. A low-cost structure is a powerful competitive advantage in that it enables a company to generate higher profits that it can reinvest into its business and distance itself from its competition. A low-cost structure also provides a business flexibility to use price as a weapon to take market share, weakening higher cost competitors who must match price and risk potential losses.
The Berkshire episode also contributed to Buffet’s move away from anchoring valuations on the balance sheet. For one thing, appraisals of liquidation value are typically unreliable. Buffet notes that Berkshire’s assets had been acquired for $13 million, had book value (after accelerated depreciation) of $866,000 and had replacement cost of $30-50 million. At auction, they fetched $163,122 gross or less than 0 net of expenses.
What checklist items does this case study produce? 1. Can the company be killed by low-cost overseas competition? 2. Is it a turnaround situation? Is this a mere blip (Amex) or an industry in secular decline (Berkshire)? Will it take large amounts of capex to turn it around? 3. Does the company have a moat? Does the industry have barriers to entry? Does the company have pricing power? 4. If the company produces a commodity, is it the low-cost producer?
Compare Berkshire with a Buffet success, See’s Candy. See’s Candy was a high quality business with durable competitive advantages that needed little capex and drowned in cash flow. Unfortunately, some companies failed to learn these lessons – even in the same industry.
See the Munsingwear case study, http://csinvesting.org/2011/09/12/case-study-munsingwear-a-test-in-thinking-strategically/. There, management continued to reinvest in the textile industry even though it was losing money on every sale.
How do these lessons apply to a company like Dell, which shows up in the portfolios of a lot of prominent value investors? In 2004, IBM sold off its PC division. At the time, the IBM CEO explained that the PC had become commodity-like and returns were unlikely to exceed IBM’s cost of capital. Is the US PC business the 2011 version of the New England textile industry in 1965?
