“That was a monumentally stupid decision” Buffett wrote in his 2014 letter to his company’s shareholder, Berkshire Hathaway.
What stupid decision?
That decision is of buying Berkshire Hathaway, the failing textile business back then in the 1960s.
Wait, what? Isn’t Berkshire Hathaway THE investment company? How is it an investment mistake?
In a nutshell, Warren Buffett ended up purchasing Berkshire Hathaway because of spite and anger. When you are investing, it is most ideal to refrain from involving your emotions too much.
Let’s hear from the man himself
Berkshire’s Back Story
Berkshire was then a northern textile manufacturer mired in a terrible business. The industry in which it operated was heading south, both metaphorically and physically. And Berkshire, for a variety of reasons, was unable to change course.
That was true even though the industry’s problems had long been widely understood. Berkshire’s own Board minutes of July 29, 1954, laid out the grim facts: “The textile industry in New England started going out of business forty years ago. During the war years this trend was stopped. The trend must continue until supply and demand have been balanced.”
About a year after that board meeting, Berkshire Fine Spinning Associates and Hathaway Manufacturing – both with roots in the 19 th Century – joined forces, taking the name we bear today. With its fourteen plants and 10,000 employees, the merged company became the giant of New England textiles. What the two managements viewed as a merger agreement, however, soon morphed into a suicide pact. During the seven years following the consolidation, Berkshire operated at an overall loss, and its net worth shrunk by 37%. Meanwhile, the company closed nine plants, sometimes using the liquidation proceeds to repurchase shares. And that pattern caught my attention.
Toby’s words:
Berkshire was a declining textile business, but really huge in size. Despite their size, they continued to operate at a loss. To be exact, their net worth continued to shrunk by 37% following the merger of Berkshire Fine Spinning and Hathaway Manufacturing.
Warren Buffett’s investment into Berkshire Hathaway
I purchased BPL’s first shares of Berkshire in December 1962, anticipating more closings and more repurchases. The stock was then selling for $7.50, a wide discount from per-share working capital of $10.25 and book value of $20.20. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.
Berkshire thereafter stuck to the script: It soon closed another two plants, and in that May 1964 move, set out to repurchase shares with the shutdown proceeds. The price that Stanton offered was 50% above the cost of our original purchases. There it was – my free puff, just waiting for me, after which I could look elsewhere for other discarded butts.
Toby’s words:
Buffett noticed a short term money making opportunity in purchasing Berkshire’s shares. Because Berkshire is in a sunset industry, the price is sold at a discount or a fraction of its working capital and book value.
After they liquidate their assets (heavy machinery) the management promised that they would buy back the shares at a premium (50% above the cost of the investors’ original purchases).
So Warren Buffett was: Sure, why not?
Berkshire’s actual offer
On May 6, 1964, Berkshire Hathaway, then run by a man named Seabury Stanton, sent a letter to its shareholders offering to buy 225,000 shares of its stock for $11.375 per share. I had expected the letter; I was surprised by the price.
Berkshire then had 1,583,680 shares outstanding. About 7% of these were owned by Buffett Partnership Ltd. (“BPL”), an investing entity that I managed and in which I had virtually all of my net worth. Shortly before the tender offer was mailed, Stanton had asked me at what price BPL would sell its holdings. I answered $11.50, and he said, “Fine, we have a deal.” Then came Berkshire’s letter, offering an eighth of a point less. I bristled at Stanton’s behavior and didn’t tender
Instead, irritated by Stanton’s chiseling, I ignored his offer and began to aggressively buy more Berkshire shares.
Toby’s words:
Buffett was given the word that his shares would be bought back at $11.50. But Stanton (the CEO of Berkshire Hathaway at the time) ended up saying no. Stanton would only buy back at $11.25.
Warren Buffett was infuriated by this. So what he did amazes me, really.
He decided to purchase the Berkshire shares (yes, that failing company) more aggressively until he takes over the company.
Warren Buffett took 18 years to put an end to his mistake
By April 1965, BPL owned 392,633 shares (out of 1,017,547 then outstanding) and at an early-May board meeting we formally took control of the company. Through Seabury’s and my childish behavior – after all, what was an eighth of a point to either of us? – he lost his job, and I found myself with more than 25% of BPL’s capital invested in a terrible business about which I knew very little. I became the dog who caught the car.
Because of Berkshire’s operating losses and share repurchases, its net worth at the end of fiscal 1964 had fallen to $22 million from $55 million at the time of the 1955 merger. The full $22 million was required by the textile operation: The company had no excess cash and owed its bank $2.5 million. (Berkshire’s 1964 annual report is reproduced on pages 130-142.)
During the 18 years following 1966, we struggled unremittingly with the textile business, all to no avail. But stubbornness – stupidity? – has its limits. In 1985, I finally threw in the towel and closed the operation.
Toby’s words:
After Warren Buffett took over and settled his revenge (firing Stanton), the company still did superbly awful with no excess cash and much bank loans.
It took him 18 years to realise his losses and shutdown the company’s operations for good. It at least stopped becoming a burden to his investment holdings.
Closing Remarks
In investing, always be careful of your emotions. Even the great Warren Buffett himself is not immune to such investing error at a much grander scale.
And if you find yourself to be in a tough spot for:
Aggressively buying stock because of emotions, not fundamentals
Not wanting to cut loss that under performing company
Remember, Warren Buffett bought a stock for a hefty sum because of anger, not because it was a fundamentally great business. He then held the company for 18 years until he decided to admit that that was a monumentally stupid decision.