How Warren Buffett Dealt With a Billion-Dollar Mistake

Wall St. Cheat Sheet

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Dirty Money

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Part of what has made Warren Buffett, chairman and CEO of Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB), such a successful investor is his capacity to recognize and admit to mistakes. In early 2008, he openly criticized himself for a decision to purchase Dexter Shoe Co. for $433 million in Class A Berkshire stock instead of cash. Buffett made the purchase in 1993, and less than 10 years later, the company ended production and was folded into H.H. Brown Shoe Group, another Berkshire unit.

“What I had assessed as durable competitive advantage vanished within a few years,” Buffett wrote at the time. “By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion.”

Buffett characteristically went on to say that the Dexter deal wasn’t the first mistake he had made, and it wouldn’t be the last. In hindsight, his words were particularly prescient. By the end of that same year, Buffett was writing to shareholders in his annual letter about another costly mistake he had made: a $7 billion investment in oil and gas company ConocoPhillips (NYSE:COP).

“I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out),” wrote Buffett in his 2008 letter to shareholders. “Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”

According to data from the letter, Buffett purchased 84,896,273 shares of ConocoPhillips, a 5.7 percent ownership stake, for about $7 billion. That same year, the financial crisis swept through the markets, wreaking havoc: oil prices crashed, and the value of Buffett’s holding in the upstream oil and gas company fell by about 37 percent to $4.4 billion, a write down of $2.6 billion at the time.

But it’s hard to knock Buffett off his feet. The ConocoPhillips investment may have been poorly timed, but it did yield some fruit. When the company split itself in half — into an upstream company and a downstream company — holders of ConocoPhillips stock, which would go on to be the upstream business, were compensated with shares of the downstream business, Phillips 66 (NYSE:PSX).

Berkshire’s stake in Phillips 66 is fairly attractive in and of itself. Shares of the downstream business are up about 40 percent on the year and nearly 120 percent since they started trading separately. But for Buffett, his stake in the business is more than an investment to sit on — it’s capital that can be put to use or, perhaps better yet, traded away.

That’s just what the investor did. Earlier this week, it was announced that Buffett would sell $1.4 billion worth of Phillips 66 stock back to the company in exchange for a specialty chemical division. The division screams of the kind of small-scale but high-quality acquisition that Buffett appears to favor. The business produces a chemical that is used to facilitate the transport of oil through pipelines.

The deal is interesting, but it’s unclear how much there is to read into it. Buffett’s relatively new position in Exxon Mobil (NYSE:XOM) sent clear signals that he is interested in the energy industry again despite his regrets about the timing of the ConocoPhillips deal. There is some concern that he may have bought Exxon when oil was near the top of its price range again — forecasts from the Energy Information Agency show the price of oil falling in the near future — but it seems unlikely that there will be a correction on the scale of what happened in 2008 in the near future.

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