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What's Berkshire Hathaway's Failure Can Tell Us About Investing

- By Rupert Hargreaves

Warren Buffett (Trades, Portfolio) has remarked in the past that investing in Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) was the biggest mistake he ever made. He has even gone so far as to call it his "$200 billion mistake."


The reason why the Oracle of Omaha believes this was such a big mistake is because the company consumed a tremendous amount of capital when he owned it. The business just could not compete with lower-cost competitors, who could produce what the company was creating for a fraction of the cost.

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The company also lacked any competitive advantage over the rest of the industry, and its product was commoditized. There was therefore no flexibility to raise prices to improve returns on capital. No matter how much money the company invested, it could not substantially improve profitability because of pricing pressures from the rest of the market and due to the lack of pricing power.

Berkshire: A bad decision

In reality, and I'm sure this is something the Oracle of Omaha would admit himself, Buffett should never have acquired Berkshire.

Buffett owned the shares originally as the company was trading at a significant discount to its net asset value, and the stock looked attractive as a cigar butt investment. As he described in his 1966 letter to partners of the Buffett Partnerships:


"Our purchases of Berkshire started at a price of $7.60 per share in 1962...(the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965), the company on December 31, 1965, had net working capital alone (before placing any value on the plants and equipment) of about $19 per share."



Buffett went on to say that "Berkshire is a delight to own" and while "there is no question that the state of the textile industry is the dominant factor in determining the earning power of the business," he was pleased to have "Ken Chace running the business in a first-class manner." Buffett added, "it is a very comfortable sort of thing to own."

By the mid-1970s, after Buffett had closed his partnerships and was focusing all of his time on growing Berkshire Hathaway, it seems his opinion on the company had changed. He was no longer proclaiming that it was a "delight to own." Instead, Buffett was trying to postpone the inevitable. He wrote in his 1977 letter to shareholders:


"A few shareholders have questioned the wisdom of remaining in the textile business which, over the longer term, is unlikely to produce returns on capital comparable to those available in many other businesses. Our reasons are several: (1) Our mills in both in New Bedford and Manchester among the largest employers in each town...(2) Management has also been energetic and straightforward in its approach to our textile problems...(3) With hard work and some imagination regarding manufacturing and marketing configurations, it seems reasonable that at least modest profits in the textile division can be achieved in the future."



Unfortunately, the business continued to deteriorate, and in the mid-1980s, Buffett decided that the time had come to close the textile business forever.

Writing to shareholders in his 1985 letter, he said that the conglomerate faced a miserable choice. It either had to make a "huge capital investment" in the textile business, which would have kept it alive but "left us with terrible returns on ever-growing amounts of capital," or not invest, which would make us "increasingly non-competitive, even measured against domestic textile manufacturers."

The choice was simple: Either continue to invest vital capital in a declining business or exit the enterprise and move funds to more productive sectors. Buffett described the trade-off in his 2016 letter to shareholders:


"We closed our textile business in the mid-1980s after 20 years of struggling with it, but only because we felt it was doomed to run never-ending operating losses."

"In 1964 we could state with certitude that Berkshire's per-share book value was $19.46. However, that figure considerably overstated the company's intrinsic value, since all of the company's resources were tied up in a sub-profitable textile business. Our textile assets had neither going concern or liquidation values equal to their carrying values."



The story of the original Berkshire Hathaway is an interesting case study of why it is important to cut your winners and run your losses if you want to be a successful investor.

Disclosure: The author owns shares in Berkshire Hathaway.

This article first appeared on GuruFocus.