Tuesday, March 13, 2012

Buffett on Errant Purchases: Why We Hold On To My Mistakes

When it comes to businesses they acquire, over the years Berkshire Hathaway (BRKa) has made it very clear they don't to sell their mistakes.

It's a principle Berkshire established a long time ago and they have stuck with it. An excerpt below from Buffett's latest letter helps explain their way of thinking on this.

The same is not true when it comes to partial ownership of businesses via the purchase of marketable securities. Buffett has said many times he prefers to hold a stock "forever". They have, in fact, owned certain shares for a very long time. Yet, they're not nearly as rigid about holding on to shares of certain stocks if better use for the capital exists elsewhere.

For starters, here's a quick overview of Berkshire's Manufacturing, Service, and Retailing Operations. Quite a few (though certainly not all) of the acquisitions by Berkshire over the years is within this group.

It is, to say the least, a highly varied mix of businesses that includes:

Acme Brick
Benjamin Moore
Borsheims (jewelry retailing)
CTB (agricultural equipment)
Dairy Queen
Fruit of the Loom (including Russell athletic apparel)
Iscar (cutting tools)
Lubrizol (lubricant additives)
Marmon (140 independently operated manufacturing and service businesses)
McLane (distributor of food products, cigarettes, candy, sundries, wine and spirits)
Nebraska Furniture Mart
Pampered Chef (direct sales of kitchen tools)
See's Candies
Shaw Industries (flooring)

...among others.

This collection of businesses earned just $ 3.04 billion dollars in 2011 or just slightly more than the $ 2.97 billion that Berkshire's railroad Burlington Northern Santa Fe (BNSF) earned by itself.
(BNSF is not part of the Manufacturing, Service, and Retailing Operations. It is listed under Regulated, Capital-Intensive Businesses.)

Buffett said the following about the Manufacturing, Service, and Retailing Operations in the latest Berkshire Hathaway shareholder letter:

Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. A few, however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. These errors came about because I misjudged either the competitive strength of the business being purchased or the future economics of the industry in which it operated. I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor. Charlie's has been better; he voted no more than "present" on several of my errant purchases.

Berkshire's newer shareholders may be puzzled over our decision to hold on to my mistakes. After all, their earnings can never be consequential to Berkshire's valuation, and problem companies require more managerial time than winners. Any management consultant or Wall Street advisor would look at our laggards and say "dump them."

That won't happen. For 29 years, we have regularly laid out Berkshire's economic principles in these reports...and Number 11 describes our general reluctance to sell poor performers (which, in most cases, lag because of industry factors rather than managerial shortcomings). Our approach is far from Darwinian, and many of you may disapprove of it. I can understand your position. However, we have made – and continue to make – a commitment to the sellers of businesses we buy that we will retain those businesses through thick and thin.

Buffett goes on to make the following points:

- Up to now at least, the dollar cost of this commitment has not been substantial.
- The cost of laggards may be offset by the goodwill it builds among potential sellers.
- Future sellers to Berkshire know alternative buyers can't (or at least don't) make a similar promise. Commitments are measured in decades at Berkshire.

Now, though it has happened rarely, there are conditions where Berkshire will sell an acquisition. More from the 2011 letter:

If either of the failings we set forth in Rule 11 is present - if the business will likely be a cash drain over the longer term, or if labor strife is endemic - we will take prompt and decisive action. Such a situation has happened only a couple of times in our 47-year history, and none of the businesses we now own is in straits requiring us to consider disposing of it.

The principle behind this is laid out comprehensively in Rule 11 of the Berkshire Hathaway owner's manual.

You'll be looking for a long time trying to identify an acquirer with scale that takes a similar approach.


Long position in BRKb established at lower prices
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