Friday, August 8, 2014

Buffett on Autos, Airplanes, and Airlines

In this 1999 Fortune article, Warren Buffett (with some help from Carol Loomis) weighed in with his thoughts on some of the "industries that transformed" over the past century or so.

On Automobiles
"...there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people's lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, 'Here is the road to riches.' So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies--themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America--and also an enormous impact, though not the anticipated one, on investors.

Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make you money."

On Airplanes
"The other truly transforming business invention of the first quarter of the century, besides the car, was the airplane--another industry whose plainly brilliant future would have caused investors to salivate. So I went back to check out aircraft manufacturers and found that in the 1919-39 period, there were about 300 companies, only a handful still breathing today. Among the planes made then--we must have been the Silicon Valley of that age--were both the Nebraska and the Omaha, two aircraft that even the most loyal Nebraskan no longer relies upon."

Inevitably, this leads to an industry that has just been terrible for investors for a very long time.

That'd be airlines, of course.

Buffett mentions that no less 129 airlines had filed for bankruptcy over the previous 20 years. That was 1999. There have naturally been many more airline bankruptcies since Buffett made that point.

On Airlines
"As of 1992, in fact--though the picture would have improved since then--the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero.

Sizing all this up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did."

Some might view the consolidation of the airline industry in the U.S. is finally going to create attractive economics. Whether that turns out to be the case or not, I'll happily leave it for others to figure out. Even if airlines do become not such terrible businesses at some point, the more general lesson remains valid:

The most dynamic and transformative industries have often NOT been so wonderful for the early investors.

More from Buffett:

"I won't dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Too often, when it comes to transformative industries (and individual businesses), it's difficult to avoid big mistakes. This subtracts meaningfully from overall results. Less return; more risk. Exciting prospects can lead to speculative prices. So the current winners quickly become priced for greatness. Well, what happens if they end up being just good or worse? A sufficient margin of safety is paramount because disappointments and misjudgments happen. When the future offers a wide range of outcomes -- and that's usually the case in the most transformative industries -- an even bigger margin is required.

So the price paid should protect against what might go wrong. Yet sometimes the worst likely outcomes can't be understood well enough beforehand. In those instances, no margin of safety will be sufficient.

The right action becomes inaction. The avoidance of exposure altogether.

Paying a speculative price -- even if based on a fundamental view that an investment will someday justify the price paid -- eventually turns into a recipe for permanent capital loss. This approach -- that is, operating without enough margin of safety -- will work right up until it does not.

In fact, early success operating in this manner likely leads to an even bigger speculative disaster down the road. Some are willing to pay a premium upfront on the belief an investment will eventually grow into its valuation. Well, investment is not about whether something can justify its valuation someday; it's about understanding investment specific risk and the potential reward compared to alternatives.

A willingness to pay a premium price for promising prospects quickly becomes expensive if those prospects end up not quite being realized.

At times, even when it happens to be unusually clear who the winner is likely to be, the price of admission makes the future returns unattractive considering the risks and alternatives.

Yet paying too much is only part of the problem.

The other difficulty is that many businesses fail -- or at least fail to produce an attractive return on capital -- in the most dynamic industries. Business economics can be altered in unpredictable ways when there's lots of capable competitors. Not becoming exposed to the capital that's destroyed in the process is easier said than done.

Obviously, the industries exposed to constant change do sometimes produce some big winners. The problem is those same industries also tend to produce a long list of losers. Both possible outcomes should get careful consideration. Those who get too caught up in the "story" may not consider the downside carefully enough. Those who do not scrutinize for flaws in their own thinking, and instead seek confirmation they're right, can make unnecessary mistakes. What appears to have great potential today might just end up on that long list tomorrow.

Keep in mind that, overall, the technology sector has had lower long-term returns than the consumer staples sector.*

Well, it seems more than fair to say that the former has been more transformative than the latter. Yet that didn't translate into above average investor returns.

Competition and the risk of technology shifts can turn sound core business economics into something else altogether. A big new opportunity where lots of innovation is taking place invites disruption from well-financed and capable new entrants to an industry.

What were expected to be high returns on capital today become rather the opposite down the road.

New competitors and capital usually go where there's exciting growth prospects; where there's some new compelling territory to potentially dominate. One or two do well. Many fail.

Subpar overall returns.

This isn't to suggest that some aren't very good at figuring out who the winners are going to be while also not paying too much for the potential. Some certainly do that sort of thing very well.

It's just easy to underestimate how difficult this is to do well on a consistent basis. Some are overly confident that they can reliably pick the winners and mostly avoid the losers.

The things that end up being transformative for the world need not -- and often do not -- enrich the investors who are willing to risk their capital.

There will be exceptions, of course, but an investment approach dependent on being the exception isn't likely to lead to great results.

It's worth noting that each industry has unique characteristics and dynamics that can be far from a static thing. I'll also add that, on occasion, an industry with historically not such great overall economics will settle down or consolidate and a clear winner or two emerges.

Though far from assured, those winners might even end up with sustainable advantages and sound business economics. This makes estimating intrinsic value, within a narrower though hardly precise range, just a bit less difficult (though still not easy).

Also, thanks to the fact that market prices fluctuate far more than intrinsic business values, the shares of these winners will sometimes sell at a nice discount. Risk and reward becomes more manageable.

It's a fallacy that being in on something early is a prerequisite for investment success.

Investing well does require lots of patience followed by decisive action when appropriate.

It requires an awareness of limitations and biases.

It also requires a real willingness to be critical of one's own thinking and decision-making.

Some might think investing well comes mostly down to having some brilliant insight.

Mostly (and fortunately for me) it does not.

Adam

* This article provides returns for ten economic sectors from 1963 to 2014: Among the ten economic sectors, consumer staples had the highest returns at 13.33%. Technology produced the lowest returns at 9.75%. The future may be very different, of course, but the point is that lots of competition and unpredictable technological change isn't necessarily a recipe for exceptional returns.
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