Friday, December 19, 2014

Should Buffett Buy Uber?

A recent Fortune article made the case for something that at first glance seems rather unlikely. In it, Dan Primack argues that Warren Buffett should consider buying Uber. With this in mind and for context, let's look at some things Buffett has written over the years. Back in 2007, Berkshire Hathaway's (BRKa) four largest equity investments were Coca-Cola (KO) Wells Fargo (WFC), American Express (AXP), P&G (PG).

Here's what he had to say about those investments:

"...note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game." - From the 2007 Berkshire letter

Three of those stocks remain top four holdings. More recently (over the past five years or so) some of Buffett's bigger purchases -- everything from partial ownership via equities to outright acquisitions -- have included things like Burlington Northern Santa Fe, Lubrizol, IBM (IBM), Heinz, Exxon Mobil (XOM), and Duracell. The youngest of these businesses is 86 years old. So, to say the very least, Buffett generally likes businesses with a very long track record that are less likely to experience major change* -- especially the kind of change that fundamentally alters the core business economics -- going forward.

"In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - From the 1996 Berkshire letter

So Uber would be a rather significant break, I think it's fair to say, from Berkshire's traditional approach.  Startups -- even very successful ones -- that compete in a rapidly changing environment isn't usually a part of the Berkshire playbook. Yet you never know. If the price was right, maybe something that now seems rather improbable could suddenly make a whole lot of sense.

The fact is that there have been many great businesses launched -- and Uber just might prove to be one of them though, at this point, I have no idea -- during the period that Buffett has been managing Berkshire (roughly five decades).

Berkshire's success over that time -- a 693,518% total return through the end of last year -- has essentially come from none of them.**

Many more great businesses will no doubt be created in the coming decades.

It seems likely they also won't be contributing much to Berkshire's intrinsic value going forward.

If nothing else, Berkshire's approach shows that attractive investment results do not necessarily depend on some unusual acuity for finding the next big thing. Exciting growth prospects and dynamic change might, in fact, offer the possibility for big investment gains. The problem is they also sometimes offer the chance to lose a whole lot of money. Big wins and big losses usually reside in the same neighborhood. They can be tough to reliably tell apart beforehand without making large mistakes.

This is not only due to unpredictable future prospects and a wide range of possible outcomes; this is also because the price one usually has to pay upfront for the most promising businesses is rather high.

Insufficient margin of safety.

Of course, some might be able to reliably pick the big winners, but it's easy to underestimate how difficult this is to do without also incurring big losses.

That may offer a more exciting ride but it's the net result, in the context of risk, that matters.

Owning businesses that can maintain attractive economics for decades, bought at a reasonable price or, better yet, at a meaningful discount to a conservative estimate of value, isn't a bad way to balance risk and reward. Exciting growth prospects not required.

Almost any business -- even a very good one -- will eventually experience real difficulties and unexpected challenges. Buffett's approach is, in part, an attempt to reduce the likelihood that investment results will be ruined by what are almost inevitable future business challenges.

"It's vital, however, that we recognize the perimeter of our 'circle of competence' and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses." - From the 2013 Berkshire Hathaway letter

So, even with such an approach, mistakes will still get made.

Just because a particular business has succeeded for a very long time guarantees absolutely nothing.


Long positions in all common stocks mentioned excluding XOM

* This is not meant to be an all-inclusive list of Berkshire's more recent investment activity but, instead, just some good examples of the larger moves that have been made. Burlington Northern's historical lineage dates back to the late 1840s. Heinz was founded in 1869. Exxon was formed in 1870. IBM was founded in 1911. Duracell began in 1916. Lubrizol was founded in 1928. The names may have changed over time but all of these go back quite a ways. Naturally, all of these businesses have dealt with change over time but the question is how likely those changes will damage business economics. IBM would seem to fit the least well when it comes down to whether its business is likely to experience major change going forward. The Heinz investment is made up of common stock, warrants, and preferred shares. Berkshire also made a large investment in Bank of America (BAC) preferred stock and warrants. It won't be clear for some time how much BofA common stock Berkshire will end up owning though at this point it appears that it will be substantial. Once again, the bank isn't exactly a startup.
** This total return over five decades or so means that $ 10,000 invested in Berkshire would have grown to just under $ 70 million.
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