Warren Buffett may be a successful investor, but he has made mistakes. Journalist, Becky Quick, once asked him about his blunders.
Buffett said: ‘The dumbest stock I ever bought was… drumroll here – Berkshire Hathaway.’
This snippet of information surprised me. Buffett started buying Berkshire in 1962, at $7.50 a share.
It now trades around $750,000! Yes – that’s the share price, not the market cap! And yet, Buffett called Berkshire Hathaway a $200billion blunder.
When he first saw the stock, he saw a bargain. Later in life, he said: ‘I would have been better off if I’d never heard of Berkshire Hathaway.’
He would always resent the fact that a large chunk of cash had been sunk into an unprofitable business — cash which could have been invested elsewhere at high rates of return.
Was the writing on the wall? To answer, we must return to 1962 and see the world as Buffett once saw it.
Buffett started buying Berkshire in 1962, at $7.50 a share.
From textile mill to multinational conglomerate
Back in 1962, Buffett was a zealous disciple of Ben Graham and David Dodd – the founding fathers of value investing.
He had memorised their textbook, Securities Analysis, and once admitted, ‘I knew the book even better than Dodd’.
The principles of value investing were drummed into his head. Buffett was attracted to Berkshire Hathaway because he saw a value investing opportunity.
Berkshire was a struggling textile company, selling at a discount to the value of its assets (i.e. mills).
Warren connived a plan to buy shares on the cheap, in the hope that Berkshire would buy them back at a premium. This made sense.
Berkshire had previously been selling off mills, before using the cash proceeds to buy back its own stock.
This reasoning led Buffett to believe that Berkshire was worth $19/share, even though it was trading at $7.50.
It was an elaborate plan, but it didn’t quite work out, in part because Warren’s emotions got the better of him.
We may think of Buffett as a folksy, grandfatherly figure, but they say we look at history through tinted glass. Buffett was once a young corporate raider, charging around, selling off this and that company and firing people along the way.
When Buffett fell out with the management at Berkshire, he decided to buy up the whole company and fire the managing president. He won the boardroom battle, but it was a Pyrrhic victory.
Learning from Martin Luther…and the Pope
Warren’s original plan was for Berkshire to buy the shares back from him. This plan quickly unravelled; Buffett had become Berkshire’s largest shareholder and would, in effect, be buying the shares from himself.
Furthermore, Buffett had lumbered himself with a declining company in a dying industry. Berkshire Hathaway’s old financial statements are now preserved online.
Using these, we can reconstruct the financial landscape of the ‘swinging sixties’. Even a quick glance reveals several red flags that should have been obvious to the Oracle of Omaha…
Reflecting on the episode, Warren said: ‘I bought my own cigar butt and I tried to smoke it’ — alluding to the idea that if cigar butts on the pavement are free, then you can get one last puff for no price.
That was his idea of a bargain investment. The problem was that Berkshire didn’t have any more puffs. ‘All you had was a soggy cigar butt in your mouth’.
Like all great people, Buffett learned from his mistakes and reinvented himself. He did not neglect his old, value investing self. Instead, he integrated the best of value investing with a new approach.
His philosophy became a blend of quality and value. He started to focus on cheap companies with strong, sustainable competitive advantages and the potential for long-term growth.
A key influence was Charlie Munger, Buffett’s longtime business partner. Warren later said: ‘I was in this Charlie Munger-influenced type transition – sort of back and forth. It was kind of like during the Protestant Reformation.
‘And I would listen to Martin Luther one day and the Pope the next. Ben Graham, of course, being the Pope.’
Quality merchandise, marked down
This back-and-forth conversation went on until Buffett could clearly articulate his philosophy in one line: ‘I like buying quality merchandise when it is marked down.’
The Washington Post newspaper perfectly exemplified Buffett’s idea of quality merchandise.
Here was an established brand with wide circulation and a loyal customer base. The newspaper had a mile-wide moat, but the company went through a rough period in 1973 after exposing the Watergate scandal and incurring the wrath of President Nixon.
The stock fell from $38 to around $15.
Buffett recalled that ‘when we were buying that stock at $20 a share, if you’d asked the people how much the company was actually worth, they would have said $100 a share’.
‘But they sold it anyway,’ he added.
So there you have it. Quality merchandise, marked down.
To understand how Buffett’s view of quality evolved, it is useful to compare the profitability of Berkshire Hathaway and the Washington Post in the years preceding his investment.
The Post consistently delivered higher margins and returns. Furthermore, the Post’s returns and margins were fairly steady, while Berkshire’s profitability had declined noticeably from earlier periods.
If we were to impose the technical language of today on the investment universe of the 1960s and ’70s, we would say that Buffett was shifting from a ‘value strategy’ toward a ‘quality-value strategy’.
These are the terms we might use in the framework of a factor investing – a systematic approach that quantifies the characteristics (i.e. factors) associated with outperforming stocks.
One factor is value; cheap stocks tend to beat expensive stocks. Another factor is quality; companies that are profitable, financially stable and cash generative tend to outperform those that are loss making, highly leveraged and cash-strapped.
Berkshire Hathaway was only exposed to one factor, namely value. It was trading below asset value. Quality metrics, like profitability, were weaker.
The Washington Post was exposed to two-factors: Value and Quality. It was cheap, having fallen from $38 to around $15. It was also a profitable company with an established brand.
Berkshire Hathaway was what we might call a ‘value trap’. The Post was a ‘contrarian play’.
What is your story?
These labels are part of our categorisation system, which can be used to separate the wheat from the chaff – or separate the Washington Posts from the Berkshire Hathaways.
Value traps are cheap for a reason. To extend Buffett’s analogy, these are cigar butts with no puff left.
By contrast, contrarian companies are cheap, but they are also profitable, cash generative and financially stable. The term is a play on Buffett’s maxim: be fearful when others are greedy; be greedy when others are fearful.
These labels – contrarian and value erap – are shown on every StockReport via Stockopedia’s platform.
Generally speaking, value traps will only have better than average value ratios. Contrarian stocks with better than average value ratios and quality ratios. As such, the difference is in quality.
A key part of growing up is learning the balance between doing things ‘by the book’ and doing things your own way.
Various anecdotes suggest that young Warren was a ‘by the book’ value investor – the kind of guy who would hold up The Intelligent Investor, wag his finger and say, ‘You see, Ben Graham said so!’
For example, in 1950 Buffett met with Lou Green, one of Graham’s business associates. Green asked, ‘Why did you buy Marshall-Wells?’ Warren replied, ‘Because Ben Graham bought it.’
Later in life, Buffett described his investment style as 85 per cent Ben Graham, 15 per cent Phillip Fisher.
Fisher enhanced Buffett’s approach by focusing on quality companies with strong growth potential and strong financials.
This shift is just a reminder that no philosophy is static, especially in investing.
Whether you’re early in your journey or have decades of experience, understanding what makes a stock both cheap and good is a skill that takes time to master, though.
At Stockopedia, we’ve built a variety of tools to help accelerate that learning curve. Our StockReports were designed to highlight factors like quality, value, and momentum, helping you avoid those value traps and zero in on contrarian gems, just like Buffett did with the Washington Post.
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