February 15, 2009

Buffett's Biggest Mistake

This article originally appeared on The Div-Net Feb8 2009
Much has been written about the success of Warren Buffett, but little on his failures. I think a great deal can be learned by analyzing the failures of successful people. By studying these failures hopefully we can avoid them ourselves.

The Deal

Buffett purchased preferred shares in US Airways in the early 1990's, and later remarked that this was one of his biggest mistakes. Now before getting to far into this it is worthwhile to comment that Buffett did in fact end up making a profit on his holdings of US Airways but Buffett certainly cannot claim credit for this. In his own words:

Two changes at the company coincided with its remarkable rebound: 1) Charlie and I left the board of directors and 2) Stephen Wolf became CEO. Fortunately for our egos, the second event was the key... Warren Buffett, Bershire Hathaway Letter 1997.

A few years after purchasing Buffett had pretty much written off the investment and had tried to sell out of the stock numerous times at a substantial discount. The investment had essentially become out of control and Buffett wanted out. Luckily he wasn't able to sell until sometime later when the company had started to rise again.

What Went Wrong?

So what did Buffett do so wrong? Lets look at the principals that Buffett uses for analyzing an investment:

Charlie and I look for companies that have a) a business we understand; b)favorable long term economics c)able and trust worthy management d) a sensible price tag. Berkshire Letter to Shareholders 2007

Understandable Business

Looking from the outside the airline business is fairly easy to understand. Money is made by moving customers and packages from one location to another. But behind the scenes the airline business is a huge gamble with 183 airlines having gone bankrupt since 1978. So much of the business is frozen in the assets in the business that any turn in the economy can destroy it over night.

Sustainable Competitive Advantage

Part of the reason that so many airlines have gone out of business is that consumer's are essentially unable to determine the difference between one airline and another. The planes are all the same make and model, you leave from the same airports, the pilots are all trained by the same schools and military, the food is very similar and they show the same movies. For the consumer in most cases it comes down to a question of price- who can get me there cheaper. Did US Airways have a way to keep their costs under any better control than their competition? No, unfortunately they shared several of the same unions as other airlines and were being charged the same airport fees as others also. It is difficult then to see the sustainable competitive advantage that US Airways had.

Able & Trustworthy Managers

Within a year of purchasing the preferred shares in United Airways the CEO Ed Colodny had been replaced and the stock price had gone into a deep dive. While Buffett still remarks that he has the utmost respect for Colodny he obviously could not get the job done and was on his way out as Buffett was coming in. In terms of Able then US Airways appears to fail this criteria.

Bargain Price

A bargain is only a bargain if you get something of value. While the preferred divided Buffett was to receive was an appealing 9.25% he was unable to collect that for 2 years. Several other ratios were also appealing; if the market teaches value investors anything its that sometimes things appear cheap because they, in fact, garbage.

Analysis Conclusion

Buffett failed to enforce his own rules of selection and got wrapped up in a bad decision. As he put it:

I liked and admired Ed Colodny, the company's then-CEO, and I still do. But my analysis of USAir's business was both superficial and wrong. I was so beguiled by the company's long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir's revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline's past record might be. 1996 Letter to Shareholders, Warren Buffett

What Can We All Learn From This?

Buffett has a good system, when he settles on an investment choice he writes down the reasons that he feels it is a good investment. If he can't persuade himself to buy based entirely on what he writes down on the paper then he walks. This would have been one of those times he should have looked more carefully at the paper.

We can all learn from this mistake; do your homework and, most importantly, stick to your principals. If you have rules for investments make sure you are sticking to them. What went wrong here then is that Buffett stopped using his rules and veered off the track- don't make the same mistake in your investing.


widemoatinvesting said...

Thanks for your work.

It looks like the big problem here--using Buffett's criteria--was that USAir was not in a business with favorable long-term prospects.

In some respects, this is a very difficult judgment for an amateur investor to make, and it may involve some qualitative judgments (i.e., beyond the balance sheet) that someone like Fisher has been able to do, but not a lot of others.

For example, you look out at American retailers right now, and the business is relatively simple, but even in duopolies (e.g., Best Buy, Circuit City), not all can profitably compete.

All of which is to say that potholes abound out there as value traps, and it is amazing to me that Buffett has done so well--by and large--at sidestepping them.