Warren Buffett is one of the most talked about investors of our time, but he is also the most misunderstood. We hope that what you read in this article will open your eyes to new investment horizons and strategies. We hope it will help you cut through the marketing materials of others that you read so much. And at the very least, we hope it will help you learn more about the Oracle.
As you’re reading, it will be very important to keep in mind that it is not Warren Buffett’s admission of his mistake in this article, but the idea that he would pursue an investment of this quality in the first place. We ask: If he can make such a move so late in his career (but still in his prime), doesn’t such a move speak volumes about what Warren Buffett really puts first (or maybe didn’t put first until recently)? And doesn’t such an action then bring into question the commonly-held view of the main driver behind his early and most critical performance?
We further ask: Is Buffett’s main criteria ‘sustainable competitive advantages’ – as Maubboussin wrote in the following piece “Measuring the Moat” more than a decade ago? Or is what we hear from Buffett about competitive advantages more of an explanation that is only partially true or (perhaps more appropriate) more recently true? And has the research marketing machine taken his words too far?
According to Van Eck, investors can now buy a competitive-advantage based ETF, gaining exposure to such companies as Western Union (click ticker for report: ), St. Jude (click ticker for report: ), St. Joe (click ticker for report: ) and even Berkshire Hathaway (BRK.A) (BRK.B) itself, as of January 4, 2013. Western Union is down about 50% since July of 2008, St. Jude is off by more than 30% from its highs set in mid-2011, while St. Joe has fallen to the mid-$20s from over $80 in recent years. Yet, this ETF is still modestly beating the market.
Lots of questions asked thus far, so let’s get started. First, here’s the quote from the Oracle of Omaha that prompted this article:
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here’s a durable competitive advantage that has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
— Warren Buffett, annual letter to Berkshire Hathaway shareholders, 2008.
The above assessment of the airline industry makes a lot of sense to us. In fact, we agree.
So how can it be then that Warren Buffett actually bought airline stock? How can this advocate of “competitive advantages” buy stock in an industry that is about as far away from generating sustainable competitive advantages as possible? And how could he still have held a position in airline stock to as recently as the late 1990s (years after he bought it) – after the majority of his fantastic returns had been generated. Berkshire’s return record began in 1965 – some 25 years earlier!
We have to believe that Warren Buffett was aware of competitive advantage analysis in 1989 when he first opened a position in US Airways’ () preferred stock. So why did he do it? And most importantly, were there other examples in those previous 25 years where owning the “highest-quality” stocks didn’t factor into his thinking? We have to think so.
In the Essays of Warren Buffett, the Oracle says “he was not pushed into the (US Airways) investment nor misled by anyone when making it (page 143).” So, this was not a case where one of his lieutenants may have gotten him into something he didn’t like (which may happen today).
Warren Buffett even said: “In an unregulated commodity business, a company must lower its cost to competitive levels or face extinction. This principle should have been obvious to your Chairman, but I missed it (page 144).”
But can we really believe the Oracle of Omaha when he said he didn’t know that airlines have no competitive advantages? Even if he may have thought they weren’t terrible businesses at the time, he couldn’t have thought they were good ones. So, again, we ask: are “competitive advantages” the most important thing that matters to Buffett? Are the highest quality companies the most important thing to him?
The amazing part of this story is that the Oracle of Omaha spent $358 million in US Airways’ preferred stock in 1989, only to see the company defer its dividend for years, and for Berkshire to write it down to $89.5 million at year-end in 1994. Warren Buffett even declined to stand for reelection to US Airways board. All seemed lost.
However, in the second half of 1996, US Airways started to turn a profit and pay preferred dividends – not because of any improvement in its competitive stance, but because of a cyclical upturn and industry tailwind. Buffett fully recouped the value of his preferred investment and even received extra preferred dividends due to stipulations agreed upon in the event of a deferral of them (which had occurred). US Airways common stock jumped from $4 to over $70. And then, as the preferred stock was called for redemption, Buffett made a killing thanks to conversion rights.
If only every investor was this lucky.
Still, it is not that Buffett made a mistake. And certainly, there is a degree of luck to every investment. And we’re not challenging the Oracle’s investment prowess. He is truly a remarkable investor.
Instead, we hope readers can see that there is reasonable doubt brought about by this example that Buffett may not have put competitive advantage analysis first at all from the period of 1965 (Berkshire inception) through the late 1990s (US Airways). If he did, there is no way an airline would ever fall on his radar. Maybe we could believe that he might have thought airlines were average businesses in the late 1980s, but we can’t believe for one second that he thought they were great businesses.
So the one thing that you never knew about Buffett is not his foray into the airline business. Most people know this. But, instead, it’s what such a foray really means about his style and returns from inception through the late 1990s — when his fantastic returns were generated.
Our view is that a young Warren Buffett was a Valuentum investor (click here for why). This isn’t inconsistent with other research pieces on the topic. In any case, we want you to have as much information as possible.
An Interesting Parallel: In Essays of Warren Buffett, Warren Buffett describes derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Yet, Berkshire owns derivative bets on global stock markets, which have caused wild swings in the firm’s profitability. Overall, we believe investors should assess Buffett’s style on what he does not what he or others say he does.
A version of this article had previously appeared on our website.