Lessons learnt from Buffett's colossal mistake - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Lessons learnt from Buffett's colossal mistake 

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In this issue:
» Should RBI be buying dollars?
» Emerging markets aren't a cakewalk
» US' estimated long term growth rate optimistic?
» Damodaran's balanced view on Bitcoin
» ...and more!

Legendary investor Warren Buffett's annual letters contain gems of wisdom that provide a glimpse of what has made him one of the most successful investors of his day. For the most part, his investment track record has been impeccable. But that does not mean that Warren Buffett has not made mistakes. He has. He is human after all. But even from these mistakes, there are valuable lessons to be learnt on good, sensible investing.

In his recent shareholder letter, Buffett has highlighted one such colossal mistake that cost him a whopping US$ 900 m. The investment in question is the Texas energy company Energy Future Holdings (EFH) . As reported in an article in Fortune, a deal was entered into at the peak of euphoria before the 2008 global financial crisis wherein Texas energy company Energy Future Holdings was bought by private equity firms KKR, TPG Capital, and Goldman Sachs' private equity arm. The deal size was pegged at US$ 45 bn making it the largest leveraged buyout in history. KKR, TPG, and Goldman put up US$ 8 billion for their ownership stakes. Energy Future had US$ 13 bn in debt already on its books. The rest of the deal was financed by issuing more debt. And Buffett bought just under US$ 2 bn of those bonds.

Buffett's bet turned out to be a big mistake. The biggest risk turned out to be too much leverage. On top of that natural gas prices began falling as a result of which Energy Future's plants became less profitable. Since then, Buffett has been writing off that investment and as of now holds no bonds of Energy Future.

Given that Warren Buffett was highly critical of leveraged buyouts, it remains a mystery as to why he went in for such a high risk investment in the first place. Especially when the deal was struck in the days before the 2008 crisis when most asset classes seemed to be in bubble territory.

But there is something to be learnt from Buffett's mistake. That too much of debt is always a bad thing even if one is investing in bonds of a leveraged entity. Excessive debt becomes a huge burden especially when the macro environment is weak because this debt has to be serviced in the form of interest payments even in a tough economic climate. On top of that if the business is under weather, then the pressure on cash flows just piles on. The other thing to learn from this is to exit from a bad investment as soon as possible rather than staying invested and hoping that things will improve thereon. Indeed, once you exit from a bad investment, you are free to invest elsewhere which can generate better returns.

Buffett admitted that he made this ill timed investment without consulting his long time business partner Charlie Munger. Things could probably have been different had he done so. But there is something that investors can learn from this and that is to stay away from companies that have too much debt on their books even if the growth potential looks enticing.

Do you agree that investing in companies with huge debt is ultimately unrewarding for shareholders and investors? Share your views in the in the Equitymaster Club. Or post your comments below.

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01:36  Chart of the day
FY14 is almost at an end with only one month left to go, but one can safely say that this year has been an extremely difficult one for the Indian auto industry. Slow economic growth, sluggish manufacturing activity, inflation and firm interest rates adversely impacted demand across various segments of the auto space. The worst hit has been the commercial vehicles (CVs) segment whose fortunes are closely linked to that of the Indian economy. As industrial production remained sluggish, freight rates also took a hit and this impacted the demand for CVs. What has made matters worse is the uncertain political climate as well. With the upcoming general elections in April 2014, there are hopes that demand would pick up as the new government introduces reforms that will bolster economic activity and development. One will have to wait and see.

FY14 has been a tough year for Indian Auto
*April 2013-Feb 2014

The RBI was caught on the wrong foot when the rupee saw a sudden and rapid depreciation in 2013. Its ability to intervene into the markets to halt the fall of rupee was also limited due to forex constraints. Hence the central bank should be taking lessons from its past mistakes. As per an article on Mint, the RBI should be buying dollars to prepare for currency wars in the future. The rupee has been the biggest gainer against US dollar amongst the Asian currencies. Further debt worries in China have also tilted the balance in favour of the rupee.

In addition to the strong capital inflows, a shrinking current account deficit has also worked in India's favour. Thus as the rupee's position stands favourable it is time the RBI strengthens India's forex reserves too. We agree with the article in Mint that a confusing political mandate post elections could tilt the balance heavily against the rupee. And it would be wise for the RBI to look into currency concerns in addition to those on inflation.

What has been the single most important strategy of big western multinationals over the last two decades? Well, without a shadow of doubt it has to be their expansion into emerging markets. And the sales that the emerging markets contribute to their overall topline do highlight the success of this strategy. However, the Economist has urged readers to dig a bit deeper. It wants them to draw their conclusions by not only taking a look at wide variety of industries but also glancing through the profitability. And this is where the myth begins to fall apart we reckon. In other words, the picture is not as rosy as it's being made out to be. There have been success stories no doubt but the list of disasters is as big if not bigger.

Thus, western firms looking at emerging markets as a panacea for the evils in the developed world need a serious rethink we reckon. The emerging markets aren't a cakewalk anymore. For even here, the same rules apply. Firms need to have a sustainable competitive advantage and should also be careful about the valuations they pay for taking over a local firm. Absent these factors and there will be significant losses to bear according to us. As the Economist rightly points out, MNCs need to re-align their entire strategy keeping in mind that developing markets too operate with the same principles of survival of the fittest.

The Quantitative Easing program was designed for many reasons; with a key one being to boost growth levels in the US. Given the declining GDP, the country needed to increase its overall output levels. However, the US seems to have now realized that the projected long term growth rates are not likely to be met, or touch full potential, and thereby need to be revised lower. As such, what should be expected? A quicker than expected tapering in money supply.

In an interesting article, Bloomberg discussed about the likelihood of the country's projected future potential output not being reached on the back of the severe impact of the recession that has hit the economy over the past few years. And as such, the Congressional Budget Office has had to revise the country's potential output targets downwards (for the year 2017, which was set in 2007). And with the same happening, the US would need to revise its unemployment targets - given the lower output would require lesser people in the workforce - and thereby reducing the need for QE all the more. If this was to come true, we could possibly see the hot capital moving out of emerging market nations such as India much faster than what has been anticipated.

What does the term 'Bitcoin' bring to your mind? While not yet popular in India, the new digital currency has been a rage in the developed countries. As with anything that gets popular, Bitcoin has been the topic of heated debates. While advocates swear by the digital currency, detractors are prophesying doomsday scenarios for the newfound fad.

In his blog, renowned Professor Aswath Damodaran presents a very balanced view of the digital currency. While Warren Buffett has said on record that Bitcoin is not a currency, Mr Damodaran does believe that it qualifies as a currency. The principle role of a currency is to be a medium of exchange. The Bitcoin does qualify as a currency because it is accepted in transactions. The second important aspect is determining the currency's price. The value of any currency cannot be determined because there is no way to find out its intrinsic value. But a currency's price can be determined in relation to other currencies.

There are three key factors that determine the worth of a currency and its staying power. One is trust in the issuing authority. In case of Bitcoin, there is no central authority but a complex computer algorithm that determines the currency's supply. So unlike central bankers, no entity can intervene and distort the supply of Bitcoins. The second factor is about its acceptance in transactions. It must be noted that Bitcoin transactions have been growing at a fast rate. It has lower transaction costs compared to paper currencies. And the third factor concerns about the security of the currency, how easily it can be stored and converted to other currencies. While the Bitcoin can be easily converted, its security is not foolproof and may call for regulation and protection by a centralized entity. All in all, it would be too early to take a clear position on Bitcoins. It is best to wait and watch.

In the meanwhile Indian stock markets slipped in the red after opening the day on a firm note. At the time of writing, the benchmark BSE Sensex was down by 85 points (-0.4%). Consumer durables and metal stocks were the biggest losers. The major Asian stock markets were trading higher led by Japan and South Korea.

04:56  Today's investing mantra
"I think you have to learn that there's a company behind every stock, and that there's only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies."- Peter Lynch
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7 Responses to "Lessons learnt from Buffett's colossal mistake"

Kirandeep Atwal

Mar 13, 2014

I think secret of Warren Buffet success is that he is investor and businessman. Most of the businessman are not investors and most of the investors are not businessman. How can financial analyst analyse the future free cash flow of business when he himself has never ran business?

Like (2)


Mar 12, 2014

FY14 means the period from April 2013-March 2014. We have mentioned ‘one month to go’ from the perspective of the auto volumes figures published by SIAM for the period April 2013-Feb 2014.

Like (2)

Om Arora

Mar 11, 2014

An unbelievable story. If a stalwart like Buffet can goof then an ordinary investor need to be smarter.

Like (2)

Kuruvilla Abraham

Mar 11, 2014

Investing in companies with huge debt is not at all rewarding. I invested some funds in the shares of Lloyd Steel and Modern Syntex. More than 20 years now. I never received any returns from these two companies. Lloyd steel is listed while there is no news of Modern Syntex.

Like (2)

Ganesh Sastri

Mar 11, 2014

The lesson is LIVING WITHIN MEANS HAS NO LIMITS and LIVING BEYOND MEANS HAS ITS LIMITS. It ends painfully for those doing so and those helping them to do so: Creditors, Shareholders. This is true whether you are an individual or company or government or country. GOI for example spends THREE rupees for every ONE rupee it earns. Luckily it can print its way out of trouble. But India as a whole does live beyond its means. It has massive trade deficits ( even if it has come down in recent past). This is not sustainable and will end some day with a lot of pain for Indians. The same is true of US and USD. US continues to accumulate MASSIVE TRADE DEFICITS and rest of world will pay a price for its profligacy.

Like (2)

Anil Kumar

Mar 11, 2014

It appears law of averages caught up with the great Warren Buffet. The gamble did not pay of. As per the Article he did not take a informed decision. Too much of debt is bad for any business. Knowingly investing there is a gamble.

Like (2)


Mar 11, 2014

" FY14 is almost at an end with only one month left to go, but one can safely say that this year has been an extremely difficult one for the Indian auto industry "

The above editorial sentence - FY 14 is almost at an end- I could not understand this meaning because normally April-2014 to March 2015 is considered as FY 14-is it not?
Kindly clarify .

Like (2)
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