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Did Warren Buffett make his most expensive mistake ever?

Aug 12, 2015

In this issue:
» Fiscal adjustment at the cost of lower expense
» Growing incidence of these loans is worrisome for banks
» ...and more!

Smart investors always keep an eye on Warren Buffett's moves. He's one of the wealthiest men around. But that's just one reason. After all, he did not create all this wealth out of thin air. His investing acumen and ability to spot great businesses has set him apart from the rest.

Luckily for us, Buffett has not chosen to keep his investing secrets to himself. He shares them in his annual letters to shareholders - always a compulsive read for devout value investors.

So when Buffett's Berkshire Hathaway announced the acquisition of Precision Castparts Corp. a couple of days back, it raised a few eyebrows. Ours included. At US$32.4 billion, many consider this the company's largest acquisition in terms of value. But the key here is whether the price paid is right. At 21.2 times last year's profit, P/E valuations do seem high, which Buffett has acknowledged.

So has Buffett made his biggest investing mistake ever? Before we rush to judgment, given Buffett's success over the years, let's take a deeper look into his thinking and what prompted this move in the first place.

Let's start with the company itself. Precision Castparts makes nuts, bolts and other fittings for the aerospace industry. The company also derives some revenues from the oil and gas sector.

Weak oil prices have taken a toll on the oil industry in the US. Naturally, this has impacted Precision Castparts in the last few quarters.

But is that something to worry about? Buffett has always invested in companies for the long haul. So a few quarters of tepid growth is hardly something to bother him. And the practice of predicting oil prices in the short to medium term is futile at best.

What matters to him is the strength of the business. And the biggest clients for the company are in aerospace. This is what Buffett had to say in an interview with CNBC: "The aerospace industry needs them as they [Precision Castparts] are universally regarded as the most reliable, innovative and dependable supplier of very key parts that goes into all kinds of aircrafts."

Thus, as long as the aerospace industry exists (and there is no reason not to believe so), Precision Castparts will continue to have that competitive edge or the moat that so attracts Buffett. A few years of tepid growth, common in cyclical industries such as aerospace, won't deter him.

Furthermore, in addition to the strength of the business, Buffett values the quality of management. This, of course, cannot be measured in numbers. As the Wall Street Journal reports, Buffett appears to be impressed by the Castpart CEO's low-key profile, how cost conscious he is, and his passion for and deep involvement in the business.

So although the price Buffett paid for the company might seem slightly high now, his logic with respect to the strength of the business and management quality appears as sound as ever. But will this acquisition add considerable value to Berkshire in the longer term? Only time will tell.

Do you think that Warren Buffett paid too much for Precision? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
Government finances have been under strain in the last few years. This has resulted in rising fiscal deficit which is essentially the difference between government expenditure and non-debt receipts. Typically, growing economies fund high fiscal deficits through higher debt or borrowings. However excessive debt can push a country to bankruptcy in the event of an economic downturn as was the case with Greece recently. Therefore the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 had set out a target of three per cent of GDP for India by FY17. In FY15, the government has been able to bring down fiscal deficit to 3.99% of the GDP, lower than its revised estimate of 4.1% of the GDP. The fiscal consolidation road-map outlined in Union Budget 2015-16 proposes to bring down the fiscal deficit to 3.9% in FY16, 3.5% in FY17 and 3% in FY18.

There is no doubt that a lower fiscal deficit results in lower interest payments leaving more money in the hands of the government for welfare and development. However, the measures taken to reduce deficit has an important bearing on a country’s growth plans.

The fiscal consolidation exercise in the past has been driven by expenditure cuts by the government. The total government expenditure has reduced from 14.8% of GDP to in 2011-12 to 13% of GDP in 2014-15 (provisional). This in turn has led to lower capital expenditure over the years which can hamper the country’s efforts to fast-track its growth. Going ahead, the government has budgeted for a higher capital expenditure in FY16. Even lower crude prices will continue to help the government in reducing the expenditure on major subsidies and aid the fiscal consolidation exercise.

Fiscal adjustment at the cost of lower expense

Infrastructure financing by banks has its own set of problems. Rising bad loans in the banking system may not be over as yet. However, some public sector banks have reported lower slippages and a slight improvement in the gross non-performing assets in the June 2015 quarter. Largest public sector lender, State Bank of India saw a 6.6% YoY fall in gross non-performing assets during the quarter. Even the slippage ratio for the bank has come down to 2.1%.

But what is worrisome is the growing incidence of loans in the Special Mention Accounts-2 (SMA-2) of banks. Technically speaking, SMA-2 loans are loans where the repayment has been due for more than 60 days but below 90 days, after which the loan is classified as bad. Although a share of these loans may also be on account of habitual late payers, but a jump in these loans raises a red flag. This is on account of two reasons. Firstly, banks do not share this data. Secondly, with the government permitting banks to refinance infrastructure loans of 25 years tenure every five years, there is a possibility of banks continuing to suppress potential loan defaults under the guise of this scheme.

There is no doubt that infrastructure projects world over have long gestation periods before they start earning cash flows. And if India were to catapult among the fast growing nations, infrastructure financing is the need of the hour. However, it would do well if more transparency is brought in these schemes to make banks more proactive in improving loan recoveries and thereby reducing the pile-up of stressed assets plaguing the system.

A last word on real estate prices. Vivek Kaul, our colleague at Daily Reckoning, has recently published a new report where he takes a view that "real estate prices are headed down". We strongly recommend you read that report for it contains some of Vivek's best writings on real estate. To claim the report and get Vivek's Daily Reckoning issues where he continues to share updates on Real Estate among other things, just click here... (it's a one click sign up).

The Indian stock markets languished in the red today on the back of global cues especially related to China devaluing the Yuan. At the time of writing, the BSE-Sensex was trading down by around 178 points. Gains were largely seen in metal, oil & gas and auto stocks.

 Today's investing mantra
"Don't buy a stock just because everyone hates it." - Warren Buffett.

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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2 Responses to "Did Warren Buffett make his most expensive mistake ever?"


Aug 12, 2015

To say that Precision Castparts makes nuts and bolts is NUTS. It has a 50000 tons press, world's biggest and makes mainly pressed and other parts for mainly aerospace industry. The Company is a worthy successor to the World's famous and leading Forging Company of yesteryears Wyman Gordon (also existed in India earlier). As you are aware, aerospace industry is looking up and up and not down. Parts for oil rigs is only one part of the business and that too not ordinary nuts and bolts.

Like (1)

R.Prasanna Venkatesan

Aug 12, 2015

I am also cric of Waren, for his sleeping over top IT stocks like Google, Microsoft, etc.,stating that he does not understand the business.Ridiculous, he has a battery of top equity research geniuses around him, including Jain, but has woken up and bought IBM, when it is dying a slow death, losing both computer harware and software markets. this will be the biggest folly of Buffett, nt Precision .controls, a nut and bolt industry, tat serves, aircraft, defence and a variety of industries.But dividends, will not be very big, as competition from Korea, Japan, China, France and India, will give it a run for money..

Like (1)
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