With volatility being the order of the day, we as investors indeed need some calming influence so as to help us stay rational and make sense of the crisis that has gripped the global capital markets currently. And what better way to do this than to turn to the man who answers to the name of Warren Buffett and who arguably, is one of the world's best practitioner of the art of rationality and objective thinking.
Few weeks back, we had embarked upon a series of write-ups based on the investment wisdom contained in the master's yearly letters to the shareholders of his investment vehicle, Berkshire Hathaway. So far, we have covered letters upto the year 1984. In the following few paragraphs, let us see what the master offers by way of investment wisdom in his 1985 letter.
This letter like his previous letters touches upon a variety of topics, some covered before while others brand new. What we would like to reproduce here is the biggest and the best of them all. The year 1985 was the year when the master finally chose to shut down his textile business by liquidating all of company's assets. While going through the brief history of the business and explaining his rationale behind the sale, the master has systemically busted some of the biggest myths related to investing and shown us why one should prefer business that generate returns with as little capital employed as possible. He has also shown why reliance on book values and replacement costs while valuing a company could turn to be dangerous.
While the discourse is indeed exhaustive, we believe that every sentence is worth its weight in gold. Laid out below is an edited account of his textile business shutdown:
"In July we decided to close our textile operation, and by year end this unpleasant job was largely completed. The history of this business is instructive.
When Buffett Partnership Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway 21 years ago, it had an accounting net worth of US$ 22 m, all devoted to the textile business. The company's intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value. Indeed, during the previous nine years (the period in which Berkshire and Hathaway operated as a merged company) aggregate sales of US$ 530 m had produced an aggregate loss of US$ 10 m. Profits had been reported from time to time but the net effect was always one step forward, two steps back.
We felt, however, that the business would be run much better by a long-time employee whom we immediately selected to be president, Ken Chace. In this respect we were 100% correct: Ken and his recent successor, Garry Morrison, have been excellent managers, every bit the equal of managers at our more profitable businesses.
We remained in the business for reasons that I stated in the 1978 annual report (and summarized at other times also): "(1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should generate modest cash returns relative to investment." I further said, "As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."
It turned out that I was very wrong about (4). Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.
The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage.
Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.
But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers.
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
There is an investment postscript in our textile saga. Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.
The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about US$ 13 m, including US$ 2 m spent in 1980-84, and had a current book value of US$ 866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps US$30 to US$ 50 m.
Gross proceeds from our sale of this equipment came to US$ 163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for US$ 5,000 apiece in 1981 found no takers at US$ 50. We finally sold them for scrap at US$ 26 each, a sum less than removal costs."
Conclusion: The master's liquidation of his textile business shows what could potentially lie in store for a business with a rather poor economics, despite the presence of an excellent management. Thus, while Buffett was able to correct his mistake by devoting some of the textile company's capital to other more profitable businesses, no such luxuries await small investors. Hence, they can do their investment returns a world of good by refusing to invest in such businesses, no matter how cheap they might look based on book value and replacement costs.
To view our discussions on previous letters of Warren Buffett, please click below: