Warren Buffett (Trades, Portfolio) is arguably the greatest investor of all time, which inspires us to celebrate his achievements more often. Many investors have learned a lot from Buffett’s success, but there are many lessons one can learn by paying attention to his mistakes as well. Not surprisingly, the guru seems to have learned from his mistakes over the years, which has been confirmed by Buffett in many instances.
Lesson 1: Do not let your emotions run wild
In his 2014 letter to shareholders, Buffett discussed the track record of both his good and bad investments, and purchasing Berkshire Hathaway Inc. (BRK.A, Financial)(BRK.B, Financial) was highlighted as one of his worst investment decisions. In a 2010 interview aired on CNBC, Buffett called Berkshire Hathaway “the dumbest stock” he had ever bought. He first invested in Berkshire in 1962 even though the textile industry was declining, believing he would make a profit on the expected closure of mills.
Commenting on his decision, he wrote to shareholders:
“I purchased BPL’s first shares of Berkshire in December 1962, anticipating more closings and more repurchases. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.”
When Buffett received an offer letter from Berkshire in which the company tried to "chisel" him out of an eighth of a point on a tender deal, he ignored the offer and began to aggressively buy more shares to show his disagreement with the offer.
Commenting on this aggressive buying, Buffett told CNBC:
“He chiseled me for an eighth. And if that letter had come through with 11 and a half, I would have tendered my stock. But this made me mad. So I went out and started buying the stock, and I bought control of the company, and fired Mr. Stanton.”
Buffett struggled for another 20 years to keep the textile business running until closing it down in 1985. His impulsive decision to act in anger cost him a substantial amount of money over a long period of time. Berkshire Hathaway is one of the largest investment conglomerates today, but Buffett did not have to buy a troubled textile company to achieve what he did.
The lesson for investors is to avoid making investments based on emotions and to draw a clear line between personal matters and investment decisions. Unfortunately, investing based on emotion is still the most common cause for people to get into risky investments and lose money in the market.
Lesson 2: Ensure the company has a sustainable competitive advantage
In 1993, Buffett bought an American shoe manufacturing company called Dexter Shoes for $433 million. He called this deal his “most gruesome” in his 2014 letter to shareholders as he made a wrong assessment of the company’s competitive strengths. Explaining his mistake, Buffett wrote:
"When we purchased the company in 1993, it had a terrific record and in no way looked to me like a cigar butt. Its competitive strengths, however, were soon to evaporate because of foreign competition. And I simply didn’t see that coming.”
He also made the mistake of buying Dexter using Berkshire’s common stock. In his 2007 letter, Buffett said this was the worst investment he made using Berkshire shares, which resulted in a $3.5 billion loss to shareholders as the stock continued to advance at a stellar pace while Dexter was proving to be a disastrous investment.
Investors should keep an eye out for companies that enjoy durable competitive advantages and are preferably in a position to maintain industry-leading profit margins. As evidenced by Buffett's mistake, which he said, "deserves a spot in the Guinness Book of World Records,”failure to invest in companies with a strong competitive advantage could lead to massive losses in the long run.
Lesson 3: Evaluate all possible risks
In 1998, Berkshire bought General Reinsurance, and while the company became“a fine insurance operation”, the acquisition had a rough start. General Reinsurance’s profitability plummeted in 1999 and 2001 due to underwriting losses and the Sept. 11 terrorist attacks. Berkshire realized $800 million in losses in 2001 as General Re had inadequate liquidity to cover losses from old policies.
In a letter to Berkshire Hathaway shareholders in 2001, Buffett acknowledged the company took a big hit as a result of this investment. The guru wrote:
“In setting prices and also in evaluating aggregation risk, we had either overlooked or dismissed the possibility of large-scale terrorism losses. That was a relevant underwriting factor, and we ignored it.”
Buffett also bought preferred stock in U.S. Air in 1989. This investment quickly turned into a nightmare as U.S. Air failed to generate enough revenue to pay the dividends. However, he got lucky and was able to sell his shares for a handsome profit in 1998. In his 2007 letter, Buffett wrote:
“Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.”
These cases highlight the importance of keeping track of the industry, the nature of business and any inherent risks involved with a company. Investors must do everything they can to understand all the potential risks attached to any investment opportunity.
Lesson 4: Businesses go through cycles, so does the market
Even though Buffett is aware of market swings, he made the mistake of buying a large percentage of shares of energy giant ConocoPhillips (COP, Financial) in 2008 as a bet on future energy prices. Buffett overpaid for the stock, causing Berkshire Hathaway to suffer a multibillion-dollar loss. In his 2008 letter, he wrote:
“Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year.”
Investors need to understand their risk tolerance level and choose stocks that fit their risk appetite. They should also make sure that their portfolios can withstand different business and market cycles as a whole, which is an important portfolio construction strategy ignored by many investors today.
Takeaway
Despite being widely regarded as the most successful investor the world has ever seen, Buffett has made quite a few mistakes as well, and the guru has been the first one to acknowledge them. His discussions of these moments make for great reading, and investors can learn many invaluable investing lessons by reading Buffett’s annual letters.
