It is well known that one of Warren Buffett (Trades, Portfolio)’s largest mistakes was actually purchasing Berkshire Hathaway. In his letter to shareholders, he has shared the lessons learned from this experience so that we can, as Charlie Munger (Trades, Portfolio) says, learn vicariously.
On Investing More Capital to Achieve Terrible Returns
“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 decisiones neutralized each other and were irrational (just as happens when each person watching a parade decides he cna 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. I always thought myself in the position described by Woody Allen in one of his movies: “More than any other time in history, mankind faced a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly.”
My conclusion from my 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.”
Charlie Munger (Trades, Portfolio) has also mentioned: “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested -- there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business.”
It is very clear that the lesson here is to pay a lot of attention at the kind of business that you’re going to invest in. The reason is that returns and year-over-year improvements by themselves can be misleading. It is very important to see the free cash flow levels and to monitor where is the money going, either to the owners or back in the business to keep the pace. I consider this one of the pillars of investing and a very common mistake that we make as investors, creating significant value traps. Personally, I have made mistakes with these type of businesses and have proven costly. What have been your experiences and lessons learned on this topic?
