Over the course of an investment career spanning nearly seven decades, Warren Buffett (Trades, Portfolio) has won the esteem of countless admirers across the world of finance – and beyond. His leadership of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) has been a testament to the value investing principles codified by Benjamin Graham and expounded by the authors and analysts of GuruFocus. Yet, as I discussed in an article last month, even the Oracle of Omaha can make mistakes.
Busted growth story to turnaround bet
In 1989, Buffett invested in USAir, buying $358 million worth of preferred stock with a 9.25% dividend and a mandatory redemption in 10 years. Unfortunately, Buffett quickly found that his growth investment had become a turnaround play. As he told Berkshire shareholders in 1994, this was not a position he relished being in:
“USAir has a cost structure which is non-viable in today’s airline business...I think the cost structure could be brought into line, but whether it will be brought into line or not is another question...Looking backwards, the answer is not to get into businesses that need to solve problems like that. But that was a mistake I made.”
Investing in a turnaround play is always a dicey business. For a capital-intensive, heavily leveraged business, it is even worse. Buffett realized his problem a bit too late for comfort.
Even as things began to improve for USAir from the 1994 nadir, Buffett was still feeling rather burned. In 1996, he ruefully told investors that he should have “gone out to a bar instead” of investing in the troubled airline.
Waiting for the turnaround
Faced with a struggling USAir investment, Buffett opted to hold steady and wait for the turnaround to unfold. Under the new management of CEO Stephen Wolf, the company successfully righted its financial ship so as to restart dividend payments to Berkshire in 1997. Indeed, things improved so sufficiently that Buffett began to muse that the turnaround might have been successful enough to “nullify” the mistake of investing in the first place.
Sometimes it is better to take a small loss immediately than to wait for things to deteriorate further. However, panic sales can be just as damaging. While Buffett’s investment in USAir was, in hindsight, poorly judged, his decision to hold on was not. By 1998, Buffett had managed to craft an exit for Berkshire. Opting to issue $574 million in new shares, USAir retired its $358 million Berkshire loan. Buffett’s investment was repaid, an unambiguous win for an investment that looked like it might end up a big loss.
Buffett made it out of USAir with his skin intact and Berkshire’s honor unblemished, but it had not been a smooth ride.
Once burned
One might think that Buffett, after having narrowly avoided disaster with USAir, would have soured on airline investments for good. For a while, the experience did seem to have chastened him.
In 1998, Buffett told Berkshire shareholders that he would be steering clear of airlines, stating, “It’s not a business that intrigues us.” A decade later, Buffett was even more scalding in his assessment of the airline industry, claiming that it has been a capital incinerator since the very first flight at Kitty Hawk:
“The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.”
By 2013, USAir was no more, having suffered through two bankruptcy restructurings before finally merging with American Airlines Group Inc. (AAL, Financial). Yet, even as industry consolidation expanded airlines’ profit margins thanks to diminishing competition, Buffett was still publicly skeptical of the airline industry.
Verdict
Buffett's fortuitous exit from USAir was only made possible thanks to the outsized position Berkshire held in the company. For an ordinary investor lacking the ear of the CEO and the financial clout to shape corporate strategy, the story would likely have ended far less happily.
It is wise to be very wary of turnaround bets as they rely on exceptional management execution and other factors that are out of an investor’s control.
Trade carefully!
Disclosure: No positions.
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