In his 2020 letter to shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), Warren Buffett (Trades, Portfolio) admitted he made a mistake buying Precision Castparts Corp. Last year, Berkshire wrote down the value of Precision by nearly $10 billion due to the pandemic.
Buffett also admitted that he made a mistake in paying $37 billion for the engineering group, as the business might not have been worth that much based on its prospects.
At this year's annual meeting of Berkshire investors, one shareholder wanted to know more about the mistake. They asked, if Buffett could go back to 2016, if there were any changes he would have made to his calculations that may have altered his estimate of value.
The Oracle of Omaha started his response by clarifying it wasn't Berkshire that made the mistake. It was his mistake pure and simple. He went on to add:
"Anytime we look at buying a business, we're evaluating the competitive strengths of the business, the price we have to pay, the management we got, everything. We didn't make a mistake on the management, but in terms of the earning power on average."
Buffett continues to say that he made a mistake in estimating how high demand for the company's services would be in the future. He said GE (GE, Financial) didn't need as many engines "as we thought they'd need," and he also didn't take into account companies would "necessarily be in something close to a depression" within five years.
He continued to explain that mistakes are just part of business, and Berkshire will continue to make errors. However, the good thing about owning a diversified basket of companies, Buffett continued, is that a disappointing corporation "usually becomes a smaller and smaller percentage of our business just because of the nature of things."
The CEO of Berkshire went on to explain:
"When we got a successful business, like a GEICO or something of the sort… GEICO, they're doing 15 times as much business as when we bought control in 1996… they become a proportionally much more important part of our mix. You really get, through just natural forces, you get more of your money in the things that have developed more favorably than you thought. You actually end up getting a greater concentration in the ones that work out."
Good businesses rise to the top
A great case study of this is Berkshire itself. A century ago, this company was a struggling textile concern. In 1985 the textile business was finally closed down, but by then, it was a virtually non-existent part of the overall group.
And the textile business was not the only part of Berkshire that has disappeared into obscurity over the past few decades. As Buffett noted, "We started with three businesses, Charlie [Munger] and I. Berkshire was textiles. Diversified Retailing was a department store, and trading stamps, Blue Chip business." Since then, all of these businesses have disappeared into obscurity.
Companies need to change and adapt to different environments. Otherwise, they slip away into terminal decline. The most critical factor in avoiding this decline, Buffett summarized, is management. A good management will know when the company has to change direction. As Buffett noted:
"That's the biggest single danger that a business has, and that that person stays and runs it for 10 or 15 years, and either stays in the textile business, a department store business, and expands. I've looked at a lot of businesses and that's what's caused the number one problem."
So, while Buffett admitted he made a mistake overpaying for Precision, he's confident the company has the right management to see it through. That's what he really paid for.
Disclosure: The author owns no share mentioned.
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