Warren Buffett (Trades, Portfolio)’s history with Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) is fascinating because it showcases his skills as a capital allocator. When he first became involved with Berkshire, the textile business was struggling. Despite the company’s best efforts, it could not turn things around.
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Originally, Buffett wanted to stay in the business, reduce capital spending and use all excess funds to expand of the rest of his empire. As Buffett wrote in his letter to shareholders in 1977:
"A few shareholders have questioned the wisdom of remaining in the textile business which, over the longer term, is unlikely to produce returns on capital comparable to those available in many other businesses. Our reasons are several: (1) Our mills in both New Bedford and Manchester are among the largest employers in each town, utilizing a labor force of high average age possessing relatively non-transferable skills. Our workers and unions have exhibited unusual understanding and effort in cooperating with management to achieve a cost structure and product mix which might allow us to maintain a viable operation. (2) Management also has been energetic and straightforward in its approach to our textile problems. In particular, Ken Chace’s efforts after the change in corporate control took place in 1965 generated capital from the textile division needed to finance the acquisition and expansion of our profitable insurance operation. (3) With hard work and some imagination regarding manufacturing and marketing configurations, it seems reasonable that at least modest profits in the textile division can be achieved in the future."
Despite his best intentions, however, by the early 1980s, it was clear the mills were no longer a viable business. The closure of these operations began in the first part of the decade and had concluded by 1985. As he said in his letter that same year:
“I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable."Â
The reason Buffett was forced to shut down Berkshire’s textile operations was cost. The business was struggling, so without further substantial investment, it would not be able to compete with peers. But this required investment would have generated a relatively weak return compared to Berkshire’s other, growing lines of business at the time. As Buffett said in a 1985 letter to shareholders:
“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 faces 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.'"
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In the same letter, Buffett goes on to describe why it was kinder to kill Berkshire’s textile business than keep it alive. The example of peer Burlington is used, a company which had spent significant sums on its manufacturing process only to see deteriorating returns:
“Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.
Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.”
Considering this performance, I bet Berkshire Hathaway’s shareholders are glad Buffett decided to exit the business, rather than wasting his time, effort and capital trying to compete in a business with such terrible economics.
Disclosure: The author owns no share mentioned.
