He is the world’s greatest, or one of the greatest, investors, but Warren Buffett (Trades, Portfolio) also made mistakes in his investing career. And unlike many gurus, he has acknowledged those mistakes and apologized to his shareholders for them.
Buffett’s story is told in chapter eight of Michael Batnick’s book, “Big Mistakes: The Best Investors and Their Worst Investments,” a chapter about overconfidence.
As the author pointed out, every person who has sold and “every algorithm” that has bought believed they were on the right side of the trade. They believed that because they were overconfident in their own abilities. He also noted that this faith in oneself shows up in a phenomenon called “the endowment effect.” The theory holds that once we buy something, be it a consumer product or shares of a company, we value it more after we own it.
The researchers in one study argued the main effect of “endowment” — believing something is worth more once you own it — is to experience pain in giving it up. You don’t think any more highly of the shares you own, but you likely expect too much when you sell them.
Batnick wrote, “It's not just the average Joe investor or even financial professionals that fall victim to this embedded blind spot, it's everyone who has ever bought or sold a stock, including one of the greatest investors of all time, Warren Buffett (Trades, Portfolio).”
To get a sense of his greatness, consider these data points since 1962 (and presumably to the end of 2017, just before the book was published since Batnick does not provide an end date): The Dow Jones Industrial Average grew 30-fold since 1962; Berkshire Hathaway grew 33,333-fold. The sum of $10,000 invested in 1965, when Buffett took control of Berkshire, was worth more than $185 million 52 years later.
Referring to Buffett during the dozen years in which he ran his highly successful limited partnership (1957 to 1969), Batnick observed, “It's funny that despite his monstrous returns and his youth, two things that tend to favor the brash, Buffett's confidence level was kept in check. It's funnier still, that at 63, oozing with confidence, he would make the single costliest mistake of his investing career.”
The mistake began with Berkshire’s 1991 purchase of H. H. Brown, a manufacturer of work shoes and boots, a company with “a history of earning unusually fine margins on sales and assets.”
Because H. H. Brown did very well in its first year under Berkshire, Buffett (and Charlie Munger (Trades, Portfolio)) added Lowell Shoe to the portfolio. It manufactured women’s and nurses’ shoes, but required “some fixing,” which Berkshire did, and the results “surpassed our expectations.”
In his 1993 annual letter he went on to write, “So we promptly jumped at the chance last year to acquire Dexter Shoe of Dexter, Maine, which manufactures popular”priced men's and women's shoes. Dexter, I can assure you, needs no fixing: It is one of the best”managed companies Charlie [Munger] and I have seen in our business lifetimes.”
Based on his two previous successful forays into the shoe business, Buffett had become overly confident in his knowledge of the industry. Most importantly, he downplayed the threat from imported shoes, that the business did not have a moat, and that they were being influenced too much by the low purchase price.
According to Batnick, “Buffett was overconfident in Frank Rooney, who headed H. H. Brown and helped broker the Dexter acquisition. Buffett also put too much stock in Harold Alfond, the leader at Dexter. Finally, he had too much confidence in himself.”
In 1994, the year after the acquisition, Dexter began shedding profits, while revenues declined, and that situation continued for five years. By that time, revenue was down 18% and the operating profit was down 57%. When he wrote his 1999 annual letter, Buffett admitted his mistake, noting that 93% of shoes sold in the U.S. that year had come from abroad.
His 2000 letter was blunt:
“I clearly made a mistake in paying what I did for Dexter in 1993. Furthermore, I compounded that mistake in a huge way by using Berkshire shares in payment. Last year, to recognize my error, we charged off all the remaining accounting goodwill that was attributable to the Dexter transaction. We may regain some economic goodwill at Dexter in the future, but we clearly have none at present."
Clearly, Buffett was affected by the mistake: Batnick reported that Buffett came back to the Dexter case in his 2007, 2014 and 2016 letter, and for good reason because it cost Berkshire Hathaway $6 billion.
Turning to the rest of us, Batnick counseled that we should think about why we are investing and what we really know. We should assume the person on the other side of the trade knows as much or more than we do. We should ask about the consequences if we are wrong.
Buffett had a suggestion for investors to help deal with overconfidence: the familiar story of the punch cards with 20 holes. The idea is that those 20 holes represent all the investments you can make in your life; each acquisition uses up one of those punch holes. Ultimately, such a card would make us choose ultra carefully when we make investments.
Part of the effectiveness of this tool is that it should slow down and deepen our thinking about each acquisition. In addition, it should help us avoid impulsive transactions.
Finally, Batnick’s most important check on overconfidence is to have a plan. Know in advance the appropriate price levels, dollar-loss triggers and percentage-loss triggers, “Making decisions ahead of time, especially decisions that involve admitting defeat, can help conquer one of the biggest hurdles investors face; looking in the mirror and seeing an ability that we just do not possess.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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Big Mistakes: Michael SteinhardtÂ
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