The Biggest Mistake of Warren Buffett’s Career

Warren Buffett is a hero to many investors, myself included.  His record speaks for itself: 18.3% annualized returns in Berkshire Hathaway’s ($BRK-A) book value over the past 30 years compared to just 10.8% for the S&P 500.  And his returns in the 1950s and 1960s, when he was running a much smaller hedge fund, were even better.

Mr. Buffett is also quite generous with his investment wisdom, sharing it freely with anyone who cares to listen.  But as with most things in life, failure is a better teacher than success.  And Mr. Buffett has had his share of multi-billion-dollar failures.

You want to know the biggest mistake of Buffett’s career?

By his own admission, it was buying Berkshire Hathaway!

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  And Berkshire Hathaway was not always a financial powerhouse; it was once a struggling textile mill.

Buffett had noticed a trading pattern in Berkshire’s stock; when the company would sell off an underperforming mill, it would use the proceeds to buy back stock, which would temporarily boost the stock price. Buffett’s strategy was to buy Berkshire stock each time it sold a mill and then sell the company its stock back in the share repurchase for a small, tidy profit.

But then ego got in the way.  Buffett and Berkshire’s CEO had a gentleman’s agreement on a tender offer price.  But when the office offer arrived in the mail, Buffett noticed that the CEO’s offer price was 1/8 of a point lower than they had agreed previously.

Taking the offer as a personal insult, Buffett bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett later called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.

By Buffett’s estimates, had he never invested a penny in Berkshire Hathaway and had instead used his funds to buy, say, Geico, his returns over the course of his career would have been doubled.  Berkshire will still go down in history as one of the greatest investment success stories in history, of course.  But it was a terrible investment and a major distraction that cost Buffett dearly in terms of opportunity cost.

What lessons can we learn from this?  I’ll leave you with two quotes from Buffett himself:

“If you get into a lousy business, get out of it.”

“If you want to be known as a good manager, buy a good business.”

In trader lingo, cut your losers and let your winners ride.  Holding on to a bad investment wastes good capital and mental energies that would be better put to use elsewhere.

Thank you, Mr. Buffett, for sharing your failures with us.  Your willingness to do so is one of the reasons we love you.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Is Sears the Next Berkshire Hathaway?

I originally penned this articled in December 2011.  Given Sears’ stock action in the year that has passed, it’s worth another read.

A well-respected value investor buys an old American company in decline, promising to restore its fortunes.  Alas, the recovery never comes.  The economics of the industry have changed, and the company cannot compete with younger, nimbler rivals.  The company ceases operations, but the value investor holds onto the shell to use as an investment vehicle.

Could this be the future of Sears Holdings (Nasdaq: $SHLD) under Eddie Lampert?  Maybe; maybe not.  But it was certainly the case for Warren Buffett’s Berkshire Hathaway (NYSE: $BRK-A).

Unless you’re a history buff or a dedicated Buffett disciple, you might not have known that Berkshire Hathaway was not always an insurance and investment conglomerate.  It was a textile mill, and not a particularly profitable one.  It was, however, a cash cow.  And after buying the company in 1964, Buffett used the cash that the declining textile business threw off to make many of the investments he is now famous for, starting with insurance company Geico.

So, when hedge fund superstar Eddie Lampert first brought Kmart out of bankruptcy in 2003, the parallels were obvious.  With its debts discharged, the retailer would throw off plenty of cash to fund Lampert’s future investments.  And even if the retail business continued to struggle, Lampert could—and did—sell off some of the company’s prime real estate to retailers in a better position to use it.  Lampert sold 18 stores to the Home Depot (NYSE: $HD) for a combined $271 million in the first year.

That Lampert would use Kmart’s pristine balance sheet to purchase Sears, Roebuck, & Co.—itself a struggling retailer—seemed somewhat odd, but his management decisions after the merger seemed to confirm that his strategy was cash cow milking.   Lampert continued to talk up the combined retailer’s prospects, of course.  But his emphasis was on relentless cost cutting, and he invested only the absolute bare minimum to keep the doors open.  Sears Holdings didn’t have to compete with the likes of Home Depot or Wal-Mart (NYSE: $WMT). It just had to stay in business long enough for Lampert to wring out every dollar he could before selling off the company’s assets.

The strategy might have played out just fine were it not for the bursting of the housing bubble—which killed demand for the company’s Kenmore appliances and Craftsman tools—and the onset of the worst recession in decades.  With retail sales in the toilet (and looking to stay there for a while), there was little demand among competing retailers for the company’s real estate assets.

It’s fair to blame Lampert for making what was, in effect, a major real estate investment near the peak of the biggest real estate bubble in American history.  But investors  frustrated by watching the share price fall by more than 80 percent from its 2007 highs have no one to blame but themselves.   Anyone who bought Sears when it traded for nearly $200 per share clearly didn’t do their homework.  They instead were hoping to ride Lampert’s coattails while somehow ignoring the value investor’s core principle of maintaining safety by not overpaying for assets.

Lampert is a great investor with a great long-term track record, and there is nothing wrong with paying a modest “Lampert premium” for shares of Sears Holdings.  If you like Lampert’s investment style but lack the means to invest in his hedge fund, Sears may be the closest you can get.  But at $200 per share—or even $100—the Lampert premium had been blown completely out of proportion.  The same is true of Buffett, of course, or of any great investor.  As the Sage of Omaha would no doubt agree, there is a price at which Berkshire Hathaway is no longer attractive either.

This brings us back to the title of this piece—is Sears the Next Berkshire Hathaway?

I would answer “yes,” but not necessarily for the reasons you think.

Everyone assumes that Buffett’s decision to buy Berkshire Hathaway was a typical Buffett stroke of genius.  Nothing could be further from the truth.  In fact, Buffett revealed in an interview last year that Berkshire Hathaway was the worst trade of his career.



If you cannot view the video above, please follow this link: “Buffett’s Worst Trade
 

We like to think of Warren Buffett as the wise, elder statesman of the investment profession, but Buffett too was young once and prone to the rash behavior of youth.  He had been trading Berkshire Hathaway’s stock in his hedge fund; he noticed that when the company would sell off an underperforming mill, it would use the proceeds to buy back stock. Buffett intended to sell Berkshire Hathaway its own stock back for a small, tidy profit.

But due to a tender offer that Buffett took as a personal insult, he essentially bought a controlling interest in the company so that he could have the pleasure of firing its CEO.  And though it might have given him satisfaction at the time, Buffett called the move a “200-billion-dollar mistake.”

Why?  Because Buffett wasted precious time and capital on a textile mill in terminal decline rather than allocate his funds in something more profitable—in his case, insurance.  Berkshire Hathaway will still go down in history as one of the greatest investment success stories in history.  But by Buffett’s own admission, he would have had far greater returns over his career had he never touched it.

So, in a word, “yes.”  Sears probably is the next Berkshire Hathaway.  And investors who buy Sears at a reasonable price will most likely enjoy enviable long-term returns as Lampert’s plans are eventually realized.   But Mr. Lampert himself will almost certainly come to regret buying the company—if he doesn’t already.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Warren Buffett is Rotating into Riskier Sectors; Should You?

If Warren Buffett is doing it, it must be good, right?

That’s actually horrendously bad advice. Warren Buffett is one of the greatest investors in history, but you should never blindly follow any investor–not even the Sage of Omaha. You don’t know what their rationale for buying was or what their sell criteria is, and you certainly lack the clout and control over management that Warren Buffett brings to a deal.

That said, if Buffett is buying it, it might at least make sense to do a little research. We may or may not end up buying what he’s buying, but it can’t hurt to pick his brain a little.

So, what is Buffett buying? A lot of gritty industrials.

RECENT REPORT SHOWS

Berkshire Hathaway (NYSE:$BRK-A) recently released its holdings for the third quarter, and three of the company’s four new buys were industrials: Deere & Co (NYSE:$DE), the producer of tractors and others heavy-duty equipment, Precision Castparts Corp (NYSE:$PCP), which is essentially a metal shop with a worldwide presence, Wabco Holdings Inc (NYSE: $WBC), a world leader brake and control systems for large commercial vehicles.

WHAT DID HE DUMP?

Interestingly, Buffett sold out or reduced his holdings in several consumer-oriented stocks. Most of Buffett’s most famous investments involve consumer product names–a Coke anyone–while his single greatest failure was an old-line industrial stock: the textile company Berkshire Hathaway itself.

BIG PICTURE

In any event, Buffett is clearly bullish on the global economy. He’s not playing it safe by buying defensive consumer names (though he does maintain large legacy positions in Wal-Mart, Procter & Gamble & Coca-Cola). He is buying companies that very much live or die with cyclical economic activity.

There are different ways to skin this cat, and Buffett’s industrial picks would not be my first choice. But, if you want to follow Buffett, buying the Industrial Select SPDR ETF (NYSE:$XLI) isn’t a bad option.

But if you’re going to play the “risk on” game, I would be more inclined to buy an emerging market ETF. Once good choice might be the MSCI Turkey ETF (NYSE:$TUR). Turkey is an attractive market right now for several reasons. It’s the most politically and monetarily stable it’s been in years, and it stands to be one of the prime beneficiaries of the eventual rebuilding of Syria. It’s also a dominant economy in the Eastern European and Middle Eastern markets, and its stocks are very reasonably priced at just 9 times earnings.

With fiscal cliff worries likely to keep the market choppy for a while, you may want to ease into this position over the course of the next few weeks. As always, general common sense rules apply. If global stocks look to be starting a new bear market, you do not want to own volatile Turkish stocks. I recommend using a 15% trailing stop to guard against that possibility.

Disclosures: Sizemore Capital is long TUR. This article first appeared on TraderPlanet.

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What is Warren Buffett Buying?

It’s filing season again, that time of year when we get to peek at what big, high-profile investors are buying.  And perhaps no portfolio is waited for in more anticipation that Warren Buffett’s Berkshire Hathaway (NYSE:$BRK-A).

Buffett is still bullish these days, even with all the talk of the fiscal cliff.  If we fell over the cliff and the economy got whacked with higher taxes and massive spending cuts, Congress and the White House would hash out a deal before the economy slipped into recession.  “We’re not going to permanently cripple ourselves,” he said recently in a CNN interview.

That may be true, but I’m a little more worried than Mr. Buffett.  I agree that a deal will get made eventually, but the psychological damage can still be huge.  And we could easily get a deep stock correction or a recession in the meantime.  Policy paralysis has consequences.

With that said, what is Buffett and his team buying and selling these days?

To start, he’s buying broadcast TV.  Berkshire Hathaway bought nearly 20% of Media General  (NYSE: $MEG).  This is a small holding for a portfolio of Berkshire’s size, but it does show bullishness on the part of Buffett for traditional media.

I like to think I am a contrarian investor.  But then I look at Warren Buffett and I realize that I’m not nearly as big of a contrarian as I thought.  I wouldn’t touch traditional media right now because I can’t see where the profits will come from.  Advertising is an industry in flux, and TV competes with the internet for eyeballs.

But then, there is a proper price for everything, and Buffett seems to believe that, at .16 times sales, Media general is simply too cheap to ignore.

Buffett additionally made three additions in the gritty industrial sphere, buying nearly 4 million shares of Deere & Co (NYSE:$DE), the producer of tractors and others heavy-duty equipment,  1.2 million shares of Precision Castparts Corp (NYSE:$PCP), which is essentially a metal shop with a worldwide presence,  and 1.5 million shares of Wabco Holdings Inc (NYSE: $WBC), a world leader brake and control systems for large commercial vehicles.

Truck parts and tractors.  Buffett clearly believes that industrial activity will be picking up in the years ahead, both in the United States and overseas.

Now, what’s Buffett and his team selling?

He sold out of Dollar General (NYSE:$DG), Moldelez International (Nasdaq:$MDLZ), Ingersoll-Rand PLC (NYSE:$IR) and CVS Corp (NYSE: $CVS).

The sales have little obvious in common, other than all but Ingersoll-Rand have a strong consumer focus.  Dollar General is a discount retailer of assorted sundries, CVS Corp is national chain of pharmacies, and Mondelez is a producer of packaged foods.   Yet Berkshire still maintains enormous positions in Coca-Cola (NYSE:$KO), Procter & Gamble (NYSE:$PG) and Wal-Mart (NYSE:$WMT), so  you can’t reach the conclusion that Buffett is bearish on the consumer.

Still, Berkshire’s portfolio has been consistently drifting away from consumer-oriented stocks for months and towards grittier industrial stocks and business services stocks such as IBM (NYSE:$IBM).

Disclosures: Sizemore Capital is long PG and WMT.  SUBSCRIBE to Sizemore Insights via e-mail today.

Three Dividend Stocks Owned by the Smart Money

As I wrote back in August, it can be helpful at times to look over the shoulders of successful investors to see what their highest-conviction investments are.  And during times like these, when the economy is looking wobbly and the potential for a Eurozone meltdown is hanging over our heads like the sword of Damocles, that extra insight is all the more valuable.

Today, I’m going to take a look at one high-conviction dividend stock each from three investors whose skills I respect and whose track records have withstood the passing of a crisis or two.

The usual caveats apply; I’m basing this analysis on SEC filings that are reported on a time lag and may already be out of date by the time they become publicly available.  For these reasons, I will stick with large positions that the investor has held for a long period of time or new positions that I consider unlikely to have been sold so quickly.

Stock

Ticker

Guru

Dividend

International Business Machines

IBM

Warren Buffett

1.6%

Johnson & Johnson

JNJ

Prem Watsa

3.5%

Six Flags Entertainment Corp

SIX

Kyle Bass

4.1%

Let’s start  with the granddaddy of modern value investors, Berkshire Hathaway’s ($BRK-A) Warren Buffett.

Mr. Buffett made quite a splash last year when he bet big on technology powerhouse International Business Machines (NYSE:$IBM).  It was his first major purchase in the tech sphere, and it quickly became one of Berkshire’s largest holdings.    Buffett added to his position last quarter, and IBM now accounts for nearly 18% of Berkshire’s portfolio.

The appeal of IBM is straightforward; Buffett was attracted by the stability of the company’s cash flows and its business model as a high-end service provider whose customers are locked in to long-term contracts.

But its qualifications as a “dividend stock” might be a little more controversial.  At current prices, IBM yields only 1.6%.  Still, this is roughly in line with the current yield on the 10-Year Treasury Note, and—importantly—IBM’s dividend rises every year.  IBM’s dividend rose 13% this year and 15% the year before.

Of course, this is nothing new.  IBM is a proud member of the Dividend Achievers index, an exclusive fraternity of stocks that have boosted their dividends for a minimum of ten consecutive years.

So while the current yield of 1.6% is a little uninspiring, it’s safe to assume investors buying IBM today will be enjoying cash payouts far higher in a couple years’ time than they would have had they opted to invest in bonds.

Next on the list is the “Warren Buffett of Canada,” Fairfax Financial Holdings (FRFHR) Chairman Prem Watsa.

Like Buffett, whom Watsa admires, Watsa built his financial empire around a solid insurance business, which provided him with a growing float to invest.  And like Buffett, Watsa is known for being a patient investor who often holds his best positions for 5-10 years or even longer.

Watsa’s track record speaks for itself.  According to research site GuruForus, Watsa has grown Fairfax’s book value by an astonishing 212% over the past ten years.  This compares to total returns of just 34.9% for the S&P 500.  Impressively, he actually made money in 2008.  Fairfax saw its book value rise 21% in the midst of the worst financial crisis in 100 years.

Diversified health and pharmaceutical company Johnson & Johnson (NYSE: $JNJ) is Watsa’s largest holding by far, and accounts for more than 21% of his listed portfolio.

Johnson & Johnson is an obvious choice for a conservative dividend stock, and it is a current holding on the Sizemore Investment Letter’s Drip and Forget Portfolio.

It also happens to be one of the highest-yielding major American blue chips, with a 3.5% dividend at current prices.  And like IBM, Johnson & Johnson has a long history of raising that dividend.  J&J is a member of the Dividend Achievers Index.

Given the low repute of ratings agencies this matters less than it used to, but Johnson & Johnson is one of only four American companies to have its bonds rated AAA.  Yes, Johnson & Johnson is actually considered to be less risky than the U.S. government, and its stock pays more in yield.  This is one you can buy and lock in a proverbial drawer.

Our final guru today is hedge fund manager and fellow Dallas resident Kyle Bass, principal of Hayman Advisors.  Though he does trade equities, Bass is a macro investor better known for making large bets in the credit and currency markets; he made his investors a small fortune betting against subprime mortgage securities in the run-up to the 2008 meltdown.

Bass’s equity portfolio is completely dominated by Six Flags Entertainment Corp (NYSE:$SIX), the owner and operator of theme parks.  Six Flags makes up nearly 40% of his equity holdings.

With a current yield of 4.1%, Six Flags certainly qualifies as a dividend stock.  But readers should consider this stock a riskier bet than IBM or Johnson & Johnson.  Theme parks are sensitive to the state of the economy, and the stock trades at a nosebleed valuation of 32 times expected 2013 earnings.  There is a lot of optimism built into the price at current levels.

All of this said, Bass has certainly done well by owning Six Flags—it’s up more than 100% over the past year—and he clearly has a high level of conviction in the stock if he’s make it nearly 40% of his equity portfolio.

Disclosures: Sizemore Capital is long JNJ.