Warren Buffett: Investing in Turnarounds Is Difficult
It is well known that Warren Buffett (Trades, Portfolio) considers the purchase of the original Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) textile business a big mistake. By the late 1970s, the company was struggling and required increasingly large infusions of capital to produce results that were mediocre relative to those of Buffett's other holdings; in other words, he faced an opportunity cost in keeping the business afloat.
Although he was loathe to close down a business just to squeeze out an extra point of return, he eventually made the decision to shutter Berkshire's textile operations for good in 1985. This illustrates the difficulties value investors face when choosing to invest in turnaround situations, a point Buffett made in his 1979 annual letter to shareholders.
If it's 1980, don't buy a textile company
As mentioned, by 1979, Berkshire's textile business was waning in importance, and the insurance side of the company was becoming more prominent. Buffett chalked this underperformance up to the underlying economics of the industry, rather than inherent weakness of management or the company itself. He contrasted this weakening sector with other industries, like network television, which he saw as goldmines:
"In some businesses - a network TV station, for example - it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the "easy" business may be the better route to go."
Buffett's evolution from "cigar-butt" investing to "great companies at fair prices" is on full display here. It was clear to him that buying underpriced assets in distressed or otherwise weak businesses was not as good as ponying up for the cash cows of the world. Sometimes underpriced stocks are really just value traps, as Buffett found out:
"Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed."
Although the Waumbec purchase was not a total disaster, with some parts of the business contributing to Berkshire's other franchises, with 20-20 hindsight, it is unlikely that Buffett would have invested in such a business. He went so far as to say that "both our operating and investment experience cause us to conclude that 'turnarounds' seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price." Sometimes it's better to pay more for a business that is set up for smooth sailing than to get stuck with a poor one.
Disclosure: The author owns no stocks mentioned.
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