Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1985 letter.
Shutdown of Textile Business
In July 1985, Berkshire Hathaway finally shutdown its textile business. The letter goes into great detail as to why and what might have been had Berkshire tried to grow this business. As Buffett noted, “The history of this business is instructive.” Indeed.
When the Buffett Partnership gained control of Berkshire Hathaway in 1965, Buffett said it had an intrinsic value considerably less than its accounting net worth of $22 million “because the textile assets were unable to earn returns commensurate with their accounting value.” Buffett concluded that over the following 21 years, the textile business was never a good earner, not even in cyclical upturns.
As we know, over time Buffett aggressively diversified into other businesses and the textile operations' “depressing effect on our overall return diminished as the business became a progressively smaller portion of the corporation.”
While keeping the textile business was a big mistake in hindsight, Buffett explained the reasons for that decision:
(1) "Our textile businesses are very important employers in their communities."
(2) "Management has been straightforward in reporting on problems and energetic in attacking them."
(3) "Labor has been cooperative and understanding in facing our common problems."
(4) "The business should average modest cash returns relative to investment."
Buffett further said, “As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital.”
He was wrong about the fourth point, however.
Adam Smith vs. Karl Marx
Buffett went on to say:
"Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.
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."
The guru's “only position that leaves me comfortable” statement is very interesting. It shows he is not immune from emotional decision-making.
Buffett estentially thought he could turn around the textile business and get to a position of sustainable profitability. In regard to management’s efforts, who had his full backing, Buffett said:
"They reworked product lines, machinery configurations and distribution arrangements. We also made a major acquisition, Waumbec Mills, with the expectation of important synergy (a term widely used in business to explain an acquisition that otherwise makes no sense). But in the end nothing worked and I should be faulted for not quitting sooner. A recent Business Week article stated that 250 textile mills have closed since 1980. Their owners were not privy to any information that was unknown to me; they simply processed it more objectively. I ignored Comte’s advice - “the intellect should be the servant of the heart, but not its slave” - and believed what I preferred to believe."
Buffett, and this is one of the things that makes him great, in his analysis of the situation recognized the situation for what it was; he did not make excuses or try to pass on the blame, as many other investors might.
He continued:
"But that in no way means that our labor force deserves any blame for our closing. In fact, in comparison with employees of American industry generally, our workers were poorly paid, as has been the case throughout the textile business. In contract negotiations, union leaders and members were sensitive to our disadvantageous cost position and did not push for unrealistic wage increases or unproductive work practices. To the contrary, they tried just as hard as we did to keep us competitive. Even during our liquidation period they performed superbly."
Over the years, Buffett had the opportunity to make large capital expenditures in the textile business that would have allowed it to reduce its variable costs. He noted that each proposal to do so looked like an immediate winner and that “Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational.”
Ultimately, however, capital investments into the textile business would have left Berkshire with terrible returns on ever-growing amounts of capital at a time when “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.”
Buffett thought himself in the position once 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.”
People often criticize the "Oracle of Omaha" for not coldly exiting textiles much sooner. But just avoiding significant investment was a significant accomplishment. To understand why, Buffett went on to analyze the “to-invest-or-not-to-invest dilemma plays out in a commodity business” by looking at Burlington Industries, by far the largest U.S. textile company both in 1965 and in 1985.
In 1964, Burlington “had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours.” By 1985, according to Buffett, each Burlington share commanded “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.”
Buffett called it a devasting outcome for Burlington’s shareholders and an indication of “what can happen when much brain power and energy are applied to a faulty premise.”
He then likened the situation to Samuel Johnson’s horse:
“'A horse that can count to 10 is a remarkable horse - not a remarkable mathematician.' Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business."
In his concluding thoughts, Buffett reminded readers that:
"Some years ago I wrote: 'When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.' Nothing has since changed my point of view on that matter."
Conclusions
What can we take away from this?
In summary, when we exit investments, we should have a clear rationale of why we are exiting and what went wrong if we have lost purchasing power. We should also should look at the opportunity cost and, in this case, of how similar investments performed over the same timeframe. For instance, Berkshire did better than Burlington Industries by not expanding in a poor industry.
It is also a reminder not to be emotional or sentimental. Sticking with textiles was probably one of Buffett’s worst decisions. He wanted to be in a “comfortable” position,but he should have behaved as Smith would have recommended: economically rational.
