Learning From Mistakes: Don't Be Afraid To Pay For Quality

Includes: BASFY, BIP, BRK.A, BRK.B
by: Ján Mazák

Since most American blue-chip companies appear rather expensive at the moment, I have focused on reviewing some of my investments and tried to identify mistakes to learn from. Somehow, I take my own experience much more to heart than other people's advice, even if it was from Warren Buffett himself.

One major mistake that I have been guilty of is not buying into quality businesses whilst shares were at a reasonable or even appealing price, or buying very timidly and in small amounts. I will discuss what I have learned from investing in three particular stocks. While Brookfield Infrastructure (BIP) and Berkshire Hathaway (BRK.A, BRK.B) appear to be fairly valued, BASF (OTCQX:BASFY) is still attractive compared to many US dividend stocks.

Brookfield Infrastructure (NYSE:BIP)

I first considered buying BIP in 2010. As far as I understood, the company had a significant moat around most of its assets. However, it seemed to be too leveraged for my taste and had a short operating record. Moreover, it had (and still has) a very complicated structure: a partnership directly owning only interests in various holding companies. In such a case, one needs a large degree of faith in the management; however, that is more or less true for all companies -- accounting rules themselves are never tight enough to prevent presenting whatever earnings one wants to. The company was priced at about 1.3 times book value, which I did not consider cheap according to the old Ben Graham's criteria. Instead of trying to find out more about the management (e.g. by studying a long-term record of Brookfield Asset Management), I have decided to wait for a better price. That was my mistake: due diligence at research cannot be replaced by buying at a larger discount.

In 2011, I wanted to buy shares in this apparently great business so much that even when the yield had declined under 5% (and the price had advanced to $24), I bought a small chunk of BIP. This was another mistake, succumbing to emotions. The 50% return realized on that chunk does not justify the purchase by the smallest bit. One cannot judge a decision solely by its outcome, especially not in investing. I had hoped to buy more on a dip, but the dip never came and I watched the stock price go up and up above $40, which was a rather painful experience for me.

A few months ago, after understanding the business much better (long-term contracts, non-recourse debt, and backing by BAM being the key words for understanding that the leverage is not too dangerous) and gaining the necessary faith in the management, I bought a much larger chunk of BIP between $34 and $35 (BIP's recent results might also have played a role in my decision, see my analysis).

Warren Buffett's ideas of buying a quality company at a fair price instead of a mediocre one at a bargain price make much more sense to me now. I should have done the research and bought a lot of shares even when the price of $24 did not look like a great bargain (or instead viewed BIP as a non-opportunity if the research indicated so).

Berkshire Hathaway (BRK.A, BRK.B)

There is no need to introduce Berkshire Hathaway. This hand-picked collection of businesses is known to almost every investor. After reading some of Buffett's letters, I was sure that BRK is a great company. However, I was afraid of the insurance business it is based on because I did not understand it at the time of considering an investment. In April 2011, Berkshire was trading at 1.2 times book value (BRK.B at about $80). Again, instead of trying to understand the business better, I decided to buy a small chunk (my decision was mostly based on Buffett's authority). After the price declined to $70 in the summer of 2011, I bought another small chunk. What a wonderful opportunity I have missed! BRK.B now trades at $115 and has the P/B ratio above 1.5. And there is a floor put on the stock by the potential repurchase program: Berkshire promised to buy its stock at 1.2 times book value (which is about $100 for BRK.B at the moment), and has tens of billions ready for that.

There are two things I missed about Berkshire at that time of great opportunity.

Firstly, insurance will remain with us forever. Since human life is short, there are many events influencing it very significantly. Such events, e.g. a death or a house-destroying flood, should be mainly judged not by their probability, but by their outcome. Insurance is a great solution to this problem of low-probability, high-impact events. Compared to companies creating products, software, chemicals etc., which have to reinvent themselves from time to time, there is nothing new that needs to be invented in insurance. It's just historical data and a bit of mathematics. Thus the risk of insurance does not lie in the business itself, but in the management. And BRK is probably the best in prudent management. The $20 billion cash reserve ready to cover extraordinary insurance claims and the negative attitude towards participating in the derivative mess makes me sleep well.

Secondly, BRK has added plenty of high-quality operating companies to their portfolio. Consequently, the risk of Buffett's death or retirement is sufficiently mitigated. In fact, at the current price, BRK seems to be fairly valued based on its operating businesses and investments alone, so one can buy the Buffett's skill and legacy "for free."

Altogether, I perceive the risk of BRK.B to be much smaller than with other companies, even though I do not understand all types of insurance in detail. My lesson: if a quality business is available at a good price, it pays off to take time doing the research and buy a huge chunk. It pays off much more than trying to find a few different small-chunk risky investments -- that's what I have been doing instead...

BASF, The Chemical Company (OTCQX:BASFY)

BASF is the world's largest diversified producer of chemicals (almost $100B in sales). They produce hundreds of different substances ranging from basic commodity-type chemicals to highly-engineered specialty products. While studying BASF, I have identified various kinds of competitive advantages.

1. They have the best patent portfolio among chemical companies and spend enough on research and development to keep this lead in the future. Consequently, they sell many products that are simply unique and cannot be easily substituted, so they can charge premium prices. BASF offers reliable top brands of coatings, foams, plastics, and other polymers. The company is based in Germany and maintains the image of a reliable supplier of German-quality products.

2. There is a significant scale advantage. Research and experience can be shared among different production sites, which can save a lot of overhead on testing, pilot plants etc. Moreover, the company can tailor its business model to suit customers' needs; for instance, they are forming joint ventures with major customers. When it comes to building plants, they also have an advantage in financing: BASF only needs to take a few weeks' profit and can build a whole new plant. I like it much more than haggling with bank consortia and having to pay large interest on the borrowings because of a large risk premium. In fact, BASF can buy smaller competitors outright, and they are actually doing it -- in a conservative and well-thought-out manner.

3. The balance sheet is much stronger than is common at chemical producers which have very cyclical earnings. BASF's stable A+ credit rating from S&P looks much better than Dow Chemical's BBB. The management of BASF is especially focused on mitigating the cyclical nature of earnings by making appropriate acquisitions and dispositions of assets.

4. BASF is a low-cost producer of many chemicals. They have a concept called 'Verbund' to assure this. In particular, they have six very large production sites where exothermic reactions are paired with endothermic ones to save excess heat, and where by-products of one process are re-used as inputs in another one.

5. The company has above-average relationships with its employees. Half of the seats on the board of directors are taken by employee representatives. I believe that potential labor disputes will be solved quickly and efficiently.

6. BASF subsidiary Wintershall is engaged in oil production and refining. This gives BASF vertical integration not very common among chemical producers. A steep increase in oil prices can drive down margins of competitors because oil is the basis of various chemicals (e.g. plastics), but would not be much of a concern for BASF.

BASF offers a nice dividend yield in the 3-4% range and is committed to grow it over time. According to the company presentation, the dividend has increased by at least 3% every year from 2003 to 2013 (there was a stock split in 2008) and the compounded annual growth rate was about 16%. The total shareholder return in the last decade was about 16.5% p. a. Free cash flow ranged from 2.5B to 4B euros between 2003 and 2013. About 17B euros of that cash was distributed as dividends.

The future of the chemical industry seems bright: chemical compounds are needed in almost anything humans produce; the market for chemicals is estimated to grow about 3% faster than the general economy for decades; and BASF is in a perfect position to profit from this growth by increasing its market share and enhancing competitive advantages.

The current P/E ratio of 15 and dividend yield of 3.6% make BASF a compelling opportunity compared to top US dividend growth companies. However, it is not such a great opportunity as it was a few years ago; I would prefer to buy the shares amidst another dose of Europe-based worries or in a general market downturn. I believe such an opportunity will materialize in a few years since chemical producers are prone to cyclical short-term declines in earnings.

My mistake again was buying too little. In 2011, the stock traded for about 45 euros. Although I identified BASF as a great company and the price seemed favourable, I was afraid of temporary European troubles. The price has mostly climbed up since then and hovers around 70 euros in 2013. (The price graph looks a bit different in US dollars and the returns would be less spectacular for an American investor.) My lesson is that great companies rarely come at a great price, and so I should buy massively if such an opportunity arises.

Disclosure: I am long BIP, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long BASF via Xetra.