- Buffett was wrong about those Energy Future Holdings bonds, and I flagged it at the time, but dismissed the insight because Buffett is usually right.
- Beware of even the most deserved "halo effects," and always honor gut feelings enough to undertake further research and analysis. Ask a smart friend's opinion.
- Know and improve knowledge of yourself, such as a tendency to take on faith views which appear to come from legitimate authority.
- Know both history and its limitations; be open to change and new things which appear to contradict old rules or received wisdom.
- Keep things in perspective. Buffett has been right hundreds of times, and EFH was a single and relatively minor mistake.
Warren Buffett's unforced error was Energy Future Holdings. I can remember the day back in 2007 that the first story appeared in the financial press. Buffett was taking two billion of PIK-toggle bonds in a Texas outfit that appeared to be mainly the survivor of the old Texas Utilities. Hmmm. A number of areas lit up in my head.
First off, I was familiar with Texas Utilities. I had even sent off for their annual report back in the 1950s when I was a boy. They were what was known then as a "growth utility." That was the tail end of the era of electrification of American life, and utilities in places like Texas were still growing along with the population and increasing industrialization. TXU had an assured rate of return and a regularly rising dividend, but a PE well into the 20s. The small and growing dividend return nevertheless promised to beat every kind of fixed return you could get at that time, and I even jotted down tables showing how it would compound for many decades. I never actually bought TXU, but I developed a warm and fuzzy feeling about it.
A couple of decades passed, and two things happened to Texas Utilities. The first was that the level of interest rates climbed quite a lot, making their dividend yield seem paltry and increasing their heavy borrowing costs. The other was that the era of electrification ended, and growth in the Sun Belt slowed. One day in the 1970s, I took a close look at the utility industry, and Texas Utilities and all the rest of them were pretty much a mess, selling at low PEs and offering high yields that nobody wanted.
Apparently, however, by 2007 something more had happened to the old TXU. If they were trying to raise money with PIK-toggle bonds, they had come a cropper in a big way. The big change was deregulation of the industry. Now utilities were being forced into trading their commodity product among themselves, and the "smartest" (for which read "dumbest") were trying to use trading as a profit center. It called to mind another Texas outfit called Enron, which had started out as a simple gas company. I had looked at that one, too, in the late 90s. A broker told me it was the great new thing. I took a pass.
Then there was the PIK-toggle aspect. PIK means payment-in-kind, meaning they don't give you cash, but will give you more of the same garbage paper on which they aren't giving cash. Toggle means they flip back and forth at will. Which way do you suppose they will flip? To my mind, you are buying a bond which tells you from the get-go that they see a large possibility of not giving you back cash money. PIK-toggle: your pockets get picked, your head gets toggled. Buffett knew all this, of course.
My gut said EFH was a bad idea. It failed the smell test.
I asked: "What is Uncle Warren thinking?"
I answered: "Gee, I guess he must know something I don't know."
Hey, maybe it was just a matter of fixing up a few things in what had once been the very fine business of Texas Utilities.
I went on to the next news story.
The good news is that there was no convenient way to piggyback Warren on this one. The other good news was that on the scale of Berkshire Hathaway (BRK.A, BRK.B) the amount at stake was small - not quite trivial, but small. I'm okay with the fact that I didn't sell any Berkshire.
Several years passed, and they weren't kind to Energy Future Holdings. The price of natural gas went down inconveniently. EFH wasn't really Enron; they don't appear to have defrauded anyone. They were just a bunch of guys out of their depth under the new operating rules for utilities. The price and prospects of those PIK-toggles sank and sank some more. Warren began to sound cautious about them.
Warren had been wrong about EFH. This is what he had to say about it in his recent 2013 Annual Letter:
In addition to our equity holdings, we also invest substantial sums in bonds. Usually, we've done well in these. But not always. Most of you have never heard of Energy Future Holdings. Consider yourselves lucky; I certainly wish I hadn't. The company was formed in 2007 to effect a giant leveraged buyout of electric utility assets in Texas. The equity owners put up $8 billion and borrowed a massive amount in addition. About $2 billion of the debt was purchased by Berkshire, pursuant to a decision I made without consulting with Charlie. That was a big mistake. Unless natural gas prices soar, EFH will almost certainly file for bankruptcy in 2014. Last year, we sold our holdings for $259 million. While owning the bonds, we received $837 million in cash interest. Overall, therefore, we suffered a pre-tax loss of $873 million. Next time I'll call Charlie.
The Lessons Learned packet is something I brought home from Vietnam. When an American or American-advised unit took a licking or got another form of unsatisfactory outcome, we had to make up a packet for the brass in Saigon describing how we had walked away from it wiser than before. Warren's packet is the above paragraph. As for me, here goes:
(1) Beware of "halo effects," even when they are as well earned as the halo of Warren Buffett or as small as the residual warm and fuzzy feeling I retained for Texas Utilities of the 1950s.
(2) Trust instinctive misgivings. Any time your gut feeling is negative, you should undertake further steps to find out why. You might start by asking a smart friend - your Charlie Munger.
(3) Know yourself, and keep trying to improve your self knowledge. I am sometimes too fond of legitimate authority. It is all too easy and comfortable to accept things on the basis of authority. I actually thought there must be weapons of mass destruction in Iraq. I was late on Santa Claus, too. This is a very useful thing to admit about yourself. I have to remind myself frequently that the argument ab auctoritate is generally weak, and that I have to examine my opinions carefully to see if they are merely grounded in authority.
(4) Know and understand history, but know its limitations. Knowledge of history is a good starting point, but the world is always changing. The old rules may or may not apply.
(5) Be more open to new things and less quick to embrace conventional wisdom. This is the flip side of the "know history" argument. Received wisdom - the wisdom of history and authority - leads me to dismiss new things like Tesla (NASDAQ:TSLA) and Amazon (NASDAQ:AMZN), just to name a couple, but I need to remind myself to analyze with an open mind. To modify one of the most common epigrams from investment blogs: History doesn't actually repeat, and occasionally it doesn't even rhyme.
(6) Buffett was wrong on those EFH PIK-toggles, and I flagged it at the time. However, he has been right hundreds of times, and often on opportunities which I could not have clearly identified. The percentages continue to be with Buffett.
And now as to those local newspapers he seems to like: Well, I don't see any real chance to piggyback Buffett on those, and I'm just as happy not to. Even if he turns out to be totally wrong (does he have a case of warm fuzzy feeling about the old journalism?), I'm not too worried. I'm certainly not selling any of my Berkshire Hathaway.