My thesis is that even the Warren Buffetts of the world can’t always tell a good business from a bad one. Buying the first half of GEICO for $45.7 million was one of his biggest home runs and buying Dexter was one of his biggest mistakes. Eventually Berkshire Hathaway (BRK.A, BRK.B) bought the second half of GEICO in 1995 and the $2.3 billion price looks good today but it wasn’t nearly as good as the price for the first half. Looking at the GEICO home run example and the Dexter failure example, we see that even great investors make mistakes like not being able to tell the difference between a good business and a bad one. Investing can be a humbling experience - the pre-acquisition Dexter financials in 1993 actually looked better than the pre-purchase GEICO numbers in 1976.
Berkshire’s shrewd purchase of GEICO stock from 1976 to 1980 became more substantial over time as GEICO repurchased shares such the position eventually became half of GEICO. The numbers for this in the 1994 letter to shareholders jump off the page - we see a market value of $1,678 million and a cost of just $45.7 million!
In the 1980 letter to shareholders Buffett said
with few exceptions, 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.
This is one of his famous sayings that he has repeated over the years. He was talking about turnarounds and he noted that GEICO is an exception. It’s true that GEICO was near bankruptcy in 1976 but its fundamental business advantage was still in place.
Buffett went on in the 1980 letter to phrase it as follows:
GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true “turnaround” situation in which the managers expect - and need - to pull off a corporate Pygmalion.
So in the case of Berkshire’s 1976 purchase of GEICO stock, Buffett was able to tell that it was a good business despite the fact that they were approaching bankruptcy such that standard yardsticks like the P/E ratio were not usable.
Business Economics Vs Management
The “reputation of the business that remains intact” phrase above was used again in the 1985 letter explaining the July decision to close the textile business. Buffett’s point was that the textile business in the U.S. was difficult such that their operation was doomed despite the fact that they had great management. The phrase was used yet again in the 1989 letter when talking about the textile business and the Hochschild Kohn department store acquisition.
Berkshire’s 1993 acquisition of Dexter was one of the biggest mistakes the company ever made. Playing Monday morning quarterback, the signs seem somewhat visible. It goes to show that even the smartest investors in the world endure their share of errors.
Buffett talks about the shoe business being difficult in the 1991 letter to shareholders. Some of the problems are clear at this stage while others are latent:
Shoes are a tough business - of the billion pairs purchased in the United States each year, about 85% are imported - and most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables. In this kind of environment, only outstanding managers like Frank and the group developed by Mr. Heffernan can prosper.
By this point we know what Buffett thinks about a business “with a reputation for poor fundamental economics.” At least three times up to this point he has basically said that a good business is more important than good management. And he has said that the shoe business is tough. So he knew what he was getting into when acquiring Dexter in 1993. He talks about the competition from low-wage countries in the 1993 letter to shareholders:
Dexter, I can assure you, needs no fixing: It is one of the best-managed companies Charlie and I have seen in our business lifetimes.
As you probably know, the domestic shoe industry is generally thought to be unable to compete with imports from low-wage countries. But someone forgot to tell this to the ingenious managements of Dexter and H. H. Brown and to their skilled labor forces, which together make the U.S. plants of both companies highly competitive against all comers.
This is one of the few times where the “generally thought” component of the crowd was right and Buffett was wrong.
In the 1995 letter to shareholders Buffett sees that there are issues with the shoe business but tells shareholders to view the disappointing figures as a cyclical problem. In the 2000 letter to shareholders Buffett reveals that Dexter was a mistake and that they charged off all the remaining accounting goodwill. By this point it was clear that Berkshire shareholders merely held vestigial Dexter assets that were not “highly competitive.”
Buffett’s number one rule is to not lose money and his number two rule is to remember rule number one. Still, there are worse things than losing cash. For a company like Berkshire with great economics, it is much worse to lose shares. The 2007 letter to shareholders points this out:
Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion – to buy a worthless business.
Again in the May 2007 annual meeting Buffett talks about the extent of the Dexter mistake:
When I gave away 2 percent of Berkshire Hathaway to acquire Dexter Shoe, that was one of the dumbest deals in the history of the world.
And I did it all by myself. Charlie didn’t participate in that one. I wish he had.
But, you know, it was dumb. I mean, here’s —it wasn’t 2 percent of what I had then at Berkshire, it’s 2 percent of the present Berkshire Hathaway company.
You’d all be 2 percent richer —a little more than 2 percent richer —but you’d be a full 2 percent richer if I hadn’t done that.
Based on standard yardsticks like the P/E ratio, the 1993 Dexter looked much better than the 1976 GEICO. Yet GEICO went on to be one of Berkshire’s biggest success stories and Dexter became of the biggest failures. Investing is hard. Even the best investors in the world show their humanity by making mistakes.
We are able to learn from this by remembering that no matter how good or bad the rear view mirror looks, the windshield can be substantially different and it is the per-share economics of the windshield that make or break us.
Fortunately Berkshire has a lot more Geicos than Dexters. Other success stories like See’s and Coca-Cola are beyond the scope of this article. On the other side of the equation, many of the large mistakes are on the omission side such that we don’t see them. One omission example that has been discussed was not buying Walmart when it went up slightly over the desired purchase price many years ago.
The takeaway is that investing is hard and even the best investors in the world are continually making mistakes. Buffett has said that he'll make more mistakes in the future but he recognizes that his home runs will more than compensate for his strikeouts. In the case of Dexter, the crowd was right but he will continually go against the crowd when opportunities present themselves. Among other things, Buffett did not recognize how devastating foreign competition would be when he said "the domestic shoe industry is generally thought to be unable to compete with imports from low-wage countries." It turns out he had too much confidence because Dexter was one of the “best-managed companies” he had ever seen. This may have been a large part of why he underestimated the importance of what was “generally thought” about the domestic shoe industry. He was aware that 85% of shoes bought in the U.S. at the time were imported but he thought he knew something that everyone else didn’t.
If we lose the confidence to go against the crowd from time to time then we might as well buy an index fund. This isn't to say mistakes should be ignored. We should learn from them and try to minimize them while remembering that not even Buffett expects to eliminate them completely. Sometimes the crowd is right but we can't let the fear of more Dexters get in the way of the more GEICO's. We have to be willing to continue going against the crowd knowing that we won't always be right.
Disclaimer: Any material in this article should not be relied on as a formal investment recommendation. Never buy a stock without doing your own thorough research.
Disclosure: I am/we are long BRK.A, BRK.B, VOO. 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.