An article appeared in the Wall Street Journal last week titled “NetJets Unrest Puts Warren Buffett in a Rare Pinch,” describing the labor unrest at the Berkshire Hathaway subsidiary and detailing the company’s historical underperformance. (Buffett bought NetJets, which sells fractional-ownership shares in jet airplanes, in 1998).
The labor dispute is more or less the usual bickering between union employees and management and I encourage you to read the article if you’d like to learn more about it.
However, the most salient point is hidden about midway through the article:
In Berkshire’s “owners’ manual,” where Mr. Buffett and his business partner, Charlie Munger, explain their business principles to the company’s shareholders, the two wrote that a money-losing business and poor labor relations are the only two reasons that would compel Berkshire to sell a company.
It would appear that NetJets, of all of Berkshire’s companies, would fit this bill.
From 1998 to 2009, the company reported an aggregate pre-tax loss of $157 million, a figure that was in fact far understated since borrowing costs at NetJets were heavily subsidized by its free use of Berkshire’s credit.
The company was bleeding cash and only survived the crash in 2008 because Berkshire guaranteed its $1.9 billion debt load. The company lost $711 million in 2009. For many years NetJets was Buffett’s biggest headache and Berkshire’s only struggling business.
In August 2009, David Sokol became CEO of NetJets and led the turnaround of the company’s financial situation. NetJets returned once more to profitability in 2010 and continues to be profitable in 2014 (Sokol resigned as CEO in 2011 amid allegations of insider-trading). Its debt is now down to $500 million and its profit rose 7% in 2013.
However, NetJets has never paid a dividend back to Berkshire and its net worth is reportedly much less than the $725 million Berkshire paid for it in 1998. So after a decade of miserable financial performance, why didn’t Buffett sell the company back in 2009? Why doesn’t he sell it now?
It’s true. As the WSJ reported, Buffett believes that a money-losing business and poor labor relations are the only two reasons that would compel Berkshire to sell a company. But there’s more to the story than that. Take a look at one of the principles in the Berkshire Hathaway Owner’s Manual, which is posted on Berkshire’s website and is included in the back of every Annual Report [bolded emphasis mine]:
11. You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.
So, Point #1: Buffett doesn’t just simply discard businesses that have been losing money. Why? Because his investment horizon is forever. Viewed through that lens, Buffett would only sell NetJets if it would never again have a chance to be cash flow positive (implying a catastrophic change in industry dynamics or company operations) and/or the business would require enormous sums of capital investments from Berkshire to keep it afloat.
This clearly wasn’t the case: (i) NetJets cash requirements from Berkshire were small (by my estimates, NetJets only accounts for a little over 1% of Berkshire earnings and, assuming capital requirements for NetJets are analogous to pre-tax income, the aggregated pre-tax loss of $157 million could have been financed with just 1% of Berkshire’s free cash flow in a single year; and (ii) NetJets is now again profitable (airplanes are simply costly to operate, demand dropped sharply in the Great Recession, and the company was being run inefficiently – his original investment thesis was never proven to be fundamentally flawed, even if it wasn’t perfect).
Additionally, managers would have to be unethical and disreputable (not just idiotic) and/or labor relations would have to get bloody for Buffett to want to sell. While the current NetJets negotiations have indeed become contentious, it appears as if they are more par for the course and temporary in this case than they are extreme and permanent.
Point #2: Berkshire’s corporate culture is one of a kind and owning businesses forever is a key differentiator in the way that its subsidiaries operate and when Buffett looks to acquire to businesses. Take a look at this excerpt from the Q&A discussion during the Berkshire Hathaway Annual Shareholder Meeting in 2014 [bolded emphasis again mine]:
Berkshire is known to buy companies for many years. But that wasn’t the same earlier in your career. What do you do to gain the trust of founders/owners of companies you’ve bought out in the past?
Warren:We have kept our word. We are careful about what we promise. We can’t promise not to have a layoff. We can promise not to sell the business unless it has significant losses or labor problems. We do keep certain businesses that you wouldn’t get a passing grade in business school if you wrote down your reasons. We keep them because we made a promise, which we write in the back of our annual report.
We can’t make the promise we’ll never break employment or sell a business, but we can keep the promise not to sell unless there is the prospect of unending losses or labor problems. If we didn’t keep our promises, word would get around. We have put ourselves in a class by ourselves for people that care about their business. It doesn’t matter to private equity — they don’t care. But some founders do care about the future of their businesses. They don’t want to see them torn apart by a few MBAs that want to show their stuff.
We have a unique asset in Berkshire, and we’ll maintain it as long as we behave ourselves. Its valuable, and it’s how we like to operate.
Charlie: Obviously, we behave the way we do because we like doing it. We’re doing pretty well, and we’re unlikely to stop.
Warren: You can tell he doesn’t get paid by the word.
“You can sell it to Berkshire, and we’ll put it in the Metropolitan Museum; it’ll have a wing all by itself; it’ll be there forever. Or you can sell it to some porn shop operator [a PE firm], and he’ll take the painting and he’ll make the boobs a little bigger and he’ll stick it up in the window, and some other guy will come along in a raincoat, and he’ll buy it.”
In auction processes (often the case in corporate M&A), there exists a phenomenon called the “winner’s curse,” which is the tendency for the price of the item to be bid up and for the winning bid to far exceed the intrinsic value of the item purchased.
People often complain that Buffett’s not a value investor anymore because he has recently been buying companies for prices that far exceed their market cap (for example, Berkshire and 3G Capital bought H.J. Heinz in early 2013 for 20% more than the previous day’s closing price and 30% more than the one-year average share price).
This debate could command an entire article of its own but let me make two comments:
1. Buffett must pay a control premium to acquire the entire company and not just a single share of it. Control premiums are normally in excess of 20% and can be as high as 50% (although the high end of the range is likely influenced by the winner’s curse).
2. Buffett’s promise of incredibly long-term ownership, his hands-off management style, his personal reputation, and the brand name of Berkshire means that he doesn’t have to be the highest bidder when seeking to acquire a company, which allows him to largely avoid the winner’s curse. And it also means that he is more likely to win the next deal.
In other words, Point #2 is this: “Buffett would prefer to lose money, or make very little, from a business he owns than miss out on the next deal. Selling a business, or closing up shop, may make for a rosier earnings report today, but at a very high cost — Berkshire’s future.”
To summarize, Buffett would only sell a business if it will go on losing money forever, if the company needs huge amounts of cash inflows from Berkshire to remain operational, or if there are irreversible or irreparable changes relating to managers or employees (all these events require very fundamental or catastrophic changes to the company’s operations or industry).
Buffett never sold NetJets when it was struggling because it didn’t require much of Berkshire’s funds and because he knew that it would one day be profitable – or at least nearly profitable – again. Had he sold it, and broken his own principles, then it would have cost him future acquisitions down the road and unnerved the culture at Berkshire’s 70 or so subsidiaries.
As you probably don’t need to worry about having to position yourself for future deals, you should ask yourself the following questions when you are considering selling a stock:
Has my original investment thesis been altered? (Have industry dynamics or the company’s business model fundamentally changed? Has new management come in and have they instituted a strategy that will take the company in the wrong direction? Have there been new government regulations, has the company lost a major client, was there a major secular trend that you missed, etc.? )
What are my opportunity costs? (Are there other available investments that can give me a higher rate of return – taking into account realizable capital gains)
What are your thoughts? What do you think of NetJets? Should Buffett have sold the company?
What have been your experiences with selling stocks? Have you been able to avoid further losses or did you miss out on a major rebound?
I’ve usually found that I’ve been better off sitting on my hands and doing nothing, unless a particular stock were really to keep me up at night. To paraphrase Pascal, most of investors’ miseries stem from their inability to sit in a room alone and not call their stockbroker.