BRK.B

1 of Warren Buffett's Biggest Mistakes May Have Been the Best Thing That Ever Happened for Berkshire Hathaway Shareholders

One of the things that makes Warren Buffett such a valuable source of knowledge about investing is his willingness to admit his mistakes. After all, we often learn a lot more from our mistakes than from our successes.

If you comb through Buffett's letters to Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) shareholders, you'll find Buffett discussing mistake after mistake, year after year. He often goes on to explain his thought process before making the mistake, what he got wrong, why he got it wrong, and what to expect going forward. That makes his annual letter to shareholders a must-read for just about anyone who wants to learn to be a better investor or even a better decision-maker.

But there's one mistake Buffett puts high up on his list of blunders. He's described it as "monumentally stupid" and "the dumbest stock I ever bought." And it couldn't have worked out better for Berkshire Hathaway shareholders.

A close-up of Warren Buffett.

Image source: The Motley Fool.

Buffett's biggest mistake was buying control of Berkshire Hathaway

Before Buffett took over as CEO of Berkshire Hathaway, he operated a small investment fund called Buffett Partnership Ltd., or BPL. One of the investments he made for BPL was Berkshire Hathaway.

At the time, Berkshire was a failing textile company systematically closing down its mills. When it would close down a mill, it would take the proceeds from the sale and buy back shares. Buffett's investment was made purely on the basis that Berkshire would buy his shares back in the future when it closed another mill.

But when the tender offer came to Buffett's desk in 1964, it was lower than he expected by one-eighth of a point. He had previously discussed a buyout price of $11.50 with the CEO and received an offer for $11.375.

In response, Buffett furiously bought up shares of the company, took control, and fired the previous CEO. He then found himself in charge of a failing textile company, an industry he admittedly knew very little about. He was, as he described it, "the dog who caught the car."

We know how the story goes from there. Buffett has turned that failing textile business into a massive conglomerate. Berkshire no longer deals in textiles, with Buffett giving up that particular fight in 1985.

Sticking with the textile business may have been one of Buffett's biggest mistakes as CEO of Berkshire Hathaway. Luckily for shareholders, he managed through it and made many good decisions (despite some more bad ones) over the subsequent years. Berkshire Hathaway is now one of the most valuable companies in the world.

Three big lessons to learn from Buffett's biggest mistake

There are three main things investors can learn from Buffett's decision to take control of Berkshire Hathaway.

First, not even the best manager in the world can turn around a business with bad economics. Buffett noted this first in his 1980 letter to shareholders. "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."

Second, it's hard to recognize and overcome your own emotions and biases. Buffett made the mistake of buying more Berkshire because he was upset. He let emotions decide for him, even though he rationally knew it was a bad company to own. He liked the stock, not the company.

Then, he made the mistake of thinking he could make the textile business work. Buffett wrote that quip about managers versus economics at the start of 1981. He had previously discussed the poor economics of the textile business in his shareholder letters, but he intended to continue its operations. He believed he had a great manager in place and that it could be a profitable business to hold onto in the long run. He even doubled down on textiles with the purchase of Waumbec Mills in 1975.

Of course, Buffett is no exception to his own rule. A great manager met a business with poor fundamental economics, and the outcome was just as he predicted in 1981. Berkshire closed its textiles business in 1985.

A smiling Warren Buffett.

Image source: The Motley Fool.

The last lesson -- and one that completely changed the course for Buffett and Berkshire shareholders -- was that Buffett's investment approach had to change. In the 1950s, Buffett found success by buying shares of companies trading at a discount to a conservative estimate of their liquidation value. These were often failing businesses with poor economic prospects like Berkshire was. He would quickly turn around and sell the shares as the market realized the true value of the assets on the balance sheet. Buffett learned this strategy from Benjamin Graham.

But this approach has two big flaws, and it took Charlie Munger to finally point them out to Buffett. First, investing in these companies doesn't scale. As BPL and then Berkshire Hathaway began building more capital, there weren't enough of these types of investments for Buffett. Second, and more importantly, these are merely short-term investments and offer little in the way of actually building a long-term enduring portfolio of stocks and wholly owned businesses.

Munger's advice to Buffett was clear and concise, as only he could put it: "Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."

It's great advice, not just for Buffett but for anyone who wants to invest for the long term. A stock trading at a "wonderful price" more often reflects the "poor fundamental economics" of the underlying business than a can't-miss opportunity.

Don't make the mistake of thinking you're smarter than anyone else in the market and know something no one else does. Look for great businesses and buy their stocks when the market gives you a fair price. Over the long run, it'll work out well. It certainly has for Buffett and Berkshire shareholders.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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