On Monday, it was announced that the world’s most successful investor had bought a US$1.1 billion stake in technology company Apple. Investors in Warren Buffett’s company, Berkshire Hathaway, should hope for better results from Apple than from Buffett’s worst investment ever – in oil producer ConocoPhillips.
There’s a lot to learn from the mistakes of others – especially those who are otherwise extremely successful (like Carl Icahn, whom we wrote about here.)
Warren Buffett is the third richest person in the world, with a net worth of over US$66 billion. His company, Berkshire Hathaway, owns stakes in a wide variety of businesses – everything from Coca-Cola to banks to railroads. He’s earned investors an average return of 20 percent per year from 1965 to 2015, and is the single best answer to the claim that beating the market over an extended period is just plain luck.
Through Berkshire Hathaway (BRK) Buffett started buying shares of integrated oil producer ConocoPhillips (ticker: COP) at the end of 2005. COP does everything from finding the oil, getting it out of the ground, refining it, then selling it at petrol stations. By the end of 2008 he had invested over US$7 billion in the company and owned about 85 million shares. COP made up 15 percent of Berkshire Hathaway’s entire portfolio, and it was the largest investment in a publicly traded company for Buffett up to that time.
By mid-2008, oil prices were peaking near US$150 per barrel and COP share prices were over US$95 per share. With an average cost per share of $80, BRK was in the black.
A foundation of Buffett’s investment philosophy is to buy great businesses at a good price. At the time, on a price-to-earnings basis, COP shares were cheap compared to other big oil companies.
One of the characteristics of a good business, according to Buffett, is a high barrier to entry. This means that a company operates in an industry where potential competitors would face high expenses and other difficulties to get a foothold. It also suggests that there’s something unique about the product.
But COP was competing for market share with similar oil companies – some government-backed – around the world. And there’s nothing all that unique about the oil that COP makes… it’s pretty much the same as the oil that every other big oil company produces. Buffett somehow suspended his usual test for COP.
Part of the problem is that Buffett may have subscribed to the theory of “peak oil” that was popular at the time. This concept holds that all of the world’s major oil discoveries had already been made – and that oil production had peaked. Meanwhile, energy consumption would continue to grow, as China and other emerging markets grew.
As a result, the world would soon not have enough oil to meet the growing demand – so oil prices would stay high, and go even higher. In such a scenario, owning a big oil company, especially one trading at a valuation discount to its rivals, would make sense.
But Buffett’s belief in “peak oil” was misplaced. Soon after peaking in July 2008, oil prices collapsed. Over the next six months, they tumbled over 60 percent as the world entered the global financial crisis. And subsequently, an explosion in the supply of shale oil (which is basically oil trapped in rocks) completely disproved the notion of peak oil. And the declining cost of solar and other forms of sustainable energy are also easing concerns about peak oil.
As oil prices fell, so did the share price of COP. By February, 2009 they were down to US$35 per share. Over the course of 2009, as COP share prices were falling and then bottoming, Buffett sold 50 percent of his stake in the company. It is estimated that he lost about 55 percent on the shares. It was his biggest investment loss ever.
In his 2009 letter to Berkshire shareholders (reviewing what they did in 2008), Buffett owned up to his mistake:
“I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie [Buffett’s business partner Charlie Munger] or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”
Buffett helped make up for the loss by investing the proceeds from the sale of COP shares more wisely. As reported in the following year’s annual report, BRK used the cash raised from selling COP in part to invest in Dow Chemical and insurer Swiss Re, both of which performed strongly.
This all shows that even the best investors make mistakes. We can draw a few lessons from Buffett’s blunder:
Don’t get caught up in fads
Buffett may have bought in to the peak oil theory. This was a very popular idea in 2008 and the evidence seemed to back it up. But higher prices drive technological change and development… and these lead to new ways of tapping the world’s oil sources, and to new sources of energy.
So, when everyone is talking about the latest investment theory, think again. And when everyone is taking the same side of an ongoing debate it usually pays to consider the opposite.
Watch your opportunity cost
Even though Buffett took a hit on his COP shares, he didn’t hang onto them once he realised his error. He saw better opportunities elsewhere, so he sold part of this losing position and reinvested the funds. Had Buffett held on to COP shares until 2010, he would have broken even again. Instead, he started earning better returns right away by investing part of that money elsewhere.
Investors should always be aware of an investment’s opportunity cost.If a stock is not performing, it often doesn’t pay to keep hanging onto it and waiting for the rebound that may never come. It’s better to look for an investment that will get you better returns sooner.
Stick to your strategy
Buffett’s COP mistake happened when he strayed from one of the core tenets of his investment philosophy. Had he stuck to his strategy, he most likely would not have invested in ConocoPhillips.
Will Apple be different for Buffett? By many valuation measures, shares of Apple are cheap. The barriers to entry to Apple’s business are enormous. No misguided pseudo-scientific theory is underpinning Apple. One of its challenges is that it’s already so large. But given that the shares are down 27 percent from last year’s highs, there is clearly room for the shares to go higher.