The Four Keys To Get Rich With Failure

One of the first moments when it hit me that I would make a ton of investing mistakes over the course of my lifetime is when I read admissions from Warren Buffett about the investing mistakes that he made in his life. I find it funny that he claims Berkshire Hathaway, the vehicle he used to build a fortune north of $50 billion, is something that he considers a mistake. And the thing is, he’s probably right about that.

Per the interview:

(15) What has been your biggest investment mistake and how did you learn from it?

WB:  It is better to learn from other peoples mistakes rather than your own. Look at all kinds of business failures. I don’t believe in beating yourself over it, you’re going to make mistakes. My biggest mistake was buying Berkshire Hathaway and trying to make it better. We had all of our money in a bad business, had a drag on all of this capital for 20 years. Even after acquiring National Indemnity.  BRK to be the base of what we wanted to grow, this was a mistake. You cannot play the game without making mistakes.  We bought Dexter Shoe for $400 million in BRK stock which is now worth $5 – $6 billion.  Dexter Shoe went bankrupt as a result of foreign competition.  We lost $2 billion in Energy Future Holding bonds which KKR had invested in.  KKR lost $8 billion.

 

(16) When managing other people’s money and making mistakes, how do you deal with the responsibility/burden?

WB:  I tell them I’m going to make mistakes, but the goal is to do this and this and this. I might make mistakes in order to do this, but I will still probably achieve this goal. I try to operate in a way where I can’t lose significant sums over time. I might not make the most money this way, but I will minimize the risk of permanent loss. If there’s 1 in 1000 chance that an investment decision can threaten permanent loss to other people, I just won’t do it.

 

When he started making his powerful investments that earned him his legendary 20% returns, he had to divert some of his capital to keep Berkshire afloat. Manufacturing equipment and other machines suck up a lot of money in the form of capital expenditures, and Berkshire’s textile operations constantly needed to be upgraded. Money that could have been invested in The Washington Post, GEICO, and so on, instead got redirected to keeping a textile plant open. Incidentally, this is why companies like Visa can be cheaper when they trade at 30x earnings compared to steel mills that trade at 5x earnings. With the steel mills, the profits are illusory—they can’t end up in your pocket as cash dividends to spend as you wish, because eventually, the company’s management will have to take that money and reinvest it back into factories and equipment at some point. With Visa, the company enjoys large economies of scale—it doesn’t cost much more to process 10,000,000 transactions electronically than it does to process 1,000,000 transactions electronically—the digital technology costs so little compared to the profit generated that a lot of that excess profit could leave the company and end up in your pocket instead.

Anyway, the other mistake that Buffett often mentions was his decision to buy Dexter Shoe in the early 1990s. He underestimated the effects of global competition with generic shoeware, and to make matters worse, he spend a couple hundred million dollars in Berkshire stock to make the transaction happen, and this had the net effect of costing shareholders $5-$6 billion, depending on the price of Berkshire stock at the time you perform the calculation.

Why do I mention all of this? Two reasons. First of all, if the best investor alive on this earth can screw up and make an investment that goes bankrupt, at a very minimum—we lesser gods should prepare for the prospect that we make an investment that goes completely bankrupt at some point in our lives. And secondly, we should know that making some bad investments aren’t the end of the world—Buffett would be worth $2 billion more if he didn’t make the Dexter shoe investment, and who knows what he would be worth if See’s Candy served as his starting base instead of Berkshire Hathaway.

As investors, we have four things we can do to grow stronger in the face of failure.

-We can diversify into two or three dozen different companies.

-We can own the most excellent companies in the world.

-We can incorporate a “margin of safety” in the form of the price we pay for stocks.

-We can also keep a large chunk of cash on hand.

If those four factors are your guiding lights to wealth-building, it’s almost to screw up. I would say “very unlikely”, but I think the odds are even better than that. After all, IBM, General Mills, Coca-Cola, and Colgate-Palmolive managed to make dividend payouts during the middle of the Second World War, for heaven’s sake. I read books about WWII all the time, I did a research project at the Marshall Library at The Virginia Military Institute in Lexington, Virginia, and I have attended guest lectures with WWII vets. And I still don’t think I have a full appreciation for just how tough and horrible conditions were during the 1930s and early 1940s, and this is something I think about regularly. The existential crisis, death, high unemployment, low wages, lack of a social safety net, and all those forces conspired together, and they still could not stop some of these companies from paying a dividend.

You know why that is? People are always going to buy flour. No matter what happens, you’re going to go to a store and see flour and cereal. That makes it damn difficult for General Mills to disappear from the scene. How the hell could we live in a world where people don’t brush their teeth? That makes it damn difficult for Colgate-Palmolive to disappear from the scene. When will people stop cleaning their clothes and washing stuff? When will we enter a world in which people stop shaving? That makes it damn difficult for Procter & Gamble to disappear from the scene. If it was an essential product that generated a profit during WWII, and if it still something that is an essential product even through the technological revolution of the 1990s and 2000s, then it is probably a product you want to have an ownership stake in.

And that just addresses the quality part of the scenario. Think about what happens when you compound quality upon quality upon quality. It’s not as if I’m arguing that you should put 100% of your net worth in Colgate-Palmolive (although the funny thing is that such a portfolio could very well outperform many other investment strategies over the next thirty, forty, fifty years). Instead, I’m arguing that you combine quality with quality with quality. Here, have some Hershey stock. After eating that Chocolate, you’re gonna need to brush your teeth. So make sure you own some Colgate as well. Here, own a block of Coca-Cola stock. After you spill that Coke on your shirt, you’re gonna need to wash it off with some Tide. Hot dog, take some Procter & Gamble stock as well. All these things are supposed to come together in a complete portfolio.

And from there, it’s just a matter of getting a good price, and having some cash on hand in case of emergency or to give you opportunities in the event of another 2009 situation. The only times these blue-chips don’t work out as investments is if you do something like initiate your purchase point in 1999 and 2000, times when companies like General Electric and Coca-Cola were trading for well over 40x earnings. You can’t pay $40 for every dollar of profit that a super large company generates and expect to do well. As long as you have a general hesitancy against paying more than 20x earnings for most non-cyclical blue chips, and hesitate towards paying more than 10-11x earnings for large oil companies, you’ll be fine in the long run.

Cash. Decent prices. Quality. Diversification across quality. That’s the secret to conquering potential failures. Even if you own Wachovia, Bank of America, and General Electric before the financial crisis, you’ll still come out richer afterwards because you adequately diversified and the dividend growth from the rest of your portfolio still made you richer. Those four factors are the secret to everything. The question isn’t “How do I go through life without making a bad investment or failing in any way?” Instead, the question is: “How do I get richer each year even if I do make mistakes?” Cash. Quality. Diverisfication. Decent Prices. Never forget those things, and the world is yours. You’ll be bathing in $1,000 dividend checks that show up so often you can’t even keep track of them.

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5 thoughts on “The Four Keys To Get Rich With Failure

  1. Douglas Hager says:

    Tim,

    One of the main reasons I tell people to read Buffett's annual letter is that he eventually discusses a mistake he made in each and every one…..sometimes omission and sometimes commission. Regarding the former of those two types, during the height of the financial crisis in '08 and '09 I was working in downtown Chicago. Our building was right across the street from a Starbucks, and I remember thinking many times that even though it felt like the world was melting down in a lot of ways, it sure seemed like everyone was still drinking a lot of coffee. Several days I had SBUX pulled up in my brokerage account ready to click and purchase. Never did. Still hurts to look at what it's done since!

    I just have to realize Mr. Market will be there to serve me again.

    1. Tim McAleenan says:

      Doug, the fact that you were thinking about buying in 2008 and 2009 puts you ahead of just everyone else. You can't teach that. If you had a buy attitude back then, the future should bode quite well for you, I would think.

  2. Klaas Tadema says:

    Douglas, funny that you metion SBUX, I remember at the time I was thinking about which stocks were going to get pelted by a badly hurt middle class, and I thought one would be SBUX. I went as far as to seriously begin shorting the stock. Never did, LUCKILY.

  3. Ordinary investor says:

    Tim,

    Great article. Just so happens to be I was buying (small amounts of) GE IBM BAC MO and PM in 08-09. MO @ $14, PM $35, IBM $70, BAC $4, GE $9. Every week – small transactions. Had I backed up the truck, I'd be retired today. Still holding and re-investing the dividends. Alas, those were the days to get rich!

  4. says:

    I think even in highly defensive beating – things can go wrong. In investing in shoes: who doesn't need shoes? However, it does not mean individual shoe companies will do well. There are risks in investing in P & G etc – economic moat can go come and go, and big companies can get outmanoeuvred by competitors (look at Ford; Ford was outmanoeuvred by companies from a country that came back from being a war ruins) or smacked by unexpected events that inflicts permanent damages. That is why diversification is a cornerstone to reduce risk. That said – I agree that you do want companies that appear to show some systemic competitive advantage.

    My portfolio has over 40-some stocks of well reputed business within their own specific field. I also set put money in an index fund. Sometimes I wonder if I am over-diversification (Neither Warren Buffet nor Peter Lynch a big fan of over-diversification).

    As for making mistakes in stock choices, Peter Lynch had once said: "A successful investor is 60% right and 40% wrong."

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