Warren Buffett (Trades, Portfolio) is a living legend in the world of finance and investment. His decades at the helm of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) have been a testament to value investing and long-term focus. Buffett’s seeming prescience has earned him the moniker “Oracle of Omaha,” a title he has earned repeatedly.
However, even oracles can get things wrong from time to time.
The bewitching power of top line growth
As virtually every value investor will attest, a company’s bottom line is what matters most to a sound investment. Yet, during bull markets, investors’ attention often tend to shift to other metrics. As value strategies tend to lag growth strategies during bull markets, it is often hard to resist the urge to follow the inexorable tide.
During bull markets, top line measurements such as revenue growth can come to dominate discussions rather than the bottom line, especially when a company or sector captures investors’ imaginations with exciting growth narratives. Such was the case with dotcom stocks at the turn of the millennium.
One can see the same sort of narrative obsession in markets today, with so-called tech disruptors boasting explosive top line growth and bulging market capitalizations. Such growth is expensive, and many recent IPOs have supported tech companies that continue to post significant quarterly losses. A common justification for these losses is that they fuel necessary growth and scaling up of operations. Yet, for many of these companies, such as Lyft Inc. (LYFT, Financial) and Grubhub Inc. (GRUB, Financial), it remains far from clear how exactly scale will result in profitability.
Buffett gets sucked in by revenue expansion
Story stocks can be alluring, even to seasoned value investors. Warren Buffett (Trades, Portfolio) is no exception. Indeed, he fell for the siren song of revenue growth in 1989, investing in USAir.
In 1989, USAir was a fast-expanding airline company boasting rapid revenue growth. Over the course of the preceding decade, USAir’s organic expansion and aggressive M&A strategy had seen it transformed from a relatively small regional carrier into a significant national player. Seduced by this top line expansion, Buffett bought $358 million in preferred stock, which boasted a 9.25% dividend with a mandatory redemption after 10 years, as well as an option to convert into common stock.
Evidently, Buffett perceived USAir’s growth to be sustainable, and that it would be able to turn its impressive top line into an attractive bottom line over time. Unfortunately, this did not pan out as expected.
From ebullient binge to painful hangover
By the early 1990s, USAir was in serious trouble. Its decade-long acquisition binge had resulted in a painful financial hangover, one that threatened the company’s survival. As Eric Fontinelle observed in a 2019 article for Investopedia, USAir faced a problem common across the airline industry:
“Sometimes businesses look good in terms of revenue growth, but require large capital investments all along the way to enable this growth. This is the case with airlines, which generally require additional aircraft to significantly expand revenues. The trouble with these capital intensive business models is that by the time they achieve a large base of earnings, they are heavily laden with debt. This can leave little left for shareholders, and makes the company highly vulnerable to bankruptcy if business declines.”
By 1994, Buffett’s bet looked disastrous. USAir was on the verge of insolvency and was no longer able to pay its preferred divided. The Oracle did not attempt to conceal his displeasure, nor did he attempt to obfuscate blame for the decision. Instead, he addressed the issue head on during Berkshire’s 1994 shareholder meeting, acknowledging his mistake. He prepared investors for what he said would be an “enormously tough negotiating job” as Berkshire attempted to extract itself from the worst of the situation.
A harsh lesson in industry economics
While Buffett made a significant mistake in investing in USAir in the first place, he ended up getting out of the situation with his skin intact. This was more due to good fortune than skill, as he was able to sell into a 1996 industry-wide rally. Buffett understood this fact better than anyone, and the fact that he escaped unscathed did not change his opinion of his initial USAir investment. Indeed, when asked years later whether he would have done anything in his life differently, Buffett was unequivocal:
“I would really do almost exactly what I have done except I wouldn’t have bought USAir.”
Disclosure: No positions.
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