In May 1807, Samuel Blodget completed a canal and lock system that allowed boats to bypass the 54-foot high Amoskeag Falls near the town of Derryfield, New Hampshire.
A group of entrepreneurs soon realized the site’s potential.
Not only did the canal open up this once-remote region to commerce from the larger population centers of Concord and Nashua, but the falls themselves presented a key strategic opportunity.
The steady stream of water tumbling over the cataract generated enough horsepower to power a world-class textile mill.
Today, you won’t find Derryfield on a map; Blodget renamed the town Manchester after the city that was at the heart of Britain’s industrial and manufacturing revolution.
The name change proved apt. By 1912, cotton mills in the vicinity of Amoskeag covered more than 700 acres of land and comprised 8 million square feet of factory floor space. Churning out over 5 million yards of cloth per week, what became the world’s largest mill complex included a foundry, print shop, sawmill and fire department.
By the 1920s, cheaper competition from the southeastern US—especially North Carolina—began to erode the profitability of Manchester’s mills. And in the 1960s and early ‘70s, the region also began to feel the pinch of competition from lower-wage countries in Asia and Central America.
Although Manchester’s dominance of the textile industry waned, the mills still generated a profit from some specialized product lines.
I have a business proposition for you.
An experienced business manager in the textile trade believes he can turn around Manchester’s largest mill complex.
He’s already received significant concessions from unions and expects to cut costs by running the existing equipment instead of splashing out for modern replacements.
And because the mill is the area’s largest employer, local and state governments have expressed support for any effort to keep the operation going.
Although the mill operates at about 50 percent of capacity and continues to lose money, the logical strategy is to downsize operations and focus on draperies, home fabrics and other profitable products.
The struggling operation is unlikely to regain its former glory, but this approach would generate a reliable stream of cash flow over the next few years with minimal capital investment.
Even better, the US economy had just emerged from recession and the housing market had perked up, supporting demand for the home products that the mill produces.
And here’s the best part of all: The current owners will sell you the entire company for less than the cost of its working capital. In other words, you can purchase the entire operation at a discount to the value of its inventory, giving you everything else—the plant, machinery and real estate at this historic site—for free.
In other words, even if you can’t turn the mill around, you should be able to close down operations and sell it off piecemeal, more than covering your initial investment.
Does that sound like a good value proposition to you?
On April 28, 1975, Warren Buffett made what he’s called one of the biggest mistakes of his career: the purchase of Waumbec Mills Incorporated and Waumbec Dyeing and Finishing Company under similar terms.
The legendary investor planned to combine this business with Berkshire Hathaway’s (NYSE: BRK.A, BRK.B) legacy textile operations, extending its existing product line and benefiting from additional economies of scale.
Buffet had this to say about Waumbec Mills in his 1979 letter to Berkshire Hathaway’s shareholders:
Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing.
But the purchase was a mistake. While we labored mightily new problems arose as fast as old problems were tamed.
Both our operating and investment experience cause us to conclude that ‘turnarounds’ seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
Over the years, Buffett hammered this point home on many occasions. Early in his career, he focused on buying companies at bargain-basement prices below the cost of replacing assets, real estate and equipment. It was purely a numbers game; he paid little attention to the quality of the business.
Eventually, Buffett repudiated this approach, choosing instead to focus on quality businesses with no major competitive problems. He also shuns capital-intensive operations with undifferentiated products.
Although he bought the formerly great textile mill for a song, the company tied up Buffett’s capital and managerial efforts and ultimately produced returns that were far lower than what he could have achieved buying a more expensive but more profitable business.
Warren Buffett is widely regarded as one of the finest value investors in history. His investment mantra to “be greedy when others are fearful and fearful when others are greedy” has helped the Oracle of Omaha take advantage of numerous market panics.
In 2009, for example, Berkshire Hathaway acquired Burlington Northern Santa Fe Railway for about $85 per share, a significant discount to its 2008 high.
The same philosophy prevented Buffett and Berkshire Hathaway from getting burned during the 1990s tech boom and other market manias.
Buffett’s success has convinced many investors to mimic his approach to value investing.
The legendary investor’s stellar long-term track record has led to a proliferation of mutual funds, stock-screening software packages, trading services and portfolio management tools that claim to emulate the master’s strategies.
However, Buffett’s investment style is widely misunderstood. All too often, investors justify purchasing more shares of a losing stock by saying that they welcome the opportunity to buy additional shares at a bargain price.
This strategy—known as dollar-cost averaging—offers anxious investors the psychological comfort of denying their mistake in establishing the losing position in the first place.
A stock that has fallen out of bed isn’t necessarily a good value, even if its valuation metrics are below their long-term average. Nor does a low valuation make a stock a low-risk holding. Investing for the long term doesn’t mean that investors can ignore the business cycle with impunity.
Valuation metrics, economic analysis, chart patterns and financial projections are all valuable tools for investors. But don’t expect to replicate Warren Buffett’s strategy by running a computer screen that identifies stocks with a high long-term return on equity, low debt and a below-average price-to-earnings multiple.
Screens of this nature might be a good starting point, but Buffett’s strategy involves more nuance and complexity than buying stocks that look cheap and holding them for the long haul.
Over the past year, we’ve cashed out of several stocks in Energy & Income Advisor’s model Portfolios for significant gains.
I first recommended SeaDrill (NYSE: SDRL) in 2007, before the contract driller listed its shares on the New York Stock Exchange. And fracturing sand producer Hi-Crush Partners LP (NYSE: HCLP) was one of our top picks from the National Association of Publicly Traded Partnership’s (NAPTP) 2013 investor conference.
Many readers have asked whether these former favorites are good buys now that their stock prices have pulled back significantly.
A lot of other pundits have advised readers to back up the truck and load up on shares of formerly high-flying energy producers such as Continental Resources (NYSE: CLR), names that have already given up more than half their value this fall.
Their investment thesis: Many of these hard-hit producers trade at valuations last seen during the 2007-09 financial crisis and Great Recession, making them great long-term values.
If you’ve loaded up on former high flyers such as SeaDrill, Hi-Crush Partners and Continental Resources, you’ve placed your bets based on their past glory, not their present or near future.
Remember Buffett’s debacle at Waumbec Mills—some assets are cheap for a reason.
Although SeaDrill fetches about 0.6 times book value, the stock is far from a good value.
The company leases offshore drilling rigs to large integrated oil producers such as BP (LSE: BP, NYSE: BP), Exxon Mobil Corp (NYSE: XOM) and Royal Dutch Shell (LSE: RDSA, RDSB; NYSE: RDS A, RDS B).
After the Macondo oil spill in spring 2010, we pounded the table for SeaDrill, a company that had minimal exposure to the government-imposed moratorium on drilling in the Gulf of Mexico and stood to benefit from a tightening supply-demand balance for the modern ultra-deepwater rigs in its fleet.
In this environment, SeaDrill found itself in the catbird seat, with customers committing to increasingly high day-rates to secure the company’s advanced drilling rigs.
Like the Waumbec mills in the 19th century, SeaDrill enjoyed significant competitive advantages that fueled the company’s rapid growth. The selloff in the stock that occurred after the Macondo disaster represented an excellent buying opportunity; the panic stemmed from fear, not a fundamental shift in the offshore drilling market.
Those days are no more. Today, SeaDrill operates in a capital-intensive business and sells an undifferentiated product.
Although the company still boasts one of the largest fleets of modern deepwater drilling rigs, an influx of new capacity and reductions to producers’ capital expenditures have pushed this market into an oversupply. These headwinds started to emerge in fall 2013, long before global oil prices tumbled.
In this environment, SeaDrill’s former advantages no longer hold; overcapacity in the market has forced high-specification rigs to bid on less-lucrative work in shallower basins, where these units’ capabilities provide little to no incremental advantage. The day-rates earned by these vessels will continue to dropt.
Investors who buy SeaDrill for less than $10 per share can tell themselves that they got a fantastic price on a business that’s likely to remain under severe pressure.
Savvy value investors will find tremendous buying opportunities in the energy sector over the next 12 to 18 months—and lots of money pits.
Fools rush in. Bide your time and do your homework to identify the best bets among the downtrodden. Don’t try to be a hero and try to catch a falling knife; instead, wait until they’ve clattered to the floor and pick up the ones that can still cut it.
Finding success as a value investor requires patience, real analysis and an understanding of industry- and company-specific trends. Nostalgia and backward-looking stock screens won’t be of much use.
If you don’t believe me, just ask Warren Buffett.
Elliott and Roger on Jul. 26, 2018
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