The Lessons of a Lousy Business
The Lessons of a Lousy Business
Pulling Dempster Mill out of the fire left scars on Warren Buffett that, while painful, nevertheless prepared him to paint his masterpiece with Berkshire Hathaway
Warren Buffett often makes investing look easy.
His batting average would be the envy of anyone enshrined in Cooperstown.
At times, he even appears to possess a Midas touch of sorts — floating from triumph to triumph with nary a bump or bruise in between.
But that’s not exactly the whole story.
In fact, the very thing that honed Buffett’s ability to spot wonderful companies and identify undervalued investment opportunities was his hard-won experience dealing with the dregs of the business world.
At the Berkshire Hathaway AGM in 2017, he admitted that it was his firsthand experiences with “lousy” businesses that made him the investor he is today.
“If you want to be a good evaluator of businesses,” said Buffett, “you really ought to figure out a way — without too much personal damage — to run a lousy business for a while. You’ll learn a whole lot more about business by actually struggling with a terrible business for a couple of years than you learn by getting into a very good one where the business itself is so good that you can’t mess it up.”
“It certainly was a big part of our learning experience … Just seeing how little you can do about [a lousy business] and how IQ does not solve the problem and a whole bunch of other things. It’s a useful experience — but I wouldn’t advise too much of it.”
“It was very useful to us,” Charlie Munger agreed. “There’s nothing like personal, painful experience if you want to learn — and we certainly had our share of it.”
One of the most memorable examples of this “personal, painful experience” came when Buffett’s partnership took control of a failing windmill maker in 1961.
It’s not just one of the most interesting chapters of Buffett’s long career, but his time at Dempster Mill Manufacturing Co. imprinted several lessons on the young investor that he would apply to Berkshire Hathaway a few years later.
One of Warren Buffett’s first big investments so nearly ended in tears.
“If Dempster had gone down,” he said, “my life and fortunes would have been a lot different.”
Back in the late ‘50s and early ‘60s, business quality mattered much less than stock price to the devout Ben Graham disciple. And what appeared to be an outrageously low price is exactly what led Buffett to Dempster Mill Manufacturing Co., a windmill and farm implement maker based in Beatrice, Nebraska.
Buffett started buying shares for his partnership at $18 a piece — which was just 25% of the company’s book value. Eventually, he snapped up enough of them — at an overall cost basis of $28 per share — to take majority control of Dempster.
His prize? A front row seat to the dysfunction that caused Dempster to trade at such a low valuation in the first place. The quantitative metrics might have screamed BUY!, but the sharks were circling right beneath the surface. Sales had flatlined, unsold inventory piled up, and cash was in dangerously short supply.
Buffett tried to enact positive change without upsetting the apple cart — helpfully making suggestions as a member of the board — but that went nowhere. Dempster management paid lip service to the new owner’s ideas, but basically ignored them.
Before long, as Dempster continued its tailspin downwards, the bank threatened to seize unsold inventory as security against unpaid loans — and even rattled its saber about shutting down the whole company.
Staring disaster in the face, Buffett turned to Charlie Munger for help. And, thankfully, Charlie knew just the man for the job. “A good friend, whose inclination is not toward enthusiastic descriptions, highly recommended Harry Bottle for our type of program,” Buffett wrote to his partners in 1962.
Charlie knew that Bottle was not afraid of making tough (and unpopular) decisions. And that’s exactly what Buffett needed to put Dempster back on a sustainable path. In other words, the affable and conflict-averse Buffett needed a hatchet man.
Buffett and Bottle connected in Los Angeles in April of 1962 and, less than a week later, Bottle was in place in Beatrice. With a $50,000 signing bonus and Dempster stock options for his trouble. From Buffett’s perspective, no money has ever been better spent.
“Hiring Harry may have been the most important management decision I ever made,” he said later. “Dempster was in big trouble under two previous managers and the banks were treating us as a potential bankrupt.”
Bottle — who described himself as “a doctor of sick companies” — wasted no time in clearing out inventory, closing unproductive branches, laying off employees, and even raising prices on items where Dempster was the sole supplier. All of this combined to convert what had been stagnant inventory into a cash surplus.
A cash surplus that was deployed into an investment portfolio rather than throwing good money after bad in the windmill business.
No question: Harry Bottle played hard ball. His was not a Kumbaya-style of management. Some people don’t like that. But drastic times call for drastic measures.
(In a Christmas letter to employees, Bottle admitted that some of the things done to right the ship “were distasteful to all of us”.)
On one occasion, Bottle had a white line painted on the wall of Dempster’s warehouse ten feet above the floor. Then he told management that if he ever saw boxes of inventory piled up higher than the line, everyone working there (except the shipping department) would be fired. And, as time went on, he kept lowering the line.
Tough tactics — but they worked.
In only one year, Bottle completely transformed Dempster into a profitable operation.
1961: $166,000 cash vs. $2.3 million liabilities
1962: $1 million cash and stock vs. $250,000 liabilities
In 1963, Buffett decided to cash in and sell Dempster at a hefty profit. But, as Alice Schroeder details in The Snowball, it was not exactly a smooth process. When Buffett posted notice that the company would be sold, “Beatrice went berserk at the thought of another new owner that might impose layoffs or a plant closing on its biggest and virtually only employer.”
“The people of Beatrice pulled out the pitchforks,” wrote Schroeder. “Buffett was shocked. He had saved a dying company. Didn’t they understand that? Without him, Dempster would have gone under. He had not expected the ferocity, the personal vitriol. He had no idea that they would hate him.”
It all ended happily enough — with the town raising enough money to purchase Dempster and Buffett’s partnership nearly tripling its money on an investment that had one foot in the grave just a year earlier.
On paper, it looked like a walk-off home run for Buffett. But pulling Dempster out of the fire left scars on the young investor that, while painful, nevertheless prepared him to paint his masterpiece with Berkshire Hathaway.
I can almost picture Warren Buffett sitting in his office in 1963 for a postmortem of the whole Dempster Mill affair and jotting down three key lessons. Lessons that he would have the chance to apply just a couple of years later with Berkshire Hathaway…
(1) Don’t throw good money after bad
One lesson that Buffett didn’t learn was that you’re only supposed to take a free puff from a discarded cigar butt — not buy the whole thing.
In 1965, his penchant for super-cheap stock once again left his partnership in control of a dubious outfit — this time a failing New England textile concern called Berkshire Hathaway.
The dying domestic textile industry would not appear to be fertile ground from which a business empire would grow, but Buffett wrestled Berkshire’s costs under control and produced two unusually profitable years in 1965 and 1966. And, thanks to some large tax-loss carry-forwards, these profits were essentially tax-free.
Like with Dempster, this windfall was not reinvested into the company’s subpar normal operations — but, instead, parked in marketable securities. Which soon provided the capital to purchase game-changing acquisitions like National Indemnity and The Illinois National Bank and Trust Co. of Rockford.
And the rest, as they say, is history.
(2) Look for .400 hitters
There are some aspects of business that Buffett would rather avoid, thank you very much. Like firing employees or getting down into the trenches on a turnaround situation. Buffett’s experience with Dempster clarified — once and for all — that he was much happier allocating capital from his desk at Kiewit Plaza than actually running a company on a day-to-day basis.
The difference between Harry Bottle and Dempster’s previous leadership must have been a eureka moment for the young investor about the importance of management.
If he had the right person in place to sweat the day-to-day details — with little to no supervision — Buffett’s life would be so much simpler.
It was no surprise, then, that he soon added superstar CEOs like Jack Ringwalt of National Indemnity and Eugene Abegg of Illinois National Bank to the Berkshire pantheon — and has since continued to place a great emphasis on only acquiring companies that come with an exceptional manager in tow.
“We subcontract all of the heavy lifting in this business to the managers of our subsidiaries,” says Buffett. “In fact, we delegate almost to the point of abdication.”
(3) Some things are worth more than money
Warren Buffett’s decision to keep Berkshire Hathaway’s beleaguered textile operations — despite being awash in red ink — running for so many years never made much business sense. Outside those early profitable years, it was a constant drain on the company’s earnings and rarely showed any signs of life.
Any other business titan would have shut it down in short order.
But the Berkshire textile plants in small-town New England held the same kind of local significance as the Dempster factory did to Beatrice: the major source of employment for an entire downtrodden region.
I don’t think there’s any doubt that Buffett’s harrowing experience as Public Enemy #1 in Beatrice led to his decision to keep Berkshire’s textile operations going for twenty years after he took over. (Everything has its limits, though, and he eventually had to shut down the mills in 1985. By then, nobody could possibly blame him.)
You can still see the vestiges of this lesson today, as Buffett freely admits that he’s willing to hang onto mediocre subsidiaries simply because he likes working with their managers or because he enjoys owning that particular company.