Thursday, November 20, 2008

The Warren Buffett Way: Chp 6 Part 6: Fixed-Income Marketable Securities

USAir Group:

In Aug 1989, Berkshire Hathaway invested $358 million in convertible preferred shares of USAir Group. These shares paid a yield of 9.25% and could be converted into USAir Group's common shares at a price of $60 per share. When Berkshire made the investment, the USAir common shares were trading at $50 per share. If Berkshire did not convert into common shares, USAir Group would have to redeem the convertible preferred shares within ten years.

USAir Group was earning 14% return on equity from 1981 to 1988 and seemed to have good business economics working in its favor during this time period. Warren was optimistic but not certain about the future economics of USAir and so he structured the investment in convertible preferred shares to give added downside protection to Berkshire's investment but also provide the opportunity to participate in upside of the company if things went well. Buffet wrote that because of his lack of a strong conviction about the airline business, he structured the investment differently compared to when he buys into a company where he is convinced it will continue to enjoy great economics.

As it turned out, the airline business is one of the worst businesses to invest in. The airline companies started to compete viciously on price in order to boost market share. Bankrupt airlines were selling tickets at less than cost. Airlines were hampered by large fixed costs and overcapacity and this led to one of the worst years on record for the industry in 1991.

Buffett commented that "the problem in a commodity business like the airlines, is that you are only as smart as your dumbest competitor". Healthy airlines were suffering from the unprofitable practices of airlines that were going out of business. Buffett commented that he was very surprised to observe just how cutthroat airline executives were behaving at that time and how that exacerbated the industry's problems.

Overall, Buffett acknowledges that the investment in USAir was not a good one. He structures deals as preferred convertible shares to provide added capital protection when he feels it is necessary. However, even with the downside protection, Buffett is making the investment for the upside, and so if Berkshire doesn't get the chance to convert convertible preferred shares into common shares, the overall investment will be considered poor. The yield on a preferred convertible share like USAir group was 9.25%, which was far below the average return on investment for Berkshire Hathaway at that time.

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