“We paid too much for Kraft. … It is a wonderful business, but you can pay too much for a wonderful business.”
— Warren Buffett at May’s Berkshire Hathaway shareholder meeting
“[3G Capital has] more of a taste for leverage than we do and more of a taste for paying up, but … they’d be way better operators than we would.”
— Charlie Munger, same meeting
Warren Buffett is worshiped as the world’s greatest investor. Tens of thousands of value investing devotees make the annual pilgrimage to Omaha, Nebraska, to attend his shareholder meeting. The key attraction is to absorb nuggets of wisdom from Buffett and brilliant business partner Charlie Munger.
Buffett has affectionately labeled the annual Berkshire Hathaway meeting as the “Woodstock of capitalism.” The most recent meeting took place a few weeks ago, and 88-year-old Buffett and 95-year-old Munger continued to display their sharp investment thinking to the rapt audience.
A hot topic of discussion was Kraft Heinz (KHC), now considered one of Buffett’s worst investing mistakes. In February, KHC, one of Buffett’s largest holdings, announced a massive $15 billion asset write-down, in effect acknowledging that the brands acquired when Heinz bought Kraft in 2015 were worth much less than it originally thought.
The company also sharply reduced its dividend, and even announced that the Securities and Exchange Commission was looking into its accounting practices. KHC stock fell an astonishing 27% in a single day, inflicting a whopping $4 billion loss to Buffett. Several investment analysts consider KHC to be Buffett’s biggest investing mistake.
Adding to the controversy of the Kraft Heinz debacle was the role of Buffett’s partner in the deal, the Brazilian private equity firm 3G Capital. 3G had previously achieved spectacular returns in buyout deals such as beer giant Anheuser-Busch.
Like Buffett, 3G’s investing formula focuses on companies with legendary consumer brands. Unlike Buffett’s gentle, grandfatherly image, however, 3G brings ruthless operational cost cutting to bear. The company’s “zero-based budgeting” mantra slashes costs.
At KHC, the company laid off thousands of employees and sharply boosted profit margins. 3G is often accused of neglecting brand building and research, a charge the company strongly refutes. Despite these aggressive actions, Kraft Heinz’s stock price fell by nearly half from its highs.
When studying great investors, it is often insightful to learn how they think about their mistakes — even more than their successes. Buffett and Munger are always known for their candor and humility in acknowledging their (rare) mistakes.
The courage to acknowledge and analyze mistakes is a crucial skill for all investors to develop. So how do Buffett and Munger view their errors in Kraft Heinz?
First and foremost, they admit they paid too much when 3G/Buffett-controlled Heinz bought Kraft in 2015. By some measures, the firm paid 25 times earnings for Kraft — a rather high price-to-earnings multiple.
This high price was especially eye-popping because many of Kraft’s brands, such as Jell-O, Velveeta and Kool-Aid, have been declining as consumer preferences migrate toward healthier, less processed foods.
As Munger politely hinted, the 3G partners also had a “taste for leverage” — basically juicing acquisitions with debt. In the low interest rate environment, many companies like KHC racked up massive amounts of debt.
In good times, high debt generates spectacular returns. But when operations disappoint, high debt can cause havoc. That’s what happened at Kraft Heinz.
Credit rating agencies such as Moody’s and Standard & Poor’s slashed KHC’s ratings close to junk bond status. The risk of further deteriorating creditworthiness forced KHC to sharply cut its dividends to shareholders.
While acknowledging the error, Buffett continues to view Kraft Heinz as a wonderful business. His litmus test for a high-quality business is “return on tangible assets” — a measure of how much profit a company can produce from the capital put into the business.
Kraft Heinz — with its storied brands — gushes cash from its stable of brands with only minimal capital deployed. While acknowledging that the competitive advantages of these brands has faded somewhat, Buffett indicates that sales have only dipped a couple percent.
In other words, Buffett and Munger do not believe that Kraft Heinz’s moat — its enduring competitive advantage — has dried up.
Despite the sharp declines in KHC’s stock price, Buffett and Munger remain calm and stoic about their investments.
Munger’s concluding words on the Kraft Heinz experience: “It didn’t work so well. It happens.”