Future Shock: Warren Buffett and Berkshire May Fall Into the Kraft Heinz Trap Again and Again

March 1, 2019 by Jon C. Ogg

Warren Buffett and Berkshire Hathaway Inc. (NYSE: BRK-A) have taken a serious beating on the huge stake in Kraft Heinz Co. (NASDAQ: KHC). With many investors having considered Buffett to be the best or among the best long-term investors of the modern era, it might be easy to dismiss this as a one-off or irregular outcome. Unfortunately, that just doesn’t add up in the case of Kraft Heinz. Investors should be concerned that the trap Buffett fell into here is one that he — and his successor(s) — could easily fall into many times in the future.

Buffett looks for several criteria in his big investments. He loves the so-called wide moat. Buffett, while not paying a dividend to Berkshire Hathaway shareholders ever, loves dividends. He loves companies with long-term operating histories that span decades. He loves coming in as a financial backer during periods of distress. And Berkshire Hathaway likes to have influence inside of a company.

Buffett’s shareholder letter to investors came with a previously unheard of $25 billion quarterly loss. If you want proof that Buffett and Berkshire Hathaway will make big investments into public companies without acquiring them, the latest shareholder letter states: “Many stocks have offered far more for our money than we could obtain by purchasing businesses in their entirety.”

Berkshire Hathaway’s annual shareholder letter addressed the write-down in Kraft Heinz in the very first paragraph. The company took a $3.0 billion noncash loss from an impairment of intangible assets that were pointed out as “almost entirely from our equity interest in Kraft Heinz.”

On having influence in companies, the annual shareholder letter discussed groves and facets of the company in the grand scheme of things. One of the top categories of Berkshire Hathaway’s business ownership is having large stakes in companies in which the company shares control with other parties. The portion of the after-tax operating earnings of Kraft Heinz is 26.7%. If another “whale of a deal” fails to materialize, it seems logical that Buffett or his successors would do another deal like it did with 3G. It has such agreements in place for its investments into Berkadia and Electric Transmission Texas, and also in Pilot Flying J. Buffett also announced his retirement from the Kraft Heinz board of directors in early 2018, and he has encouraged his portfolio managers to take board seats in other large investments.

Buffett also considered the Kraft Heinz investment as deeper than its top 15 investments:

We exclude our Kraft Heinz holding – 325,442,152 shares – because Berkshire is part of a control group and therefore must account for this investment on the “equity” method. On its balance sheet, Berkshire carries its Kraft Heinz holding at a GAAP figure of $13.8 billion, an amount reduced by our share of the large write-off of intangible assets taken by Kraft Heinz in 2018. At yearend, our Kraft Heinz holding had a market value of $14 billion and a cost basis of $9.8 billion.

While Berkshire Hathaway doesn’t pay a dividend itself, it is undeniable that Buffett loves dividends. All the top holdings of Berkshire Hathaway pay dividends. Kraft Heinz had raised its dividend from 2015 through 2017, but the company dropped a bomb on investors by saying it would lower its dividend. The reality is that Buffett believed there was plenty of earnings coverage to support the dividend. In an interview on Monday, Buffett admitted that the company overpaid and that there was too much debt. Remember that the markets were basically giving away debt for free, something that is no longer the case.

Kraft Heinz also previously had a wide moat, meaning it could easily defend its brands from competition. That was very true in the years and decades past. But — it was. In the modern era of a Whole Foods and the move to more natural foods, Kraft Heinz is full of many brands and products that just do not resonate with grocery store shoppers today. Sure, it has natural and organic options, but those simply cannot make up for the full spectrum of prepackaged foods that the company sells. The wide moat of yesteryear has not been eliminated but it has been narrowed.

Another trend that has had an impact on Kraft Heinz and other branded products is that grocery stores have expanded their private-label efforts. These often prove to be more profitable sellers for big grocery stores than reselling the brands of others. And in many cases, the choices can be healthier.

Buffett is no stranger to calling it like he sees it, even after the fact. He once believed in a huge investment into IBM, but he killed it before the real drop happened in the share price. For now, Berkshire Hathaway will keep its stake in Kraft Heinz.

Buffett has a checklist of criteria for buying stocks. Kraft Heinz might not fit that bill today, but it has done so historically. There is no reason to believe that there are many other companies Buffett has on his radar wherein the business environment could change rapidly around an investment in particular.

Buffett also loves simplicity and scale. It is undeniable that Kraft Heinz has both scale and simplicity. That hasn’t kept the company from its problems now and ahead. And here is how the Kraft-Heinz deal looked at the start of the Berkshire Hathaway investment.

Many more issues could be pointed out for why Buffett or his successors might easily make the same mistake in the years ahead as it did buying into Kraft Heinz. The reality is that investment traps are sometimes hard to avoid. That’s also been proven true for the man who has been the wealthiest person alive and who has been considered the world’s greatest long-term investor.

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