Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
Of all the lessons Warren Buffett has imparted in his annual letters to shareholders of Berkshire Hathaway (BRK.A 0.94%) (BRK.B 1.27%), few are as valuable as his excoriation of "turnaround" plays.
"Both our operating and investment experience cause us to conclude that turnarounds seldom turn," Buffett wrote in 1979, "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."
That Buffett said this more than three decades ago doesn't diminish its relevance today.
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A brick-and-mortar retailer that can't profitably match prices with Amazon.com and Costco isn't a turnaround play; it's a suffocating enterprise. A casual-dining restaurant with a stale atmosphere and processed ingredients will never be able to compete against the likes of Chipotle Mexican Grill and Panera Bread Company.
The economics in both cases simply aren't present, regardless of how hard a company's management tries to persuade investors otherwise.
"We react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures," Buffett wrote in 1983. "The projections will be dazzling -- the advocates will be sincere -- but, in the end, major additional investment in a terrible industry is about as rewarding as struggling in quicksand."
Given this, it's ironic that much of Buffett's warnings about turnaround plays serve as the preamble to why he invested in them.
The quote at the top of this article was part of a conversation about GEICO, which Buffett doubled down on in 1976 just as the company seemed destined for failure thanks to loose underwriting standards in the previous decade.
The same can be said of American Express, which Buffett invested close to one-quarter of his assets in 1964, the year a massive fraud at one of its subsidiaries threatened an "enormous" loss that, by American Express' own admission, was "more than we had."
And ditto for Buffett's 1990 investment in Wells Fargo during a real estate disaster that was unmatched in severity until the financial crisis of 2008.
But unlike a traditional turnaround play, each of these companies had something unique and salvageable; they were phenomenal businesses with wide competitive moats and exceptional underlying economics.
Thanks to GEICO's cost structure -- at the time, it spent $0.15 of each premium dollar on expenses whereas other insurers spent an average of $0.24 -- it could charge less than competitors and be more selective about its customers. American Express had a near-monopoly in traveler's checks at the time. And Wells Fargo, while experiencing a temporary hiccup, was led by two of the finest bankers in American history: Carl Reichardt and Paul Hazen.
The takeaway here is as important as it is shrouded in nuance: Turnaround plays should be avoided unless there's compelling evidence the underlying business, while fighting through hard times, remains intact and is fundamentally sound.
