Profiting From the Ashes of Warren Buffett's Big Mistake

In his 2013 shareholder letter, Warren Buffett admitted that Berkshire Hathaway Inc. made a big mistake. However, it’s in the ashes of that mistake that we find a Brookfield Asset Management Inc. in search of profits.

Aug 30, 2014 at 11:19AM

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Warren Buffett is regarded as one of the world's greatest investors. However, even great investors make mistakes, and Buffett is no different. In fact, he openly admits it when he makes a mistake.

That's just what he did deep within his 2013 shareholder letter where he wrote:

Most of you have never heard of Energy Future Holdings. Consider yourselves lucky; I certainly wish I hadn't. The company was formed in 2007 to effect a giant leveraged buyout of electric utility assets in Texas. The equity owners put up $8 billion and borrowed a massive amount in addition. About $2 billion of the debt was purchased by Berkshire, pursuant to a decision I made without consulting with Charlie. That was a big mistake.

Unless natural gas prices soar, EFH will almost certainly file for bankruptcy in 2014. Last year, we sold our holdings for $259 million. While owning the bonds, we received $837 million in cash interest. Overall, therefore, we suffered a pre-tax loss of $873 million. Next time I'll call Charlie.

The mistake Buffett admits to is that he did not consult Charlie Munger before he bought $2 billion worth of Energy Future Holding's leveraged debt. It's a mistake that cost Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B) $837 million. However, the bigger mistake might have been selling too soon.

In fact, that's just what another well respected value investor, Brookfield Asset Management (NYSE:BAM), is now implying. In Brookfield's second-quarter shareholder letter CEO Bruce Flatt spent some time discussing Energy Future Holdings, which did in fact file for bankruptcy this year. Flatt went so far as to call it a great company, but one that's burdened with a very bad capital structure. Brookfield's view is informed by its presence as a major power generator across the U.S. with a large presence in Texas, where it is also the largest owner of malls and office properties.

In discussing Brookfield's investment in Energy Future Holdings Flatt said that,

As a result of these views, we have accumulated a very substantial amount of debt within the company power generation and distribution subsidiary in our private equity funds, and as one of the largest creditors have recently been in discussions about the future of EFH and its restructuring with other constituents.

We believe that EFH is critical to the infrastructure of Texas and that it has a great future. We intend to work with management to assist them to make EFH into a solidly financed company for the long term, and expect to become a major cornerstone investor in EFH when it emerges from bankruptcy.

Brookfield, which has a history of profiting from the ashes of companies that have been scorched by heavy debt balances is now seeking to profit from a company that even Warren Buffett bailed on. It's an approach that has been wildly successful for Brookfield in the past. Over the past two decades the company has generated a nearly 20% compound annual return for investors.

The bottom line here is that even Warren Buffett makes an investing mistake. However, in the case of Energy Future Holdings he might have actually compounded his original mistake of buying at the wrong prices by selling a great company too soon. At least that's what Brookfield Asset Management is hoping as it believes that Energy Future Holdings is a great company with a great future. Now that Buffett has bailed, it's hoping to generate large profits as it's investing in that great company at rock bottom prices in the hopes of generating real outsized returns for its investors as it orchestrates a turnaround. Only time will tell if it can beat Buffett at his own game, but given its track record in picking up companies out of the ash heaps I'd say it has a very good chance of succeeding. 

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Matt DiLallo owns shares of Brookfield Asset Management. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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