Buffett, Berkshire, BYD and The Greater Fool Theory in Practice

BYD, the Chinese automaker whose name stands for “Build Your Dreams,” couldn’t be more aptly named.

A Chinese rags to riches story, its shares were given the good housekeeping seal of approval several years ago when Warren Buffett bought a 10% stake after his notoriously dour, skeptical (and brilliant) business partner, Charlie Munger, convinced Buffett that the company was not just a car company, it was an engineering marvel with a shot at world domination thanks to breakthrough battery technology.

Here’s how Munger defended the unusual investment—unusual for Buffett, who prefers low-technology to high-technology, and closer-to-home rather than halfway around the world—at the Berkshire Hathaway annual shareholder meeting two years ago:

“BYD, while its founder is only 43 years old, it’s not some early stage venture capital company, it’s one of the world leaders of rechargeable lithium batteries… From a standing start of zero he created the best selling model in China. This is not some unproven, highly speculative activity—it’s a damn miracle….”

And Munger, whose distaste for con artists and unproven business models is as well known as his dry wit (read “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett” for some fun examples, didn’t stop with encomium for BYD—he applied it to the entire country:

“You get a remarkable aggregation of human talent, which when unfettered by the wrong kind of government, they succeed mightily—when they came to this country as coolies, slaves, they would leave and become the most important people in the town, so these are a remarkable people.”

Of course, Munger was speaking two years before a likewise remarkable number of Chinese scams went public in the U.S., thus paying back, it might be said, some small part of the debt owed by the American railroads to their ancestors.

But if Munger’s naïve-sounding enthusiasm was premature, it was earnest, and based in large part on the chance for BYD’s supposedly revolutionary battery technology to help solve the great problem of how to store wind and solar-powered energy so it can be used when and where it is actually needed, as opposed to the Mohave Desert:

“These lithium batteries are a remarkable technology, we need them. I know it looks like Warren and I have gone crazy, but I don’t think we have…

“It may be a small company but its ambitions are large, and I don’t wanna bet against 17,000 Chinese engineers led by Wang Chuanfu I would be amazed if great things don’t happen here.”

Now, great things did indeed happen at BYD. In this decade alone, sales grew almost 40-fold, gross profits 20-fold, and pretax income 15-fold.

And the share price really took off after Berkshire invested a quarter-billion U.S. dollars in the company in 2008.

Technically, of course, it was MidAmerican Energy Holdings that acquired the stock, buying 9.89% of BYD for $8HK per share. And in what might now look like a giant red flag for Berkshire shareholders, it was MidAmerican’s CEO at the time, David Sokol, who went to China to look the company over before Buffett approved the investment (Munger recused himself—appropriately—from the decision-making, because his family had owned BYD shares for some time, a fact Sokol later tried to use, lamely, in his own defense after making undisclosed purchases in Lubrizol shortly before Berkshire announced a deal to acquire that company).

Unfortunately, Sokol may have done Buffett no favors in encouraging the BYD investment, for while BYD shares soared immediately after the announcement, reaching $88.40HK—10 times Berkshire’s cost—they have since returned to earth ($15.40HK last sale) after a series of missteps, including missed sales forecasts in the bread-and-butter car business, an 88.6% profit drop in the most recent half-year results, and a series of missed deadlines for delivery of the company’s revolutionary electric car.

This last is most worrisome for Munger’s optimism, which he maintained when asked about BYD’s setbacks at the most recent Berkshire shareholder meeting:

“Any company that tries to move as fast…is going to have its glitches…I’m quite encouraged…”

But we would not be so sure, particularly after asking an acquaintance from a large and prosperous US-based company, which has been making car batteries for almost 100 years, about BYD’s so-called revolutionary technology.

The acquaintance shrugged. “We don’t know much about it.”

“You guys make batteries. How come don’t you know?” “We don’t work with them. They make everything themselves. Everything. We don’t know what their technology is.”

“Well, what do you think it is?”

Another shrug. “Batteries hold a charge. It’s how you put them together that makes them better or worse. We don’t know what they do.”

“Well, what do you think they do?”

He speculated that part of the answer lies in the fact that the expected life of a car battery in China is shorter than in the U.S. “They might only get five years out of it. We build ours to last 10 years, which means they’ll last 15. But what they’re doing in lithium, we don’t know.”

Thus far, the “margin of safety” by which Warren Buffett lives (read “Secrets in Plain Sight” for the meaning behind this phrase), has protected Berkshire Hathaway from an embarrassing loss on its BYD investment.

But while speculation rages that Berkshire will up its stake in the company, the speculation is dead wrong.

Warren Buffett is no fool: he can read a balance sheet, and he can read a cash flow statement…and he could have easily bought all the new BYD shares he wanted when the company offered them recently on the Shenzhen stock exchange, supposedly for “research and development.”

Against all odds—the weak sales, the State Department cables describing BYD’s alleged copycat cars, and the delayed electric car introduction—the BYD offering was 21-times oversubscribed.

The greater fool theory lives.

Jeff Matthews

Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”

(eBooks on Investing, 2011) Available now at Amazon.com

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.