Warren Buffett and the Body of his Work

 

All the passages below are taken from the book by Andrew Kilpatrick, “Of Permanent Value---The Story of Warren Buffett” It is an Updated and Expanded Edition, printed in 2001.

 

"COMMON SENSE IS GENIUS DRESSED IN ITS WORKING CLOTHES."-Ralph Waldo Emerson

 

From the beginning, common sense is the trait that has most characterized Buffett's body of work.

"We don't buy and sell stocks based on what other people think the stock market is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we are right. In other words, we tend to concentrate on what should happen, not when it should happen," he wrote in a Buffett Partnership letter, July 22, 1966.

Common sense may be the most important factor helping Buffett to make more money in the stock market than anyone; he is the only person on the Forbes 400 richest Americans list who got there entirely by investing.

"One piece of advice that I got at Columbia from Ben Graham that I've never forgotten: You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right. That's the only thing that makes you right," Buffett said at the Berkshire Annual Meeting in 1991.

         Buffett's corporate strategy often is, "hoping the phone rings." He wants bad news out quickly; good news will take care of itself. He wants red tape and meetings cut out in favor of by-the-seat-of-your pants judgments. He wants action, not paperwork. He likes people who want to manage a business, not one another.

         In the words of Ralph Waldo Emerson, "Common sense is genius dressed in its working clothes."

         Buffett's emphasis on common sense could remind one of Mark Twain's approach to common sense: "I would rather go to bed with Lillian Russell stark naked than with Ulysses S. Grant in full military regalia."

 

Stick To Your "Circle of Competence"

         Ben Graham, who liked to dance, once gave Buffett certificates to take dance lessons. Buffett never went to the classes. Apparently dancing is outside Buffett's "circle of competence."

         In the world of business, Buffett sticks to what he knows and what he can do. He does not try to do what he cannot. He knows he understands media, financial and consumer product companies and has concentrated his assets particularly in those areas over the years.

 

Mental Discipline

         You need mental discipline to stick to what you're about and not go down some side trail nor take chances where things aren't your game. Buffett's friend, Jack Byrne, once recalled a story about Buffett's attitude toward betting:

 

The bet was the kind that rich golfing buddies like. Investment wizard Warren Buffett's $10 against $20,000 that he wouldn't score a hole-in-one over the three-day outing.

Eight of us had gotten together to play Pebble Beach, and in a loose moment, after dinner and a couple bottles of wine, I offered the bet. It was meant as a fun thing, and the other six took me up on it. Everyone except Warren.

Well, we heaped abuse on him and tried to cajole him---after all, it was only $10. But he said he had thought it over and decided it wasn't a good bet for him. He said if you let yourself be undisciplined on the small things, you'd probably be undisciplined on the large things, too. (Chicago Tribune, December 8, 1985)

 

It doesn't hurt to be gifted either. The same story quoted Byrne:

 

He works at his trade awfully hard. And he has the most amazing memory I've ever encountered. Someone can bring up some obscure company, and what Warren knows about it will leave you slackjawed. He'll tell you the number of shares outstanding, the square footage of retailing space they have in Minneapolis.

Let me tell you. I follow the insurance industry pretty closely and Warren still will bring up important facts from some annual report that I've missed completely.

 

Although a stratospheric IQ probably accounts largely for Buffett's success, so too does plain old hard work. He's a combination of a sort of genius squared who pushes very hard. Those who work with him in his office say he has a great ability to focus hard, to concentrate completely on the task at hand. "He focuses very hard on the task at hand and then he focuses very hard on the next task," said a Berkshire employee.

 

Be Your Own Reporter

         Buffett's unique ability is to separate what's true from what merely seems true. The practical manifestation of Buffett's ability in the stock market is to buy a good out-of-favor business. Buffett wants to buy a great business---or, in his words, a "wonderful business," at a time when its price is temporarily depressed due to some unwarranted stigma, fear or misunderstanding about the company.

         His purchases of American Express, GEICO, and Wells Fargo are examples. He bought American Express the first time when scandal surrounded that high-quality business and he bought Wells Fargo when it seemed its real estate loans might cripple the bank.

Being your own reporter means keeping up not only with the business you own, but also with competitors.

         At the Berkshire Annual Meeting in 1993, talking about the number of annual reports he reads, Buffett said, "And we'd be interested not only in any business that we own or are thinking of owning, but we'll be interested in reading their competitors.' I get the Bic Annual Report. I get the Warner-Lambert Annual Report to read about Schick. I get the Pepsico Annual Report. I get the Cott Beverage report. Cott Beverage makes more of the generic colas than anybody---at least in this hemisphere. I want to know what competitors are doing and talking about, what results they are getting and what strategies seem logical to them."

 

The Market is Not Always Efficient

         One notion that Buffett has shot holes through is the so-called "efficient-market" theory, which holds that every stock price is fairly priced because it already incorporates all known information about a company. The theory argues there's nothing to be gained by digging for new information.

 

Here's a thought that's analagous to Buffett's thinking about supposedly efficient markets: Two University of Chicago professors were walking down the street when one of them spotted a $100 bill lying on the sidewalk. "Hey, I think that's a $100 bill. Let's stop and pick it up," said one. "No, don't bother," replied the other. "That's not a real $100 bill. Since the market is efficient, a real $100 bill would have been picked up long ago." (Business Week, November 9, 1998)

 

According to the theory, since market prices at any given moment reflect all knowledge, the prices in the stock tables are the right prices. There are no bargains. The efficient-market theory says it's useless to try to outperform the market. Further, all future prices are subject to new, random information. At Berkshire's Annual Meeting in 1997 Buffett summarized his problem with advocates of an efficient market theory. "Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient."

         Many times Buffett has said, "It has been helpful to me to have tens of thousands turned out of business schools taught that it didn't do any good to think."

         Buffett often has joked that he wished more people would subscribe to the efficient-market theory so there would be fewer investors trying to figure out where the market has gone astray, where it does not reflect intrinsic value. It is in this murky arena that Buffett thrives, doing his lab work, capitalizing on fear and uncertainty while other investors are panicked into selling. That's how Buffett has become the second richest person in the world. Buffett thinks the theory is absurd, that it's better to turn the theory on its head, believing that the market can be inefficient, subject to fear and greed, fads and herd behavior---in short---subject to temporary insanity.

         Buffett does not maintain the market is always wrong. Indeed, it is often correct, he says. The trick is figuring out when, on occasion, it's wildly off base.

         "The man is a living refutation of the random walk theory," says Newsday's Allan Sloan.

         Buffett wrote an article for Barron's (February 23, 1985), outlining the investment results of a number of value investors who have consistently beaten the market. What one has to wonder about the efficient-market theory is how anything can be efficient when fear and greed infect Wall Street. Although that is not a mathematical refutation of the theory, there is still a sure way to refute it---just present the record of Buffett, who has consistently beaten the market over a lifetime.

         And consider that the market dropped 23% on October 19, 1987. That was the day they were throwing rocks at the stock market. But did the underlying economic world change 23% that day?

 

Buffett says: "When the price of a stock can be influenced by a `herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical." ("The Superinvestors of Graham-and-Doddsville," Hermes, Fall, 1984)

 

Buffett has said: "I'd be a bum on the street with a tin cup if the market were always efficient."

 

Price vs. Value

         Early on, Buffett's common sense led him to the simple premise that there is a difference between price and value. "Price is what you pay. Value is what you get." Ben Graham taught Buffett that concept.

         "Price does not imply that you got a thing equal in value to what you paid," Buffett Wannabe George Morgan wrote in Buffett and I Have Zero in Common: He Just Has More of Them Than I Do. Morgan also recalls a story told by Joe Garagiola:

         "Yogi Berra once told his friend Whitey Ford that he had just purchased a valuable house. Ford replied that he was familiar with the house and didn't think it was very valuable. Yogi responded with, `You may not think it's valuable now but you will after I tell you the price."'

         In a different way, Buffett seeks to buy a valuable house for a bargain price.

         People who have talked with those who have traded with Buffett describe him as very tough on pricing. "You know people who want to argue about a 32nd on a trade, well, he'll try to get the last 100th out of it," is one description of Buffett's focus on price.

         However, Buffett does not like to haggle. Buying or selling, he has one price, then it's take it or leave it.

 

Inflation

         Another part of Buffett's approach is to keep in mind what havoc inflation can wreak. An investment that can't beat inflation is useless. Only gains in purchasing power count.

         Buffett says, "If you forego the purchase of ten hamburgers and place those dollars in the bank for two years, you will receive interest which after tax will buy two hamburgers. Then at the end of the two years, you will receive back an amount equal to the number of dollars in the original deposit but which will only purchase eight hamburgers. You will feel richer but you won't eat richer."

         The hamburger parable is an example of Buffett's genius. You do not have to read a textbook or some economist's bloated explanation about inflation. It's all there, simply put, in one paragraph.

         And, said Buffett at the Berkshire Annual Meeting in 1986, about valuations: "I always crank through something for inflation."

 

Compounding

         Something else Buffett understands is the beauty of compounding. Buffett ruminates, "$1,000 invested at 10% for 45 years grows to $72,800. At 20% the same $1,000 becomes $3,657,262. This difference strikes me as a significant difference that might conceivably arouse one's curiosity."

         Albert Einstein once said: "What is the greatest miracle known to man? Compounding!" And Bernard Baruch once said: "Compounding is the eighth wonder of the world."

         George Morgan's example of compounding is this: "You start a company by issuing 100 shares at $10/share. The company is now worth $1,000 (equity). During your first year, you make a $200 profit, which is equal to 20% of your company (equity). You put your profit back into the company and it is now worth $1,200 (in equity). Next year, you experience an additional 20% return on equity which is now $240. This increases your total equity to $1,420. Do this for 79 years and the original investment (equity of the shareholders) of $1,000 is now worth (equity) $1,800,000,000."

         Berkshire, since 1965, has averaged a 24% annual return on equity. That is how Buffett has pulled off his monumental achievements.

         Ben Franklin once wrote of compounding: "...`tis the stone that will turn all your lead into gold .... Remember that money is of a prolific generating nature. Money can beget money, and its offering can beget more."

 

Good vs. Bad Businesses: Company A vs. Company E

         In addition to nuggets of wisdom, Buffett really does know almost all the people, the numbers, the facts, and even the minutiae involved in an investment decision. He makes a dogged, detailed study. But the art of investing centers on the search for value---not gimmicks, not hunches. For all his intellectual powers, Buffett long has been boiling things down to investing in good businesses at reasonable prices, rather than bad or so-so businesses even at a bargain basement price.

         No smokestack industries please. There's too much chance for high costs and obsolescence.

         On occasion, Buffett has talked about good and bad businesses and has described their characteristics, often talking about a hypothetical "Company A and Company E."

         Companies A&E? "That's Agony and Ecstasy," Buffett once told Kiewit Construction's Mike Faust, the assistant to Walter Scott, head of the huge privately held conglomerate. Buffett has owned companies in both categories.

         But Buffett has had a lot more Company E's than Company A's and now runs one of the greatest Company E's on earth.

         In some ways Buffett adds value to a business when he buys it because then it's not just a business. It's a Berkshire business. Kahn Brothers' Irving Kahn says, "His skill is finding private companies that are revalued when public."

         So many times Buffett has bought an unrecognized business and given it a halo with just a one-paragraph mention in the Berkshire annual report.

 

Old-Fashioned Values

         If great achievement comes from both natural talent and the environment of one's upbringing, then Buffett has it all. No one disputes Buffett's natural mental gifts, his recall for facts and numbers, his energy.

         But he also had advantages: growing up in a family engaged in the commercial and political affairs of its community, and growing up in a place best known for its economic pursuits---mainly meat packing and grain handling in the early decades of this century and now a telemarketing and hotel reservations center. Omaha is no longer a place where the buffalo roam. But tall corn still grows outside the city unmarked by the complaints of bigger cites: rush hour traffic, pollution and high crime rates. Omaha today is also an insurance center. It all provided the right locale for a passionate businessman like Buffett.

         Omaha is also near the Strategic Air Command (SAC). Forbes (May 31, 1999), listing Omaha as one of the best cities to live in, said of the U.S. Nuclear command: "Shielding Warren Buffett?"

         Omaha folks are straightforward, open, friendly and businesslike, just as Buffett himself is open and very quick to respond to matters as they arise. He takes his calls. He responds as quickly as possible to mail. He does not leave people hanging for answers. There is no show, pretense or dissembling. Old-fashioned values prevail. Honesty and decency are assumed.

         With Berkshire's financial clout, Buffett could easily pull a lot of tricks---threaten takeovers, corner markets or create market turmoil to his advantage. But there's none of that. Buffett does not go where he's not wanted.

         He once took a relatively small stake in a company and expressed interest about a larger stake to the company. A top executive told Buffett the company wanted to buy back its stock and asked him not to buy any more shares. Buffett stopped on the spot and did not buy another share.

         Had Buffett wanted he could have bought the whole company; instead he honored the wishes of management.

 

Look Around You; Work on What's on Your Desk

There's little doubt Buffett subscribes to Theodore Roosevelt's saying: "Do what you can, with what you have, where you are."

Omaha provides a stable, comfortable home for Buffett where he can operate without a lot of distractions. "Successful analysis, like successful investment, requires a fairly rational atmosphere to work in and at least some stability of values to work with," Ben Graham wrote in Security Analysis.

Buffett took on the qualities of his traditionally agribusiness and insurance community---hard work, honesty, a pioneer's independent streak and most of all common sense---and mixed them thoroughly with his natural gifts to become both an original personality and the world's best investor.

Buffett appreciates Omaha, which has a metro-area population of 700,000 and which has produced down-home folks, and famous folks (such as Ted Sorensen, Dick Cavett, Dorothy McGuire, Fred Astaire, who was the son of an Omaha brewery worker, Montgomery Clift, Malcolm X, Gerald Ford, Bob Gibson, Paula Zahn, Nick Nolte and Marlon Brando as well as Academy Award winner Henry Fonda and NFL Hall of Famer former Chicago Bears running back Gale Sayers, who both attended Central High School in Omaha.

Buffett understands that Omaha has contributed to his success: "I can be anywhere in three hours---New York or Los Angeles.. .This is a good place to bring up children and a good place to live. You can think here. You can think better about the market; you don't hear so many stories, and you can just sit and look at the stock on the desk in front of you. You can think about a lot of things." (Supermoney, Adam Smith, p. 182)

Not everyone is clear that Buffett is from Omaha. Here's a quote from a wire service story: "Buffett's office in Kansas City said he could not be reached to elaborate."

 

Good Management

Buffett has earned success through a love of what he's doing, an ability to keep on learning as well as through extraordinary day---today persistence. But for all his ability, he knows what he cannot do. "I don't run the businesses. Can you imagine me doing what [Borsheim's former president] Ike Friedman does?" he has said.

Buffett takes a common sense approach about letting others run the businesses, but he does assert himself in some ways. "I set the price on See's Candy every year. I set the circulation prices at The Buffalo News. There are certain things, with certain managers who want me to do it, in which it's better to have it centralized.

"Because a person who is too close to a business probably would not tend to price as aggressively as they can," he told Columbia business students on October 27, 1993.

 

Value Investor, Part Contrarian, Deal-Maker

Buffett is part value investor, part contrarian and part deal-maker. He's shown it's better to buy a great business when fickle Mr. Market values it unreasonably low.

It is Buffett's genius that leads him to simple solutions. In The Money Masters (pp. 40-41) John Train relates the following story: "Buffett once met a leading executive of a capital-intensive business giant at a time when the company was selling in the market for one quarter of its replacement value."

Buffett asked the executive, "Why don't you buy back your own stock? If you like to build new facilities at one hundred cents on the dollar, why not buy the ones you know best and were responsible for creating at twenty-five cents on the dollar?"

Executive: "We should."

Buffett: "Well?"

Executive: "That's not what we're here to do."

It is through rationality that Buffett, sometimes at the expense of less rational people, has made investing his art form. There is common sense, even genius, but there is an overriding ingredient: a love of what you're doing.

"Buffett loves the investing process in the same way an artist loves his creation," says Omaha stockbroker George Morgan.

Buffett is intensely passionate about what he does. One version of his supposed employment application form other than, "What's your IQ?" is, "Are you a fanatic?"

Genius, love of what you do, and common sense. Stir well and the result can be huge success.

KISS---"Keep It Simple, Stupid" is another Buffett tenet. His passion is for analysis and problem-solving. His aim is to simplify.

 

No Stock Splits

It makes no sense to pay dividends automatically or split a stock. Berkshire did have a back-door split in 1996 (see Chapter 178). Buffett has said there's no sense splitting because transactional costs would be greater and it would draw more speculation to the stock. Besides, he says, splitting the stock is like asking for a pizza to be sliced into five pieces because you can't possibly eat seven.

"I disagree with him about not splitting the stock," says Dr. Wallace Gaye of Durham, New Hampshire. "One, I don't think the transactional costs are less. And I don't think there would be speculation if he split it 10 to 1... but that would make it easier to deal with. My dad left $5,000 for each kid and with that I can't buy a share of Berkshire for them," Dr. Gaye said.

Michael Assael thinks total transactional costs and speculative turnover are less on the unsplit stock, but he also thinks there may come a point when the shares becomes too unwieldy.

"Hopefully, if Berkshire's price passes Pluto and the shares look as though they are becoming irretrievably illiquid, Buffett will reconsider. But not to worry---there are always mutual funds that could buy shares at $100,000 apiece," Assael said.

"And perhaps someone will start a fund to invest solely in Berkshire for a pure play on Buffett. Just think of it. Kids could shovel snow, sell lemonade or baby-sit and then invest in Buffett for as little as say, five hundred bucks." Indeed there are new investment vehicles which invest in Berkshire and Berkshire related stocks. "There is no substitute though, for Berkshire itself and the total shareholder experience," Assael said.

For now and perhaps for always, splitting a stock is just another charade that makes no particular sense to Buffett, at least for Berkshire. To him splitting a stock is only a cosmetic exercise. It involves paperwork and creates unnecessary stimulation and a false sense of progress.

What is the difference whether you have one share of Berkshire at price x or 100 shares at 100th of x? Stock splits are something stockbrokers like because they increase trading, giving speculators a false energy and feeling of wealth.

Each year Buffett is asked about the possibility of splitting Berkshire's stock. At the annual meeting in 1990, one shareholder asked if he could see splitting the stock in the foreseeable future. "I don't see a stock split in the unforeseeable future," Buffett replied.

"I have a stockholder friend of mine who is 60. I just sent him a telegram on his birthday that said, "May you live until Berkshire Hathaway splits," Buffett remarked at the Berkshire annual meeting in 1987.

With the issue of the new Class B shares in 1996 (Class B shares sell at 1/30th of the price of the Class A shares), Buffett may revise his salutation to: "May you live until Berkshire's Class Z shares are issued."

 

No Dividends

Buffett doesn't believe in paying dividends so long as retained earnings are compounding at a high rate.

Berkshire paid a 10-cent dividend back in early 1967. Buffett said later, "I must have been in the bathroom at the time." (Forbes, October 21, 1991) Berkshire has not paid a dividend since.

 

Arbitrage

Perhaps one of the least understood areas of Buffett's success is his use of arbitrage---again an area that calls for common sense, judgment, sizing up the odds on discrepancies in the marketplace.

Arbitrage, a French term for profiting risklessly, involves trading on the differences in prices in different markets. Arbitrage, or "workouts," applies to a range of pursuits, but these days often to stock traders' betting on the outcome of a merger deal or reorganization plan. Buffett enters the field of arbitrage only after a deal has been announced. He does not place bets on rumors.

Buffett makes his evaluations on information, not rumors. He looks at the probability of the announced event occurring, the length of time the money will be tied up, the opportunity cost of losing out on a better use of the money and the probability of loss if the announced deal collapses.

After the takeover announcement when the stock of the target firm often soars to just below the takeover price, Buffett might step in, buy the stock and hold it until it reaches its full takeover price achieved when the deal finally goes through. This technique enables him to make a tidy percentage in a relatively short time.

In 1962 arbitrage saved the Buffett Partnership from a down year. The market was declining, but earnings from the workouts allowed the partnership to have a decent year. "They allowed the partnership to be up 13.9% compared to the Dow's miserable performance of being down 7.6%." (Buffettology, Mary Buffett and David Clark, p. 253) In years of declining markets, successful arbitrage can provide a competitive edge.

Here's an example of arbitrage. On February 13, 1982, Bayuk Cigars Inc., announced that it had approval from the justice Department to sell its cigar operations to American Maize Products Co. for $14.5 million, or about $7.87 a share. It also adopted a plan of liquidation and said it would distribute the proceeds to shareholders. Shortly after the announcement Buffett bought about 5.7% of Bayuk Cigar's stock for $572,907, or $5.44 a share. Buffett concluded the whole plan had a high likelihood of going through in a reasonable amount of time. (Buffettology, Mary Buffett and David Clark, pp. 756-757)

The Bayuk Cigar arbitrage went through successfully. The deal must go through or the investor/arbitrageur can be axed, if he isn't nimble.

Since Buffett is a good judge of the probabilities of these deals occurring, he has consistently brought Berkshire a little extra return. He describes one of his earliest arbitrage moves, which was not a takeover arbitrage, in the 1988 Annual Report.

 

I participated in one of these when I was 24 and working in New York at Graham-Newman Corp. Rockwood & Co., a Brooklyn-based chocolate products company of limited profitability, had adopted a LIFO inventory valuation in 1941 when cocoa was selling for five cents per pound. In 1954 a temporary shortage of cocoa caused the price to soar to over 60 cents. Consequently Rockwood wished to unload its valuable inventory---quickly, before the price dropped. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation's business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to the activity. Accordingly, the company offered to purchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.

Moral: Know the tax code.

 

In 1981 Berkshire bought the stock of Arcata, a forest products and printing firm, at about $33.50 a share. Arcata was the subject of a buyout by KKR. In 1978 the U.S. Government had seized more than 10,000 acres of redwood timber to expand the Redwood National Park. The government was to pay Arcata for the trees, but the question was how much.

Buffett, who has said he "couldn't tell an elm from an oak tree", added that he coolly evaluated the claim at somewhere between zero and a whole lot. The deal with KKR fell apart, but Arcata sold out in a later offer. Berkshire made about 15% on its investment, selling at about $37.50 a share, but in 1988 received an additional $19.3 million, or $29.48 a share, when the government agreed to pay a total of $519 million for the timberland. (The Warren Buffett Way, Robert Hagstrom, pp. 166-167)

At the end of 1993 Berkshire held $146 million worth of Paramount Communications stock. If Berkshire held through the Viacom takeover of Paramount, Berkshire apparently made money through arbitrage. Buffett is at ease with whatever makes money, be it arbitrage, dealmaking, value investing or understanding the importance of brand names.

After money manager George Michaelis joined Source Capital in 1971, Buffett and Munger through Berkshire bought 20% of the closed-end investment fund. (Forbes, August 21, 1989)

Michaelis, much influenced by Buffett and Munger, told Forbes, "I think of myself as an investor in really great businesses, whereas Ben Graham was really a purchaser of cheap assets. In that sense Buffett has really evolved away from pure Ben Graham."

Forbes said, "The Buffett-Michaelis version goes beyond tangible assets to count such intangibles as brand names or the kind of "franchise" that makes a newspaper or television station valuable. Such businesses tend to have a high return on book equity. Why? Because they are earning not only on their tangible assets but on the intangible ones as well." Michaelis died in a biking accident in 1996.

Buffett is always looking for value, and value may come in many forms; the Coca-Cola and Gillette brand names, for example.

And Buffett admits that growth is not separate from value, but is instead an important component of value investing.

Buffett focuses not only on price but value, the mission of any investor. Business folks in Omaha talk about business and value, not price and certainly not about wild bets, program trading and options.

It has been estimated that Buffett has added several percentage points a year to Berkshire's returns through his workings in arbitrage.

 

No Derivatives, Please

Buffett has let his horse sense tell him some other things; one result is he doesn't care much for program trading.

He has often told the story that if a group of people were stranded on an island you might well set a certain number to farming, a certain number to building shelter, even some to figuring out how to get off the island, but you would not select several of the people to trade options based on the output of the other workers. Whenever he tells that story, if Munger is around, Munger will say of program traders, "I like them less than you do."

There are no securities on Gilligan's Island either. In our world, at least, there is no options trading available on Berkshire's stock.

Buffett generally deplores options, program and derivatives trading and anything else that brings a casino-like atmosphere to the marketplace, especially where a little leverage can control a lot of assets.

In a March 1982, letter to John Dingell, chairman of the House subcommittee on Oversight and Investigations that was considering whether to allow the Chicago Mercantile Exchange to trade futures, Buffett wrote:

 

We do not need more people gambling on the nonessential instruments identified with the stock market in the country, nor brokers who encourage them to do so. What we need are investors and advisers who look at the long-term prospects for an enterprise and invest accordingly. We need the intelligent commitment of investment capital, not leveraged market wagers. The propensity to operate in the intelligent, pro-social sector of capital markets is deterred, not enhanced, by an active and exciting casino operating in somewhat the same arena, utilizing somewhat similar language and serviced by the same work force.

 

Buffett's investments are straightforward---no hot tips, no betting on the next quarter's earnings report. Using his meticulous research and common sense, he comes to decisions to buy common stocks themselves, be they 20th Century Industries, the insurer in California, or National Service Industries, the lighting equipment company in Georgia, or negotiated purchases of pieces of businesses, such as Bowery Savings of New York, which Berkshire had some ownership in from 1985 to 1987.

 

A Time to Hold A Time to Fold

Back when Buffett decided to buy shares of The Washington Post Co., he got in touch with Omaha broker Cliff Hayes, now with Wallace Weitz & Co. in Omaha.

"He asked me to buy Post shares," recalls Hayes. Hayes said when he raised a question of what price to try to buy them for and how much to buy, Buffett told him, "You don't understand, I just want to buy."

"It was just totally expected for me to use my best professional judgment in making the purchases. We'd buy a third or a half of the day's volume, then step back."

Hayes said it was understood that the buyer should not rile the market with big orders or alert the market to a big purchaser in the wings.

Offering his version of a verse from Ecclesiastes, Buffett told Hayes, "There is a time to bid for them and there is a time to take them."

Does common sense in the stock market always pan out right away? No. "We started buying The Post at $20 (at 1973 prices) and we were buying it at $12 when we were done," Hayes said.

Even though Buffett was a big purchaser, the Post's share price steadily declined. All the better for Buffett in the long run.

"He does a lot of his trading now at Salomon---but he often asked me to accumulate small positions, sometimes over a two-or three year period," Hayes said.

"I did the GEICO buying.. .We bought baskets of it when it was an almost busted company," Hayes said. Again, Hayes bought a healthy percentage of the day's volume but not so much that the market could detect a big buyer.

As for the question of secrecy of the trades, it was understood things were to be kept quiet, says Hayes. "He didn't say keep it a secret. It was just implied," Hayes said, adding it was also understood everything was to be on the up and up. "We never traded ahead of him."

Hayes said if there was something amiss, it was best to tell Buffett immediately and not let any problem fester. Once, Hayes said, word leaked about what Buffett was buying, and Hayes said he told Buffett about it right away. He wound up trading for Buffett for years.

But other brokers who did not report problems quickly to Buffett were not used again. "He's dropped brokers," Hayes said.

Hayes emphasized that it would be very rare for a broker to leak a trade, but leaks in the brokerage community often can happen in the back office, through the stock transfer agent---or anyone else along the way who may have access to the trade or stock delivery process.

Buffett has a rule against trading while he's in the frenetic city of New York. He makes his trades in the peace and calm of Omaha. (Fortune, November 27, 1995)

 

Business Franchise

Buffett discovered early the importance of a business franchise.

A franchise is a business that for one reason or another has a dominance in the marketplace---a leading business such as Pinkerton's in a difficult-to-breach market. It can be a monopoly newspaper such as the Washington Post dominating its market, or a strong brand name such as General Foods---a stock Buffett held for years before selling for a big profit when Philip Morris bought it in the mid1980s---or the ultimate brand name, Coca-Cola---it is always a business with a superior competitive edge. Such a business is so formidable that it is difficult for those wishing to compete with it even to get into the business.

Something Buffett has tried to do, especially in recent years, is to seek out businesses with extremely strong franchises, impregnable but unrecognized franchises.

Buffett saw an archetype of this idea in the monopoly newspaper. He explains:

 

The test of a franchise is what a smart guy with a lot of money could do to it if he tried. If you gave me a billion dollars, and you gave me first draft pick of fifty business managers throughout the United States, I could absolutely cream both the business world and the journalistic world. If you said, "Go take The Wall Street Journal apart," I would hand you back the billion dollars. Reluctantly, but I would hand it back to you.

Now, incidentally, if you gave me a similar amount of money and you told me to make a dent in the profitability or change the market position of the Omaha National Bank [forerunner of FirsTier Bank] or the leading department store in Omaha, I could give them a hard time. I might not do much for you in the process, but I could cause them a lot of trouble. The real test of a business is how much damage a competitor can do, even if he is stupid about returns.

There are some businesses that have very large moats around them and they have crocodiles and sharks and piranhas swimming around in them. Those are the kind of businesses you want. You want some business that, going back to my day, Johnny Weissmuller in a suit of armor could not make it across the moat. There are businesses like that. Sometimes they're regulated. If I had the only water company in Omaha, I'd do fine if I didn't have a regulator. What you're looking for is an unregulated water company. The trick is to find the ones that haven't been identified by someone else. What you want is a television station or newspaper. (Investing in Equity Markets, Summer, 1985)

 

The reason one would like a monopoly television station or newspaper: most other businesses have to go through that business to advertise.

That amounts to what Buffett calls a royalty on the other guy's gross sales---a payment that almost every business in town must pay. If you have the only newspaper, television or radio station in town, you have to get a good percentage of the advertising business.

This was a major reason, one not recognized by many in the 1970s, that Buffett was buying such stocks as The Washington Post Co., Time Inc., Knight-Ridder Newspapers, Media General, Multimedia, and Affiliated Publications, which owns the Boston Globe.

Other huge business franchises Buffett recognized are the large advertising firms. It is the large ad agencies with global interests that the giant global firms wanting to advertise must come to.

An IBM, Coca-Cola or General Motors is going to insist on a worldwide ad campaign, and it doesn't want to fool around with 100 different ad agencies in 100 different countries. Instead it picks an Ogilvy & Mather or an Interpublic Group, two firms Buffett made large profits in before selling in 1985, when he thought their merits were fully recognized.

Another conclusion Buffett reached: there are a number of poor businesses and it's best to steer clear of them.

Buffett has stayed away from big, heavy industries requiring constant new investments, businesses with rising competition, rising labor costs and rising need for more capital [except US Airways].

Also, Buffett tries to examine the opposite of a proposition---there are some good businesses with little need for new capital, businesses that have little competition and hence ultimately throw off new cash.

 

Buying Part of a Business

Overall, what Buffett sees in the stock market is a way to pick up assets that produce a steady stream of cash. Buffett buys at a good price because he buys only a part---not the whole company, for which he would have to pay a premium.

When a whole company is put on the block, everyone looks at the deal in the open, and it usually sells at full value to the highest bidder.

It is different in the stock market: you can buy shares, portions of the business, often quietly with little competition. Better yet, you can operate at the time of your picking.

You do not have to join what Buffett terms the "Swing, you bum," syndrome. You can wait for the perfect pitch two inches above the navel, as Buffett says.

"Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike at you. There's no penalty except opportunity. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it." ("Look at All Those Beautiful Scantily Clad Girls Out There," Forbes, November 1, 1974)

That's the appeal of the stock market to Buffett.

Explains Buffett, "When I buy a stock, I think of it in terms of buying a whole company, just as if I were buying the store down the street. If I were buying the store, I'd want to know all about it. I mean I look at what Walt Disney was worth on the stock market in the first half of 1966. The price per share was $53 and this didn't look especially cheap, but on that basis you could buy the whole company for $80 million when Snow White, Swiss Family Robinson, and some other cartoons, which had been written off the books, were worth that much. And then you had Disneyland and Walt Disney, a genius, as a partner."

Buffett's huge network of knowledgeable and influential friends also has been a help along the way. Buffett has been an original thinker, but it cannot have hurt to discuss prospects for a television station with Tom Murphy, chat about a common investment with Laurence Tisch, or talk with Jack Byrne about insurance.

"His network of friends has been very important," says broker Hayes.

 

Ability to Read People

For all Buffett's understanding of the inner workings of business, his greater understanding may be of human nature. He would certainly subscribe to John D. Rockefeller's warning: "A friendship founded on business is better than a business founded on friendship." And Buffett knows that human nature includes: "Fools rush in where wise men fear to trade." He reads people quickly and accurately and his judgment of their abilities, motives and ambitions is almost always on the money. He can see the first class person in a flash, and the fraudulent person just as fast.

Exhibit A: He was one of the few people to detect that Larry King of Omaha was not all the community thought he was.

King, once manager-treasurer of the Franklin Community Federal Credit Union, ultimately pleaded guilty and is serving a 15-year prison sentence for crimes connected with Franklin's 1988 collapse and the disappearance of $39 million in deposits.

GQ magazine looked at King in its December 1991 issue: "Very few people in Omaha closed their doors to Larry King. One who did was Warren Buffett...In 1978, King asked Susan Buffett if she would be willing to host his and Alice's (King's wife's) tenth anniversary party at her house, an act of chutzpah even by King's standards. Susan Buffett said yes, but her husband said no. `I knew that King was a phony,' says Buffett, `and I think that he knew I knew. I'm probably the only person in Omaha he never asked for money.' How did Buffett know? `It was like he had a big sign on his head that said PHONY, PHONY, PHONY."'

"No less an authority than John E Welch, CEO of General Electric Co., considers Buffett a superb judge of managerial talent. Buffett and Welch have gotten to know each other over the years as golf partners and as rivals in auto insurance and other businesses. `Take 20 people you know quite well but Warren has just met casually,' Welch says. `If you ask Warren his opinion about them, he'll have each one nailed. He's a master evaluator of people, and that's the biggest job there is in running a company.' " (Business Week, July 5, 1999)

 

Avoid Technology and Drug Stocks

Once a shareholder asked Buffett what he thought of pharmaceutical stocks; he said that was not the sort of thing Berkshire had expertise in. (Of course that was before he bought some BristolMyers Squibb stock in 1993.)

Buffett added, "That does not mean there are not good ones."

What Buffett was driving at is that while pharmaceutical firms were beyond Berkshire's expertise, no doubt Merck is a superb firm. But Buffett cannot predict what drug is going to be a winner and which one will wind up drawing lawsuits.

In a way they are like his forbidden category of technology stocks, a group whose performance Buffett says he has no way of predicting, because he knows little about present technology and even less about future competitors' technologies.

Buffett would say there are others who can make those determinations better than he about technology or pharmacology---but then he is not sure their determinations are so hot either. It's too tricky an area for a sensible investor trying to cut risks and guesswork.

Buffett said at Berkshire's Annual Meeting in 1998: "I've been an admirer of Andy Grove, and Bill Gates and I wish I'd translated that admiration into action by backing it up with money. But when it comes to Microsoft and Intel, I don't know what the world will look like 10 years from now and I don't want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th or even the 10,000th smartest guy in the country analyzing those businesses. There are people who can analyze technology, but I can't."

 

Debt is Poisonous, Cash is Good

Buffett's sparing use of debt has been a hallmark of his from the start. When much of the rest of the investing world, burdened by debt, encounters some new crisis forcing a panic, Buffett is usually calmly standing there with little debt and a loaded gun of cash ready to "bag rare and fast-moving elephants."

Little debt and lots of cash give him an ability to respond quickly when the right investment comes in his sights. He does not have to call bankers to get a loan. After dogged investigation in the 1950s, Buffett bought Western Insurance at $16 when it was earning $16 a share, and National American Insurance at one times earnings. (Forbes, November 1, 1969)

Then in 1962 he found Gurdon Wattles American Manufacturing selling at a 40% discount from net worth. `If you went to Wattles of American Manufacturing or Howard Ahmason of National American Insurance and asked them to be partners, you could never get in at 1 times earnings,' Buffett told Forbes.

When the reading puts him on to something, he'll do some informal field research. In one case in 1965, Buffett says he spent the better part of a month counting tank cars in a Kansas City railroad yard. He was not, however, considering buying railroad stocks. He was interested in the old Studebaker Corp., because of STP, a highly successful gasoline additive. The company wouldn't tell him how the product was doing. But he knew that the basic ingredient came from Union Carbide, and he knew how much it took to produce one can of STP. Hence, the tank-car counting. When shipments rose, he bought Studebaker stock, which subsequently went from 18 to 30.

On occasions Buffett has asked Omaha cab drivers how their business is doing. He's always watching, asking, reading, and looking for investment possibilities.

 

Don't Over-Diversify

For all his conservative, sure-footed ways, Buffett is also capable of remarkable boldness when he sees an opening. It's not that he's throwing caution to the wind. It's that his intensive research usually has ferreted out an investment with excellent prospects.

No investment is a sure thing---including Berkshire---and in the early days when he committed so heavy a percentage of his worth to American Express and The Washington Post Co., he had to be right.

 

Be Bold and Be Original When the Fat Pitch Comes

Later in life, no matter how wealthy he was, it was a bold move to take $1 billion and buy stock, even if it was Coca-Cola at a down time.

In addition to being bold, he is original. What else is it when, at a time the industry is spooked about writing officers' and directors' liability insurance due to the lack of any statistical history and the unpredictability of court awards, Buffett takes out an ad in an industry publication saying that Berkshire will write the insurance?

"To those paying or who are willing to pay over one million dollars for this O&D coverage---you tell us the amount of liability coverage you want and what premium you are willing to pay---and we will tell you if we wish to write the coverage."

Perhaps because he's in the business, Buffett often comes up with ideas on how to sell insurance. In the fall of 1990 when the S&L crisis and banking problems were front-page news, he came up with a suggestion to help the federal government with depositor's insurance---have private insurers write a piece of the action.

"What is needed is a system that combines the ability of private insurers to evaluate risk with the ability of government to bear it. Co-insurance arrangements, varying by size of bank, would appear to be the way to go," he wrote in a piece that ran in the Washington Post.

Later Buffett said Berkshire would be happy to write that kind of insurance.

Over the years he has made investments in scores of companies ranging from insurance firms to R.J. Reynolds and Philip Morris to National Presto, the pressure cooker and appliances firm, to National Service Industries.

Handy and Harman has been one as well as 20th Century Industries, General Foods, Affiliated Publications, Interpublic Group, Time Inc., City National Corp., the bank holding company in Beverly Hills, Melville Corp., and the retailer and pet food maker Ralston Purina.

Has Buffett made a few mistakes? Yes. There was too much devotion to buying really cheap companies in the early days. Remember Berkshire's textile operation failed.

And he told Forbes (October 18, 1993) he left $2 billion on the table by not buying enough Fannie Mae, then selling his small position too early. "It was easy to analyze. It was within my circle of competence. And for one reason or another I quit. I wish I could give you a good answer."

Also, he said he sold Affiliated Publications stock because he didn't fully understand the value of Affiliated's big position in McCaw Cellular. "I missed the play in cellular because cellular is outside of my circle of competence."

Still, Buffett has great trust in his thinking. People often write him with their investment ideas and he has replied, "With my idea and your money, we'll do OK."

For all Buffett's monumental achievements, he still was not known to the ordinary citizen and not universally known even in the business world until he stepped in to resolve the scandal at Salomon.

On October 12, 1986, Alan Gersten, an Omaha World-Herald reporter, called a Burroughs executive to inform him that Buffett owned 9.9% of the company's stock, an arbitrage position Buffett soon sold. The spokesman asked, "Who's Warren Buffett?" People were still asking that question when Buffett became interim chairman of Salomon.

Because of Buffett's wisdom, his counsel (and money) are often sought. When Salomon was considering taking part in the bidding for RJR Nabisco, Salomon Chairman Gutfreund called Buffett for advice.

"I'll tell you why I like the economies of the cigarette business," he said. "It reminds me of the ideal business where the product costs a penny to make sells for a dollar, is habit-forming, and there's fantastic brand loyalty."

Gutfreund asked if Buffett wanted to invest in the deal with Salomon. Not this time, Buffett said, not willing to be an active participant in the Death Merchant aspects of cigarettes. "I don't need to own a tobacco company." Says one Berkshire shareholder who is a doctor, "I appreciate that." Hence, Coke.

Salomon made its own bid, but the Kohlberg, Kravis & Roberts firm eventually won the tobacco giant.

Buffett has many views on raising children and the lessons they should learn. Probably his most famous view, regarded as eccentric by many parents, is that children should not inherit great wealth. He believes children should be left enough to cope with necessities, but not really large amounts.

Buffett has said he refuses to leave his children "a lifetime of food stamps just because they came out of the right womb." (Richard J. Kirkland, "Should You Leave It All to the Children?" Fortune September 29, 1986) Susan recalls a time when she had a car wreck and had to tell her father.

"He was reading Moody's. I told him I had had a wreck and he said, Anybody hurt?' I told him no. He later came in and said the other guy's always the jerk. What he meant was drive defensively."

Buffett taught her other lessons along the way. One day when young Susan approached her father for a loan, he suggested she go to the bank.

And Howard Buffett has said his father is fixated on finances: "If he drives out to my place (when Howard had a farm) and sees I have $30,000 invested in a tractor, it drives him nuts, especially when it's financed at 15%. But I'd have a hard time getting through life without a John Deere tractor sitting in the garage." (Register, February 1984)

Buffett can concentrate so hard on something that he can also be absent-minded on occasion, forgetting momentarily to take his baseball cap off during the National Anthem.

Susan recalls a time when her mother was sick and she asked Buffett to go to the kitchen and bring her a pan. He did and returned with a colander. His mechanical inabilities and his childrens' stories about his tight-fisted ways are representative of the height of criticism of Buffett before the Salomon crisis.

Occasionally, behind his back, people refer to him as Mr. Rogers or Jimmy Stewart, a jealous knock at his childlike, country-simple honesty. Although occasionally absent-minded in his personal life, in business he is super alert, concentrating with all his powers.

Buffett does not buy the idea held by many corporations that the chief executive should make the decisions about philanthropy. So in 1981 Buffett announced that each Berkshire shareholder could designate $2---raised as the years went by to $18 a share in 1999---of corporate donations for each share owned to the charity of the shareholder's choice. "Lots of companies don't earn or sell at what we give away," says Berkshire shareholder Bill Scargle. Back in 1981, Buffett estimated that if every stockholder contributed, the roughly $2 million in contributions would reduce Berkshire's net by about $1 million and its percentage gain in annual net worth by about one-fourth of 1%. (Forbes, November 20, 1981)

Charitable contributions in 1999 amounted to $17.2 million, which went to 3,850 charities.

Here's Berkshire's unusual charity policy: "Each Berkshire shareholder----on a basis proportional to the number of shares of Berkshire that he owns---will be able to designate recipients of charitable contributions by our company. You'll name the charity: Berkshire will write the check."

Buffett has given most of his donations to the Buffett Foundation.

Buffett, the capital allocator, has said that in examining potential purchases, the area he has probably done most of his thinking about, he has three criteria. First, the business should have good economic characteristics; second it must have an able, trustworthy management and finally it must be a business that is interesting to him.

Sounds simple, easy, sensible, right? Well, that's the whole point.

 

Buy Back Stock

Buffett has often been asked about the possibility of Berkshire buying back its stock. Buffett says he has no problem with buying it back.

But rather than just willy-nilly buying back stock, he takes the common sense approach. Clearly, the stock would have to be at a good price, and if Berkshire were selling at a cheap price, it's quite likely that would be at a time when something else is selling even more cheaply.

"We'd go wherever we'd get the most for our money," he said at the annual meeting in 1991.

 

Above All, Avoid Dragons

Buffett often has said he prefers avoiding dragons to fighting them. It's akin to the advice from the power company: call before you dig. Buffett prefers to avoid some problems, but praises his friend, Jim Burke, the former Johnson & Johnson chairman, known for facing problems.

"I would say Jim Burke is a national asset ...There are all kinds of people who have 500 horsepower motors who only get 100 horsepower of output. But Jim has a motor with horsepower equal to anyone else's, and the efficiency is 100%...

"He likes to work on problems; I try to avoid problems." (USA Today, February 16, 1993)

Once Buffett was asked just what he does, how he spends his day.

"Well, first of all, I tap dance into work. And then I sit down and I read. Then I talk on the phone for seven or eight hours. And then I take home more to read. Then I talk on the phone in the evening ...We read a lot. We have a general sense of what we're after. We're looking for 7-footers. That's about all there is to it," says Buffett of his search for business superstars.

Buffett's looking for 7-footers to make slam-dunks.

 

Be Dead Right About the Big Decisions

Buffett has said many times that every investor ought to have a lifetime decision card with just "20 punches." Buffett says his success is due to being right on a few big decisions.

Buffett has made a number of small mistakes and might have just an above average record were it not for the monumental decisions to buy big stock stakes at the right time in American Express, The Washington Post Co., GEICO and Coca-Cola.

He looks for haystacks and not needles in a haystack, as he said at the annual meeting in 1994.

"What I try to do is come up with a big idea [gorilla] every year or so.

 

Forget the Algebra

Knowing of Buffett's distrust of algebraic formulas, Robert Greene, a stockbroker with Robinson-Humphrey in Macon, Georgia, once sent a brokerage report to Buffett containing an enormously complicated algebraic formula for predicting interest rate risk carried by a given fixed-income security.

Buffett replied: "Thanks for the secret formula. With its help, Berkshire should be able to conquer the world."

 

"Better Plant the Tree Today"

At a conference for analysts June 22, 1998 shortly after Berkshire announced it would buy General Re, Buffett was asked if this was a good time for General Re to expand its insurance operations in Asia. He said yes, that it's important to build long lasting relationships as soon as possible. He told the story of a fellow who asked his yardman about planting a tree and was told it could be put off because it would take 50 years for the tree to grow. The fellow told the yardman: "Then we better plant the tree today." [pg 583-607]