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This the first installment of a three part study of Warren Buffett. I have learned much from this study. I hope you can too.
The Warren Buffet Study – PART I
Warren Buffett is perhaps the most celebrated and famous investor in the world. If in 1965 you invested $100 in the S&P 500 and reinvested all dividends your investment would have been worth almost $22,000 at the end of 2022. Berkshire Hathaway would have compounded your $100 into almost $4,000,000. Quite simply, Buffett’s performance is off the charts. However, many in the investment community question the authenticity of his track record. Although I agree with some of the criticisms made against Buffett, it is not my intention to write a critic of Berkshire Hathaway. My intention is to learn about Warren Buffet and his investment philosophy and his investing method. Studying what he has done and how he has done it has been a rewarding exercise for me. I found the ‘how’ to be a to be a good deal more revealing than the ‘what.’
Setting out to study Warren Buffett and his investing methods proved to be quite an undertaking. There are literally dozens of books and countless magazine articles about Buffett. I decided the best way start studying Buffett was to read all of his annual shareholder letters from 1977 onwards. This gives a ‘Buffett in his own words’ flavour to my research. Thankfully he is a straight shooter. Like all of us he is not perfect, but I am happy to take him at his word. An interesting aspect of reading his annual reports was a ‘history in real time’ factor. We tend to read about the past with 20-20 vision. For example, reading a book on the second World War is not the same as reading the weekly front page news from the beginning of the war to the end. Equally when Buffet is writing his letter, he has no idea as to what is coming next. This brings a freshness to this reading of financial and market history which I enjoyed. Nevertheless, I have to confess it was exhausting. After 2 months and 47 pages of notes I am finally able to pen this commentary.
I was essentially unfamiliar with Buffet and I assume the reader is as well. Therefore, the most useful way to begin this commentary is to give a summary outline of his background and career.
Family Background and Early Career
Warren Buffet was born in 1930, the second of four children (three sisters). His family was wealthy. Buffett's father, Howard, was a very able and honourable man. He founded a stockbrokerage firm and was a four-term Republican congressman. He adhered to very high ethical standards, refusing a congressional pay increase from $10,000 to $12,500 saying that he was elected at the lower salary. Needless to say, Warren couldn’t have picked a better family to be born into.
Warren showed a lot of hustle in his teenage years accumulating considerable wealth very early in his life. After college he worked in his Dad’s stockbroking firm (1951-54). From 1954 -56 he worked for his college professor and investment idyl Benjamin Graham. Warren frequently cites Graham's book ‘THE INTELLIGENT INVESTOR’ as a must read.
Buffet became a full-time investment manager in 1956 at the age of 26 managing money for friends and family. In 1959 he met Charlie Munger, his most trusted advisor and friend. In 1965 he “stumbled into business management” (SL 2020) when his investment partnership took control of a publicly quoted textile company. This is really the starting point for Berkshire Hathaway and brings us to the beginning of his recorded investment / trading career. From 1965 to today the Berkshire Hathaway share price has moved from $20 to $500,000.
Berkshire Hathaway
Although his textile business ended in failure, Buffett had diversified sufficiently to make its failure irrelevant. His first major investment was in insurance. He continued to reinvest profits from his growing collection of businesses into:
- A controlling / majority ownership of private companies (including Insurance).
- Shares of publicly quoted companies.
- Short-term trades.
The list above is ‘what’ Buffett did. But it is just as interesting to consider how he did it.
1. Berkshire’s Purchase of Private Companies.
Buffett always sought to deal with honourable people. He often and quite literally bought massive concerns with little more than a handshake. His description (given below), of how he purchased the Nebraska Furniture Mart (“NFM”) from Mrs Blumkins (known as Mrs B) is typical.
“Our evaluation of the integrity of Mrs. B and her family was demonstrated when we purchased 90% of the business: NFM had never had an audit and we did not request one; we did not take an inventory nor verify the receivables; we did not check property titles. We gave Mrs. B a check for $55 million and she gave us her word. That made for an even exchange.”
When you deal with honourable people you don’t need an army of lawyers, bankers and auditors. Furthermore, NFM does not require any managerial input from Berkshire. From Mrs Blumkins point of view, her precious company will not be put under new management, it will not be carved up and sold off. Berkshire wants nothing more than ownership and present management to continue.
Buffett’s approach was by no means normal. Consider what a ‘normal’ new owner might do with NFM. Generally, when a new buyer assumes ownership of a target company, they either want to sell the company on at a profit or improve (change) its management. For those that might wish to sell NFM on at a profit their focus would be on the new selling price that could be achieved. They would be less concerned with the long-term prospects for NFM. Alternatively, they might seek to impose new management on the firm to achieve certain synergies. All of this activity could be fuelled by imposing extra debts on NFM. The founder and owner of NFM didn’t want any of this. Mrs Blumkins wanted NFM to remain under family management. She thought it was best for the company, her family and her customers. That is why she chose Berkshire Hathaway as the buyer. Buffett not only trusted her, he believed in her. From his point of view there was nobody better to manage and guide his new company into the future other than the present management.
Warren Buffett was 53 years old when he bought NFM. Mrs Blumkins was 89. He had absolutely no problem with her age. He frequently sang the praises of his ‘older’ managers. In his 1978 shareholder letter he praises three of his older managers ageing 75, 81 and 83, We can see three unique aspects to the Buffett method when buying private companies.
- He does not waste time or money on due diligence. He deals with honourable people. Sometimes manager owners find due diligence insulting, his purchase of National Indemnity Insurance (NICO) in 1967 is a good case in point.
- He wants existing management to remain in control of the company with minimum input from him.
- Seniority or older age is a strength. As he says it is hard to teach a new dog old tricks.
These three factors set Buffett apart from the competition when buying private firms. In his view, ambitious owners didn’t seek the best price for their company, they sought the best buyer. A cash payment from Berkshire allowed existing owners to diversify their financial risk away from their company and yet maintain management control. Time and time again Berkshire collected wonderful dynamic companies that wanted to be owned by Berkshire Hathaway. In 1983 NFM had one mega store. Today it has five. NFM is one of literally hundreds of privately held companies in Berkshire Hathaway. Furthermore, Buffett bought conglomerates that themselves held a large collection of companies.
Buffet discovered early that the best managers require very little oversight. He sees his job as very little more than capital allocation. Some of his companies required very little new capital and simply allowed all of their profits to flow into Berkshire HQ. In turn other companies required capital to expand. Buffett always found it easy to allocate money to his star business managers. He often compared Berkshire to a sports team with the best collection of players. The best players soak up very little management time. They manage their little piece of the Berkshire empire as though it was their own. This is often partially true insofar as they sometimes hold on to 10%/20% of ownership.
Buffett’s approach to his all-star managers is ‘let me know if you need me’. He doesn’t ask for budgets or quarterly reports. Berkshire Hathaway’s head office is an exemplar of simplicity. He has no human resources division, no public relations department, no legal / compliance team and no acquisition team. There are literally no committee meetings. A grand total of 25 people work in HQ. His conglomerate employs almost 400,000 people generating over $300Bn revenue worldwide.
It is an oversimplification, but he would characterise his typical day as sitting in the office reading while waiting for the phone to ring. He described his approach as “masterly inactivity” (SL 1984). Managing Berkshire does not require continuous hyperactivity. He thinks in decades, not quarterly reports. Mrs Blumkins ran NFM superbly for 5 decades before Buffett came on the scene. What’s he going to do? Ask her for quarterly reports and presentations? That is frankly absurd to him. Mrs B and her family grew the business from one to five superstores in the 4 decades since Buffett bought them. They didn’t need some gobshite from head office to tell them how to sell carpets or asking for quarterly reports. Warren Buffet is no gobshite.
2. Berkshire’s Purchase of Public Companies.
Buffett brings a similar attitude to his ‘star’ managers in publicly listed companies. As an investor in public companies, Buffett could have influence but not control of the company. Obviously as he would have liked the management this would not have presented a problem to him.
His faith and backing of management was evident when he helped Capital Cities purchase American Broadcasting Companies in 1985. Buffett owned shares in Capital Cities for a number of years before the ambitious buyout of ABC. He believed that Capital Cities was the best run publicly owned company in the United States. After the acquisition of ABC he ceded his voting rights to Capital Cities / ABC senior managers Tom Murphy and Dan Burke. In addition to this he agreed to restrict his sale of his shares to another large owner without the approval of Murphy and Burke. This is extraordinary. It was his idea. He gave his voting power over to two employees of the publicly listed company. Furthermore, he restricted his ability to sell his stock to another major stockholder without the approval of these two senior managers.
Warren Buffett and his partner Charlie Munger wanted Murphy and Burke to have as much autonomy as possible. They don’t want their “managers distracted by revolving - door capitalist hoping to put the company in play”, (SL 1985).
We can see the Berkshire sought out the best managers working in the best businesses to manage its money. First and foremost Berkshire is an allocator of capital. This is its primary mission. Its secondary mission is dealing with unallocated cash. Warren Buffett manages Berkshire cash reserves personally, which leads us to short term trades.
3. Berkshire’s Short-Term Trading
This is Buffett’s least preferred investing activity. His preferences are long term ownership of private and public companies. Long-term meaning as long as possible.
The only common denominator that I can ascribe to Berkshires short term trades is that the preferred holding period for these trades is not ‘as long as possible’. That is, they will be liquidated at some target price or time duration. The shortest-term trades are probably ‘takeover target’ trades. If a stock market company is subject to a takeover bid he may get involved in the action. Quite simply, Buffett buys shares of the target company ahead of the prospective buyer. If a bidding war should ensue between two prospective buyers all the better – he can profit handsomely. Interestingly he describes this activity as arbitrage or merger arbitrage. I think speculation is a more accurate description.
Berkshire will also occasionally engage in macro forecasting trades such as buying commodities (most notably oil and silver). These “non-traditional” (SL 1997) trades can last several years. He says he only “thinks” he can make money in these trades whereas he “knows” he will make money investing in a wonderful business at an attractive price (SL 1997).
He has also shorted the Dollar against various other global currencies and engaged in various option writing (derivatives)strategies. His most notable options trades are puts he has written in various global stock market indices. In other words, if stock markets crash a lot he will have to write cheques. I think these trades are best understood as insurance policies that he is collecting premiums for. Insurance writing is a very comfortable place for Berkshire Hathaway.
Conclusion
I think we have a reasonable summation of what Berkshire has achieved and how it has been achieved. The average investor does not buy private firms and they would find Buffett’s ‘arbitrage’, commodity, forex and derivatives trading difficult to imitate. However, much can be learned from Berkshire’s thinking when buying public companies. In my next commentary (Buffett Part II) I explain how we can imitate some of Buffett's stock market investments.
