The Deals of Warren Buffett By Glen Arnold

The Benjamin Graham School of practical investing

The Definition of Investment

1. Thorough Analysis
2. Satisfactory return
3. Safety of Principal

The Great Irony: Great investors act with safety of principal in mind and aim only for a satisfactory rate of return. Yet, over the long run, they outperform those who take the path of higher risk.

The returns depend on:

• knowledge

• experience

• temperament

• The investor needs to understand the business world and how it works. Some grasp of accounting, finance and corporate strategy is essential.

• Temperament is more important than IQ when it comes to being a good investor.

• Graham told Buffett that he must understand the focus employed by other people in the markets if he wanted to outperform them.

Learning points

1. Follow sound investment principles
2. It is only necessary to outperform the market by a few percentage points to end up with vast amounts more wealth.
3. It’s only investing if you have made a thorough analysis of the company, there is a built-in margin of safety and the objective is set as merely a satisfactory return.
4. Do not accept Mr Market’s valuation of a share; do your own research.

Investment 1: Cities Services

• The sense of responsibility to those who trust him is very important in understanding the way Buffett went on to treat his partners in the 1950s and 1960s, and then shareholders in Berkshire Hathaway.

Learning Points:

• Do not unthinkingly grab at a small profit.
• Do not fixate on what you paid for a share.
• When investing other people’s money, ill feeling can be created if a mistake is made.

Investment 2: GEICO

• Buffett gained attention of Financial VP by explaining that he was a student of Graham’s, and he quickly demonstrated in conversation that he had read up about the firm, and asked pertinent questions, which made him gain valuable conversation with him.
• Competitive advantages which GEICO offered:
  • A very low cost distribution model
  • A good niche market.
• GEICO also had good growth prospects and profit margins were 5 times of an average insurer. It also had a lot of free cash.
• Buffett learned from Graham, who said you are neither right nor wrong because the crowd disagrees with you. Look at the facts, not the crowd.
• A painful lesson for him was in inadvisability of selling a stake in an identifiably wonderful company.

Learning Points:

• Do your homework
• It is possible for you to see much more than the so-called experts if you are prepared to make some effort.
• Look for businesses that make profitable use of capital.

Investment 3 & 4: Cleveland worsted mills and a gas station

• Borrowing is for very able investors and those than afford to lose the entire portfolio without affecting their lifestyle.
• As value investors we can build in a margin of safety by refusing to value on the basis of the best possible outcome.

Check the qualitative factors

• Prospects for the business: The investor must scan beyond the data for signs of vulnerability to disruption to business as usual.
• Quality of management:
  • Competence
  • Shareholder orientation
• Stability: Industries that are not subject to much change are likely to be stable

Why companies with large surpluses can be bad businesses:

• Managers have pursued value-destroying activities that have whittled away shareholder’s assets through losses year after year.
• The stock market has irrationally pushed the price of the shares down to unreasonable levels.
• Shareholders have not pressed the company to do the right thing by shareholders. Alongside the dumping of dross, there is dumping of sound companies, where there are good grounds for believing that recovery will eventually occur.

Paths to reverse pattern of losses

• Earning power lifted through an improvement in the economic background

• Management stir themselves

• A sale of the company to another

• Complete or part liquidation

• It’s very difficult to break up a business that is very established and very well liked with customer loyalty.

Learning Points:

• Every investor will make mistakes: One must develop personality traits that allow you to put failure into perspective.
• NCAV investing was central to Buffett’s approach
• Do not neglect qualitative factors

Investment 5: Rockwood & Co.

Learning Points:

• It is important to thoroughly consider a company's actions and their impact on future value (as opposed to thinking of things as a short-term, virtually risk-free payback).
• These opportunities only come along to those willing to do the groundwork

Investment 6: Sanborn Maps

• “While the degree of undervaluation is no greater than in many other securities we own… we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation.”

Learning points:

• Margin of safety
• Greater clout when you marshal millions: The advantage of working with larger sums of money is that it allows the investor to gain control of a business.

Investment 7: Dempster Mill

• The share price in this case was low because it kept making small profits or losses, and the management seemed clueless as to how to correct this miserable pattern. Also, it had a lot of debt and was in an industry with very poor economics.
• The reasons for return in such investments: first, the economics might improve, second, the management might improve or be replaced, third, the business might be liquidated, fourth, a takeover bid might be accepted.
• Meeting Charlie Munger: He was one of the few people who could keep up with Buffett and give as good as he got in well-considered discussion.

Learning Points:

• Business logic is one thing, being disliked is another, often overwhelming, thing. Buffett’s preference for sound franchise businesses with managers he likes, trusts and admires, who can grow a business over decades, and even his proclivity to hold shares through ups and downs. He likes building long-term positive relationship.
• Good managers can work wonders
• Patience will be rewarded
• The importance of spotting companies using too much shareholder’s money
• The buying price is crucial
• Look for pricing power: The ability to spot the potential for raising prices because of some degree of customer captivity was evident time and again in Buffett’s career.

Investment 8: American Express

• Buffett found that in some instances, companies with not so strong balance sheets but have strong economic franchises combined with sound finances and able, honest managers (if identified correctly) return significantly larger sums.
• Buffett, after the AmEx issue, investigated seriously about the on-going business prospects from his friends and all people he could think of to conclude that the economic franchise was intact. It was a company with pricing power because it dominated its industry and had customer captivity through its strong brand and network.
• He did’t want AmEx to shirk its responsibility for its part in the fraud because he knew that a company of this kind lives and dies by its reputation (a central component of its business franchise). It was better to take the financial hit now to preserve that reputation.

Learning Points:

• Think about the business: There are times when short-term problems bring down a share price. In many situations the long-term value is unaffected. If the market concentrates only on the short term then the opportunity arises to buy excellent businesses with strong franchises and good managers on the cheap.
• When the odds are good, invest a lot
• Ask around for qualitative data: Ask the customers about how they think of the business and keep re-evaluating it at each turns.

Investment 9: Disney

Buffett’s actions A key part of Buffett’s research was to go and sit in the cinema surrounded by a whole bunch of children watching Marry Poppins. he could see how much they loved the Disney product for himself. And he could see that with the valuable feedback catalogue, people would keep paying for Disney films, generation after generation. The wonderful thing about Snow White, for example, is that once it has been made and you have written off the cost, you can bring it out again and again. Furthermore, you can use the love of the characters in many different forms, from licensing on children’s school bags and t-shirts to theme parks. And Mickey Mouse does not have an agent (unlike Tom Cruise, say) who might take much of the value generated by a film franchise for their client.

Buffett and Munger met Walt Disney and admired his devotion to his work and his infectious enthusiasm.

Buffett logic - more like Fisher and Munger than Graham Buffett was putting a great deal of weight on the intangible assets of Disney and paying little attention to the balance sheet assets.

Learning Points:

• Mr Market can be a Dumbo
• Businesses needing little additional capital to generate increased profits can be a goldmine
• Scuttlebutt again
• Observe quality in everyday life
• Don’t sell too soon: Have a idea/investment thesis for a decision and don’t back out just because it has become over-valued/under-valued, until your idea is achieved.

Investment 10: Berkshire Hathaway

• Lacked competitive advantage because it was unable to prevent new entrants to their market.
• It was a commodity business
• It was a business of bad economics of industry
• Lesson from the fateful buy back: Don’t be intimidated by someone’s behaviour and sell when the idea/investment thesis ends for you.
• A struggling business needed to be run by the right person for it to succeed.
• Buffett’s role in the companies he controls is three-fold:
  • Capital allocation
  • Selecting the key person(s) and thinking through the right incentive package
  • Cheering on the managers who are performing well. He does not need regular meetings or briefings, but he does like to read the numbers coming from the operating units

The way Buffett organized this business:

1. Get rid of the liquidator reputation: After being hurt greatly by the loathing people of Beatrice, he announced that there would be no mill closings.
2. Allocation of tasks: Buffett was true to his word: anything to do with the mill operations was up to Ken Chace. Buffett’s job was to look after the money.
3. Incentives: Buffett does not like executive options because they offer rewards without the downside risk, and they encourage mangers to gamble with shareholder’s money.
4. Focus on return on capital employed: He wasn’t focused on the level of output of the mills, or the volume of sales or market share, or just profit. He thought what really matters is the percentage return on capital employed.
5. Release Cash: Existing cash was not being used to generate adequate returns in BH.
6. Send bad news early: Chace was asked to warn Buffett if unpleasant surprises might be around the corner.
7. Praise key people: People respond to signals that they are appreciated; it’s only fair that they are told they are doing a good job if that is the case.
8. Buffett would be the only one who could allocate capital

Chace managed to do as he had been asked and released capital tied up in inventories and non-current assets. Dividends were at first meager and then non-existent, thus saving cash.

Learning Points:

• Don’t get emotional
• Management of high ability and integrity are crucial: A business with good economics is better than a business with bad economics but extremely talented managers.
• Reallocate capital
• Try to behave decently with all who come into contact with: His reputation for decency, while born of his inherently generous nature, rather than being affected, is an important business asset. Many families who wanted to sell their businesses have found a welcoming home within the Berkshire family, where continuity, long-term value and integrity have always been important watchwords, and where asset-stripping and other forms of short-termism were anathema. People like working with their friend Warren Buffett, who offers them freedom to manage, respect, praise and a sense of purpose.

Investment 11: National Indemnity Insurance

• Jack Ringwalt believed: “There’s no such thing as a bad risk. There are only bad rates.”
• Jack knew when to take a risk and when to back away — the odds had to be right.
• Buffett felt a need to widen his circle of competence to encompass the insurance business. Thus he spent a long time in libraries researching the mechanisms and logic of insurance.
• Buffett asked Ringwalt to send him the same information he was sending out to the small number of outside shareholders. Ringwalt mistakenly thought that Buffett was flattering him by showing an interest in how NICO managed its investment float. he thought Buffett might want to learn from him about what shares to invest in and he agreed to send Buffett the information. Of course, what Buffett was really interested in was the operations of the business and he gained an impression of many years of the business’ history from the material Ringwalt sent him.
• Buffett has a wonderful knack for holding on to very talented and experienced people. He doesn’t mind that they are getting on in years; their knowledge, judgement and contacts are often vital to the success of the enterprise. Besides, he has numerous investments to think about; he simply cannot deal with the day-to-day detail of running any one company.
• NICO was a specialist in commercial auto and general liability insurance and did not appear to have any attributes that would overcome the industry’s chronic troubles. It has no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents. The only thing it had right was a managerial mindset that most insurers find impossible to replicate.
• It was that company who could take a decline in revenue due to lack of profitability and higher risks.
• Many insurers lose money because they chase after business, driving down the premiums they charge. managers of these companies are often reluctant to forgo volume and market share. They want to keep the staffing levels high so they drive volume of business up. This makes insurance profits cyclical, because when insurers lose money from badly priced policies many go bust or are forced to cut back, leading eventually to raised premiums and the start of another cycle.
• The combination of a growing pot of no-cost float and Buffett’s investing prowess applied to that float is a very important factor in his success.

Learning Points:

• The investor should be prepared to observe a good company for years before buying: Do the analysis and put it on your watch list. Have a valuation in mind. If the opportunity arises then you can invest with discipline intact. If the opportunity never arises then use your money elsewhere, where you can invest with a margin of safety.
• The float held by insurance companies can be invested to make a fortune.
• Hold on to good thing for decades

Investment 12: Hochschild - Kohn

• Case of a “second-class department store at a third-class price”.
• Buffett on this: “Even if the price had been cheaper but the management had been run-of-the-mill, we would not have bought the business.”
• Buffett — “It also does not seem sensible to me to trade known pleasant personal relationships with high grade people, at a decent rate of return, for possible irritation, aggravation or worse at potentially higher returns.”
• The problem with retail businesses is that the managers are usually under constant attack from competitors. As Buffett puts it, retail managers have to be “smart every day”, whereas in other industries the managers do not destroy the business even if they perform in a mediocre fashion for a period.

Learning Points:

• It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
• Good jockeys will do well on good horses, but not on broker down nags: Buffett said that when a management with a reputation for brilliance tackled a business with a reputation for bad economics, it would be the reputation of the business that remained intact.
• Avoid businesses with problems: It’s more profitable to simply stick with the easy and obvious than it is to resolve the difficult.
• The overwhelming importance in business of the unseen force, the institutional imperative:
  • As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction;
  • Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds;
  • Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops
  • The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
• Buffett was born neither an investor nor a businessman: The learning process took decades to get to a reasonably high standard and still mistakes were made. An interest in lifelong learning is a prerequisite for an investor. Buffett’s openness to correction has meant that he has made a sufficient number of good calls to produce a superior performance overall.

Investment 13: Associated Cotton Shops

• Buffett greatly admired a penny-pincher and a workaholic
• Rosner was highly paranoid of his business
• When Rosner offered to show Buffett around a few stores so he could see what he might be buying, Buffett turned him down flat. The details of retailing were beyond his circle of competence. What was within his circle was the financial situation of the company then and in the recent past. So he asked Rosner to read the previous five years of balance sheet data over the phone.
• Buffett likes to move quickly to get the other person what he wants. But he doesn’t sacrifice his quality at all. He has looked up other businesses almost everywhere he can find and understood the economics of that business and other competitors.
• Rosner later told his friend Buffett why it worked: "You forgot you bought this business. And I forgot I sold it.” This displays the Buffett’s hands-off managerial style.
• But he was very keen on receiving monthly reports on how the business was operating. While he felt he had no eye for retail, Buffett had a very sharp eye for financials.
• The retail industry is a very difficult game to get right, but some people have a special talent for wringing out high rates of return on capital employed.

Learning Points:

• Circle Competence: We all have a circle of competence, but some people think their circle is much bigger than it really is. Buffett (and Munger) each define their circles quite narrowly. In other words they freely acknowledge that there are many subjects for which they have insufficient competence to be able to draw conclusions from data presented to them. They regard most industries as lying outside of their circle of competence — they simply cannot analyse investments in those fields.
• It’s great to partner with keen cost-cutters: Rosner knew his business inside out and he was in the habit of looking for every ways to remove every ounce of fat from its operations every day.
• People value respect as much as financial reward: Rosner liked the mutual respect and trust between Buffett and himself. This manifest in the freedom he was given to control his domain, the praise that was lavished upon him and the absolute trust Buffett placed in him not to behave in a way harmful to the interests of Buffett’s partners.

Investment 14: Investing in Relationships

• Each crash teaches revelatory lessons to those who pay little attention to stock market history. To wiser heads it reinforces the determination to remember to take a position to exploit the madness of the crowd, rather than to participate in the madness.
• A booming market is an opportunity for asset managers to earn substantially more in fees, as everyone wants to be in shares.
• Buffett had an innate sense of decency and honour, and would honestly try to do his best for his partners, many of whom were close friends or relatives.
• Buffett pondered whether he should join the crowd and go for short-term plays and the exciting companies of tomorrow, even if they lacked a profit history? Into this mix, a major factor was that he was already rich and maybe he should try to concentrate on other things like family.
• “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 will be right.” — Buffett. In other words, we tend to concentrate on what should happen, not when it would happen.
• Buffett thought that two ingredients were now missing. He was no longer a “hungry twenty-five-year-old working with $105,100 initial partnership capital”. He was now a “better fed” 36-year-old who had the difficulty of investing a much larger amount of money: $54m. He had to buy in larger amounts to move the dial of performance and this cut down the number of possible companies because not many had a sufficiently large free float (shares held by investors other than those closely connected with the firm, e.g. founding family or directors). Second, the market environment was no longer conducive to successful implementation of his investment philosophy. At the beginning of the partnership, in a market environment of much lower share prices relative to assets and earnings, there were substantial numbers of companies selling significantly below the value to a private owner: 15 to 25 companies could be identified and Buffett could be “enthusiastic” about the probabilities inherent in all holdings.”
• Buffett never intended to step outside his circle of competence. If an investment technique who soundness he can neither affirm nor deny doesn’t satisfy his intellect (or perhaps his prejudices), and neither does it fit his temperament.
• He won’t seek out activity in investment operations, even if offering splendid profit expectations, where major human problems appear to have a substantial chance of developing.

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors… Interestingly enough, although I consider myself to be primarily in the quantitative school, the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a ‘high-probability insight’. This is what causes the ranger register to really sing. However, it is an infrequent occurrence, as insights usually are, and of course, no insight is required on the quantitative side — the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions. -- Buffett.

• Bargains were going away. Three possible reasons:
  • Competing investors had jumped the badwagon
  • Takeover bids had become more commonplace
  • The large increase in the number of security analyst who scouted the companies
• “When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behaviour by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were — not as they are. Essentially, I am out of step”. — Buffett
• He wanted to cut down his workload by focusing on businesses that he controlled, operated by people he liked, trusted and admired, even if this meant lower rates of return.
• When a stock soars, a gain is nice to have, if you know anything about stock market history you know that picking one-off winners is not a sound basis on which to project forward your future returns. What matters is the availability of numerous investment opportunities.

Learning Points:

• Markets go through periods of irrationality
• Stick with sound investing principles in good times and bad
• Life is not all, or even principally, about making money
• Most fund managers trying to pick shares to outperform the market will not do so if you take into account the high fees they are charging.

Investment 15: Illinois National Bank and Trust

• It has satisfactory return on capital employed, high returns on both assets/liabilities — earning 2% of $100m deposits and $2m over $17m of shareholder capital. It was conservatively run and achieved its returns even though it took very little risk with capital structure, liquidity and lending policy.
• In banking it is easy to make numbers look good for a while by borrowing excessively from financial markets to lend to high-risk prospects. Everything seems fine — until the luck runs out.
• Rockford bank borrowed little from capital or money markets and always maintained a high level of liquidity.

Learning Points:

• Invest in outstanding businesses at reasonable prices
• Even better, if you can get such a business at a low price then you will do very well
• Buy high proportions of great companies
• It is a very good sign when a company founder cares greatly about who’s buying the business
• Banks that stick to simple low-cost vanilla banking with an emphasis on low-risk and steady growth are a completely different prospect to complex banks
• A manager continually looking to gain efficiencies and cost savings is one that is likely to be worth backing

Investment 16: Omaha Sun Newspapers

• It was not satisfying for Buffett to make money by watching his shares rise on the market. Satisfaction came from demonstrating that his analytical reasoning was sound.
• Logical analysis first, followed by business success, followed by share price rises. This is what made sense; the correct order of the investing universe.
• Buffett kept a newspaper clipping of the crash in 1929 on his office wall as reminder of what comes from mania.
• Buffett’s most important rules of investing:
  • Rule 1: Don’t lose money
  • Rule 2: Don’t forget rule 1
• He relied on newspaper information to help develop his ideas.
• Time is precious — what you choose to read can help to form character, as well as increase breadth and depth of knowledge

Learning Points:

• There is more to life than short-term financial gain
• Payment of education
• Hold on to good people
• Don’t forget the qualitative

Investment 17: More Insurance

Learning Points:

• Grand principles are more important than a grand plan
• Intrinsic value is the focus of attention
• Capital allocation was at the heart of Buffett’s good investment performance

Investment 18: Buffett’s Investment in sanity

• Investment is about understanding the business, for which you need to conduct thorough analysis.
• Short-term, or even medium-term, movements of shares on a stock market are usually unrelated and irrelevant to what is happening at the coalface of your business. In the long run the market will recognise intrinsic value, but for many months (or years) in between you can be sure that the market will do some very odd things.
• ‘We don’t believe in miracles, we rely on them.’ — Buffett. It is possible for an old, overweight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.
• Buffett could not bear to let people down and he liked to be the best at what he did.

Learning Points:

• Market moods can be incomprehensible to value investors
• High cash balances are a suitable policy within an investment portfolio when few investments are available with a good margin of safety
• Behave with integrity and diligence toward those who partner in business
• Short-term performance statistics are meaningless in judging investment ability
• Small investors have an advantage

Investment 19: Blue Chip Stamps

• It collected cash upfront and had to pay back later thus having cash which could be deployed at a higher rate of return

Learning Points:

• Float is a very useful way to leverage a skilled investor’s resources to gain additional returns, supplying interest-free funds
• A buying opportunity may arise when there are many reluctant holders of shares
• A failing operating business does not necessarily make for a bad investment
• Working with like-minded investors can allow greater influence and therefore a better outcome for all shareholders

Investment 20: See’s Candies

• Buffett started to take a keen interest in some of the key aspects of the business, particularly things to do with finance. Huggins was not required to regularly meet Buffett or anyone else from Blue Chip or Berkshire. However, data were something that Buffett looked forward to receiving, so he got sales and other statistics frequently. But note, his need for data was not so that he could direct Huggins in how to sell more candy or improve the business; he just took an interest in the performance, particularly return on capital employed.
• Buffett did not regularly phone Huggins or look over his shoulder, though he was available to consult should Huggins need to talk something over. He could call Buffett whenever he liked and Buffett would answer, or, if he was unable to do so, would call him back within an hour.
• See’s never diverged form its chosen path of building a business franchise around quality candy.
• Buffett and Huggins agreed on the need to keep building the franchise, deepening and widening the business’ moat, by never compromising on the quality of the product, using only the best ingredients, with no preservatives, and never compromising on customer service, even if that meant a short-term profit.
• The See’s business was a great educator; it rammed home the importance of the affection with which a branch can be held in people’s minds.
• They devoted limited amounts of capital to test the See’s model elsewhere.
• Buffett felt that it was important that a person with a wider perspective and greater financial interest should have input on the pricing process. He felt that a manager may be averse to raising prices.
• See’s benefited from local economies of scale particularly in advertising and distribution.
• See’s exceptional profit occur, mainly because both new and old customers prefer the taste and texture of See’s candy, as well as the extremely high level of retailing service which characterizes its distribution. This customer enthusiasm is caused by See’s virtually fanatic insistence on expensive natural candy ingredients plus expensive manufacturing and distributing methods that ensure rigorous quality control and cheerful retail service. These qualities are rewarded by extraordinary sales per square foot in the stores, frequently two to three times those of competitors, and by a strong preference by gift recipients for See’s chocolates
• When it comes to reflecting the underlying reality of a business’s position, accounting numbers often provide more confusion than enlightenment. It is important that we focus on the economic reality rather than statistics emanating from accounting rules.
• Accounting rules usually dictate that a purchased business is examined to calculate the fair value of its assets after deduction of all its liabilities. In most cases this sum is much less than what was paid to acquire the business. That gives the accountant a problem: cash (or shares) was paid out of the holding company’s balance sheet, but the fair value of net assets received in return is less. It would seem that value has just disappeared. Of course, it has not disappeared; there might be very good reasons for paying a price much higher than the balance sheet fair value, say because the company has an excellent brand, lucrative patents or great relationships with customers. Thus we say that the extra amount paid above fair value is payment for goodwill.
• Rules for managers and investors to follow when considering goodwill, from the accounting perspective and from the economic value perspective:
  • When looking at profits from a business unit ignore goodwill write offs and amortisation charges (annual deductions to allow for declining value of intangible fixed assets such as patents or depletion of a natural resource), so that the focus is on the return earned on the unleveraged net tangible assets.
  • When trying to make a decision on the acquisition of a business ignore amortisation charges. They should not be deducted from earnings. This means that goodwill is viewed as continuing at its full cost.
  • The cost of a business acquisition should be viewed as the entire intrinsic business value of all the payments made, whether they be in the form of cash or shares in the acquirer, not just the recorded accounting value.

Learning Points:

• Be in a position to buy inputs in a competitive market with many suppliers, but sell where you have pricing power
• Always praise your key managers
• Evaluate what is in the minds of customers
• Look for high returns on small amounts of capital
• Pay-up for franchises
• Keep learning

Investment 21: Washington Post

• Buffett has busied himself analysing companies, despite not being able to take many buy decisions in late 1960s and early 1970s. As shares fell in 1973 & 1974, portions of excellent business could be bought at bargain prices. Buffett was ready; he had done the preparation in the lean years and knew the quality of what he was now buying. He could pick up many shares at single digit price-to-earnings ratios.
• “Be fearful when others are greedy and be greedy when others are fearful”
• In stock market, there’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fields are asleep, you step up and hit it.
• Brilliant journalism and fearless editorial leadership propelled the Washington Post. The paper had worldwide renown for integrity and excellence.
• Over three-quarters of revenue came from advertising. Businesses are willing to pay a lot more to place their ad in the dominant paper. Thus, over the years, the dominant paper can reap greatly increased income without spending much more on editorial or management.
• Katherine Graham was terrified that a raider would take the company out of family hands or influence it for political purposes and so she did not receive this letter from Omaha with much affection. Buffett won over Katherine with his intelligence, decency and humour. If he trusted the key people, he was no longer worried about control. Buffett was more than willing to allow her to draw from his well of experience and rationality. He also boosted her confidence by telling her how smart she was, which he truly believed. Once again, we see Buffett clearly identifying the key person for one of his businesses and then nurturing that individual as a friend and leader. He did not second-guess Graham’s operational decisions, but supported them with advice when requested, praised work well done and offered a listening ear when difficult decisions had to be made. Buffett had no real power as a shareholder, but he did have influence because Graham trusted him as a confidant and shrewd businessman.
• Share buy-backs: Buffett pressed for share repurchases. That way, EPS should rise lifting the value of each remaining share: the discounted future annual owner earnings. This can be done when shares are selling below intrinsic value, conservatively calculated.
• This is a best type of firms to own (but only if you buy at the right price), because they dominate their industries or segments of their industries. More importantly, they can reasonably he expected to dominate in decades from now because of their extraordinary competitive strengths.
• Buffett observed how foolish Mr Market can be, the importance of strong media industry franchises and his willingness to hold much-loved companies even if future returns were destined to be less than they gave in the past.

Learning Points

• Look through temporary problems to the quality of the franchise when estimating intrinsic value.
• Do not be disheartened if the share falls after purchase.
• Keep holding if high returns on capital employed are likely.
• Share buy-backs are good for shareholders if the price is low enough
• Do not pay high prices in bidding wars for hot businesses
• Inevitables are the best type of firms to own (when bought at the right price)
• High-quality economic franchises can disappear
• Do not churn your portfolio: High rates of change in portfolio constituents will please your broker and the taxman, but damage your wealth

Investment 22: Wesco Financial

• Wesco was kind of like mini-Berkshire due to its mix of wholly-owned operating businesses, especially insurance, and it’s collection of tradable securities, many of which were common to both Berkshire’s and Wesco’s portfolios.
• It did well in the building boom following the second world war while after 1972, it was regarded as well managed, with high vigilance over costs and decent profits, it was viewed as sleepy and not bound for fast growth.
• When Buffett and Munger stopped the merger plans, the stock price felt from $17 to $11 and they needed to get more votes to get their word said, so they made an open tender offer of $17 dollars which was an extraordinary thing to do in the light of a general stock market decline. They were generous of the price so that it would not seem that they caused the merger to fail simply so that they could pick up shares at falling prices in the aftermath. Apart from the common decency and the honour code by which these two operated, Buffett and Munger needed to gain the respect, trust and dedication of Louis Vincenti, who they had already identified as they key person at Wesco.
• Vincenti could see that the shareholders he had served for many years, many of whom were friends, were treated fairly. Buffett and Munger saw Vincenti as straight-talking, shrewd, independent and honourable, though cranky, and wanted him to be their long-term partner. There is that concept again — partnership — incorporating traits such as trust, respect, integrity and mutual enrichment.
• Steel suppliers operate in highly competitive markets, subject more than most to the ups and downs of the economy. For the next few years profits at Precision Steel fell. The recession-induced decline was exacerbated by what Munger and Koeppel described in their 1982 Blue Chip letter as “a business mistake. They said they should never have entered the small measuring-tool distribution business.
• (My own) Mutual funds use metal and mining companies to take bets on commodities because such companies don’t have “pricing power” and thus their profits are highly susceptible to high fluctuations in economic conditions. Thus the best time to enter such trades is in the up-tick of a business cycle and exit at the down-tick of a business cycle.
• In 1980s (in a very high interest rate environment) a very serious problem had arised because S&Ls generally offered borrowers fixed-rate mortgages stretching over decades. This money came from depositors offered floating rates. Furthermore, depositors were allowed to withdraw their money at short notice.
• To prepare for this storm, they made a smart move which helped them by:
  • reducing exposure to the S&L market by almost two-thirds at a time when a storm was about to break,
  • raising money by selling physical branch offices,
  • lowering the ongoing costs of serving customers holding the remaining $150M or so of mortgages and about $170M in deposits, because branch network had gone,
  • kept safe a pot of money (about $140M) held in cash, securities and deposits earning interest for Wesco. That was yet another substantial fund for Buffett and Munger to allocate on top of those in Berkshire’s insurance subsidiaries and Blue Chip Stamp’s accounts.
• Wesco was able to take catastrophe-related insurance, called super-cat (earthquakes, hurricanes, etc). This business required a large net worth relative to annual premiums received, because it had to withstand some enormous claims. Buyers would often wish to deal with the highest possible credit ratings and a reliable corporate personality) instead of other reinsurers less cautious, straightforward and well endowed.
• The already strong market position (in a niche market) of KBS was enhanced by BH association. Don Towle said that being part of Berkshire meant that no one questioned KBS’ ability to pay out on claims.He also said that Buffett was very good at simply letting the company grow without interference.

Learning Points:

• Treat your reputation as a highly important asset
• Mistakes in capital allocation will be made, such as with Precision Steel
• Watch for downside risk
• Trust brings large savings