The Warren Buffett Way

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"In investing, it is not necessary to do extraordinary things
to get extraordinary results."
— Warren Buffett

About Warren Buffett

Warren Buffett Biography

By Robert G. Hagstrom

Warren Edward Buffett was born August 30, 1930, in Omaha, Nebraska. He was the seventh generation of Buffetts to call Omaha home. The first Nebraskan Buffett opened a grocery store in 1869. Buffett's grandfather also ran a grocery store and once employed a young Charlie Munger, the future vice chairman of Berkshire Hathaway. Buffett's father, Howard, was a local stockbroker and banker who later became a Republican Congressman.

Early Years

When he was six years old, Buffett received a nickel-coated money changer for Christmas from his Aunt Alice. It marked the beginning of Buffett's career as an entrepreneur. He set up a table outside his house and sold Chiclets to passersby. He went door to door selling packs of gum and soda pop. He would buy a six-pack of Coke at his grandfather's grocery store for twenty-five cents and sell the individual bottles for a nickel, a 20% return on investment. He also sold, door-to-door, copies of the Saturday Evening Post and Liberty magazines. Each weekend he sold popcorn and peanuts at local football games. With him through all these enterprises was his money changer, taking in dollars and making change.

Buffett's childhood took an abrupt turn when his father returned home one night to inform the family the bank where he worked had closed. His job was gone and their savings were lost. The Great Depression had finally made its way to Omaha. Buffett's grandfather, the grocery store owner, gave Howard money to help support his family. While his father soon pulled himself up and got back on his feet and co-founded Buffett, Sklenicka & Company, the experience had a profound impression on young Warren.

"He emerged from those first hard years with an absolute drive to become very, very, very rich," wrote Roger Lowenstein, author of Buffett: The Making of an American Capitalist. "He thought about it before he was five years old. And from that time on, he scarcely stopped thinking about it."

Buffett developed an interest in the stock market at a very young age. On Saturday mornings, when the stock exchange was open for two hours, Buffett would hang out with his paternal great-uncle Frank Buffett and his maternal great-uncle John Barber at an Omaha brokerage office. Each weekend he read the "Trader" column in Barron's. Once he finished reading all the books on his father's bookshelf, he consumed all the investment books at the local library. Soon he began charting stock prices himself, trying to understand the numerical patterns that were flashing by his eyes.

When he was eleven years old, Buffett purchased his first stock. He invested $120 from the money he saved from selling soda pop, peanuts, and magazines. He decided on Cities Service Preferred, one of his father's favorite stocks, and enticed his sister Doris to join him. They each bought three shares, for an investment of $114.75 each. Largely because of Doris' aversion to losing money, Buffett sold too early, making only a $5 profit. Shortly, thereafter, the stock soared to $202. At the wise age of eleven, Buffett had already learned one of the most important lessons in investing — patience.

In 1942, when Buffett was twelve, his father was elected to the US Congress and moved the family to Washington. With no friendly brokerage firms to hang out in, gradually Buffett's interest moved away from the stock market and toward entrepreneurial ventures. At age thirteen, he was working two paper routes, delivering the Washington Post and the Washington Times-Herald. At Woodrow Wilson High School Buffett made friends with Don Danly, who quickly became infected with Buffett's enthusiasm for making money. The two pooled their savings and bought reconditioned pinball machines for $25. Buffett convinced a local barber to let them put a machine in his shop for half the profits. After the first day of operation they returned to find $4 in nickels in their very first machine. The Wilson Coin-Operated Machine Company expanded to seven machines, and soon Buffett was taking home $50 per week.

The Graham Influence

Buffett spent two unsatisfying years at the University of Pennsylvania's Wharton School of Business and Finance and then transferred to the University of Nebraska. He took fourteen courses in one year and graduated in 1950. He was not yet 20 years old.

Back in Omaha, Buffett reconnected with the stock market. He started collecting hot tips from brokers and subscribed to publishing services. One day in the local library, he came across a recently published book titled The Intelligent Investor by Benjamin Graham. "That," he said, "was like seeing the light." Buffett soon left Omaha to study with Graham at the Columbia University Graduate School of Business.

Graham preached the importance of understanding a company's intrinsic value. He believed investors who accurately calculated this value and bought shares below it in price could be profitable in the market. This mathematical approach appealed to Buffett's love of numbers.

In Graham's class were twenty students. Many were older than Buffett and several were working on Wall Street. In the evening, these Wall Street professionals sat in Graham's class discussing which stocks were massively undervalued, and the next day they would be back at work buying the stocks analyzed the night before and making money. It was soon clear to everyone that Buffett was the brightest student. He often raised his hand to answer Graham's question before Graham had finished asking it. Buffett's grade for the class was an A+ , the first such grade Graham had awarded in twenty-two years of teaching.

After graduating from Columbia, Buffett asked Graham for a job but was turned down. At first Buffett was stung by the rejection but later was told that Graham preferred to fill the slots at Graham-Newman with Jewish analysts who he perceived were being treated unfairly on Wall Street. Undeterred, Buffett returned to Omaha, where he joined Buffett-Falk Company, his father's brokerage. He hit the ground running, eagerly recommending stocks that met Graham's value criteria. All the while Buffett stayed in touch with Graham, sending him stock ideas after stock ideas. Then, in 1954, Graham called with news: the religious barrier had been lifted and there was a seat at Graham-Newman if he was still interested. Buffett was on the next plane to New York.

For Buffett, Graham was much more than a tutor. "It was Graham who provided the first reliable map to that wondrous and often forbidding city, the stock market," wrote Roger Lowenstein. "He laid out a methodological basis for picking stocks, previously a pseudoscience similar to gambling." In 1956, two years after Buffett arrived, Graham-Newman disbanded and Graham, then sixty-one, decided to retire.

Buffett returned to Omaha. Armed with the knowledge he had acquired from Graham, and with the financial backing of family and friends, he began a limited investment partnership. He was twenty-five years old.

The Buffett Partnership

The Buffett Partnership began with seven limited partners who together contributed $105,000. Buffett, the general partner, started with $100. The limited partners received 6 percent annually on their investment and 75 percent of the profits above this bogey; Buffett earned the other 25 percent. But the goal of the partnership was relative, not absolute. Buffett's intention, he told his partners, was to beat the Dow Jones Industrial Average by ten percentage points.

Buffett promised his partners that "our investments will be chosen on the basis of value not popularity" and that the partnership "will attempt to reduce permanent capital loss (not short-term quotational loss) to a minimum." Initially, the partnership bought undervalued common stocks based on Graham's strict criteria. In addition, Buffett also engaged in merger arbitrage — a strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit.

Out of the gate, the Buffett partnership posted incredible numbers. In its first five years (1957-1961), a period in which the Dow was up 75%, the partnership gained 251% (181% for limited partners). Buffett was beating the Dow not by the promised ten percentage points but by an average of 35.

In the beginning, Buffett confined the partnership to buying undervalued securities and certain merger arbitrage announcements. But in the fifth year, he purchased his first controlling interest in a business, the Dempster Mill Manufacturing Company, a maker of farm equipment. Next he began buying shares in an ailing New England textile company called Berkshire Hathaway, and by 1965 he had control of the business.

Since 1956, the valuation strategy outlined by Graham and used by Buffett dominated the stock market. But by the mid 1960s a new era was unfolding. It was called the "Go-Go Years" (the "go-go" referred to growth stocks). It was a time when greed began driving the market and where fast money was made and lost in the pursuit of high-flying performance stocks.

Despite the underlying shift in market psychology, the Buffett Partnership continued to post outstanding results. By the end of 1966, the partnership had gained 1,156% (704% for limited partners), blitzing the Dow, which rose 123% over the same period. Even so, Buffett was becoming increasingly uneasy. Whereas the market had been dancing to the principles outlined by Graham, the new music being played in the stock market made little sense to Buffett.

In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The "Nifty-Fifty" were on the tip of every investor's tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment. "On one point, however, I am clear," he said. "I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean forgoing large and apparently easy profits, to embrace an approach which I don't fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital."

When Buffett disbanded the partnership, many thought the "money-changer's" best days were behind him. In reality, he was just getting started.

Berkshire Hathaway

Berkshire Hathaway proved to be a very challenging business to run. During the next twenty years, Buffett, along with Ken Chace, who managed the textile group, labored intensely to turn around the New England textile mills. Results were disappointing. Returns on equity struggled to reach double digits.

Buffett made it clear that he expected the textile group to earn positive returns on modest capital expenditures. "I won't close down a business of sub-normal profitability merely to add a fraction of a point to our corporate returns," said Buffett. "I also feel it is inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition and Karl Marx would disagree with my second; the middle ground," he explained, "is the only position that leaves me comfortable."

As Berkshire Hathaway entered the 1980s, Buffett was coming to grips with certain realities. First, the very nature of the textile business made high returns on equity improbable. Textiles are commodities and commodities by definition have a difficult time distinguishing their products from those of competitors. Foreign competition, employing a cheap labor force, was squeezing profit margins. Second, in order to stay competitive, the textile mills would require significant capital improvements, a prospect that is frightening in an inflationary environment and disastrous if the business returns are anemic.

By 1980, the annual report revealed ominous clues for the future of the textile group. That year, the group lost its prestigious lead-off position in the Chairman's Letter. By the next year, the textile group was not discussed in the letter at all. Then, the inevitable: in July 1985, Buffett closed the books on the textile group, thus ending a business that began some one hundred years earlier.

Despite the misfortunes of the textile group, the experience was not a complete failure. First, Buffett learned a valuable lesson about corporate turnarounds: they seldom succeed. Second, the textile group did generate enough capital in the early years to buy an insurance company, and that is a much brighter story.

Investing in Insurance

In March of 1967, Berkshire Hathaway purchased, for $8.6 million, the outstanding stock of two insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine Insurance Company. It was the beginning of Berkshire Hathaway's phenomenal success story.

To appreciate the phenomenon, it is important to recognize the true value of owning an insurance company. Insurance companies are sometimes good investments, sometimes not. They are, however, always terrific investment vehicles. Policyholders, in paying premiums, provide a constant stream of cash; insurance companies invest this cash until claims are filed. Because of the uncertainty of the when claims will occur, insurance companies opt to invest in liquid securities: primarily short-term fixed income securities, longer-date bonds, and stocks. Thus Warren Buffett acquired not only two modestly healthy companies, but a cast-iron vehicle for managing investments.

In 1967, the two insurance companies had a bond portfolio worth more than $24.7 million and a stock portfolio worth $7.2 million. In two years, the combined portfolio approached $42 million. This was a handsome portfolio for a seasoned stock picker like Buffett. He had already experienced some limited success managing the textile company's securities portfolio. When Buffett took control of Berkshire in 1965, the company had $2.9 million in marketable securities. By the end of the first year Buffett enlarged the securities account to $5.4 million. In 1967, the dollar return from investing was three times the return of the entire textile division, which had ten times the equity base of the common stock portfolio.

Over the years, Buffett has added several insurance companies to the Berkshire insurance group. One prominent addition, now well known thanks to a clever advertising campaign, is GEICO. By 1991, Berkshire Hathaway owned nearly half of its outstanding commons shares. For the next three years, the company's impressive performance continued to climb; so did Buffett's interest. In 1994, Berkshire announced it owned 51% of the company, and serious discussion began on GEICO joining the Berkshire family. Two years later, Buffett wrote a check for $2.3 billion and GEICO became a wholly owned business.

Buffett was not done. In 1998, he paid seven times the amount he had spent to buy the remaining outstanding shares of GEICO — about $16 billion in Berkshire Hathaway stock — to acquire a reinsurance company called General Re. It was his biggest acquisition up to that date.

The Man and His Company

Warren Buffett is not easy to describe. Physically he is unremarkable, with looks that are more grandfatherly than corporate titan. Intellectually he is considered a genius, yet his down-to-earth relationship with people is truly uncomplicated. He is simple, straightforward, forthright, and honest. He displays an engaging combination of sophisticated dry wit and cornball humor. He has a profound reverence for those things logical and a foul distaste for imbecility. He embraces the simple and avoids the complicated.

Reading his annual reports, one is struck by how comfortable Buffett is quoting the Bible, John Maynard Keynes, or Mae West. Of course the operable word is "reading." Each report is sixty to seventy pages of dense information: no pictures, no color graphics, no charts. Those disciplined enough to start on page one and continue uninterrupted are rewarded with a healthy dose of financial acumen, folksy humor, and unabashed honesty. Buffett is very candid in his reporting. He emphasizes both the pluses and minuses of Berkshire's businesses. He believes that people who own stock in Berkshire Hathaway are owners of the company, and he tells them as much as he would like to be told if he were in their shoes.

The company that Buffett directs is the embodiment of his personality, his business philosophy, which is identically tied to his investment philosophy, and his own unique style. Berkshire Hathaway, Inc. is complex but not complicated. There are just two major parts; the operating businesses and the stock portfolio, made possible by the earnings of the non-insurance businesses and the insurance companies' float. Running through it all is Warren Buffett's down-to-earth way of looking at businesses he's considering buying outright, a business he's evaluating for common stock purchase, or the management of his own company.

Today, Berkshire Hathaway is divided into three major groups: its Insurance Operations; its Regulated Capital-Intensive Businesses, which includes MidAmerican Energy and the railroad Burlington Northern Santa Fe; and Manufacturing, Services and Retailing Operations, with products ranging from lollipops to jet airplanes. Collectively, these businesses generated, in 2012, $10.8 billion in earnings for Berkshire Hathaway compared to the $399 million Buffett the businessperson earned in 1988. At year end 2012, Berkshire Hathaway's portfolio of investments had a market value of $87.6 billion against a cost basis of $49.8 billion. Twenty-five years ago, in 1988, Buffett the investor had a portfolio valued at $3 billion against a cost basis of $1.3 billion.

Over the last 48 years, starting in 1965, the year Buffett took control of Berkshire Hathaway, the book value of the company has grown from $19 to $114,214 per share, a compounded annual gain of 19.7%; during that period, the S&P 500 Index gained 9.4%, dividends included. That is a 10.3% relative outperformance earned for almost five decades. As I said earlier, when the "money changer" shut down the Buffett Partnership, he was just getting started.

For years academicians and investment professionals have debated the validity of what has come to be known as the efficient market theory. This controversial theory suggests that analyzing stocks is a waste of time because all available information is reflected in current prices. Those who adhere to this theory claim, only partly in jest, that investment professionals could throw darts at a page of stock quotes and pick winners just as successfully as a seasoned financial analyst who spent hours poring over the latest annual report or quarterly statement.

Yet the success of some individuals who continually beat the indices — most notably Warren Buffett — suggests that the efficient market theory is flawed. Efficient market theoreticians counter that it is not the theory that is flawed. Rather, they say, individuals like Buffett are a five-sigma event, a statistical phenomenon so rare it practically never occurs. It would be easy to side with those who claim Buffett is a statistical rarity. No one has ever come close to repeating his investment performance, whether it was the thirteen-year results from the Buffett Partnership or the almost five-decade performance record at Berkshire Hathaway. When we tabulate the results of almost every investment professional, noting their inability to beat the major indices over time, it prompts the question: Is the stock market indeed unassailable, or is it a question of the methods used by most investors?

Last, we have Buffett's own words to consider. "What we do is not beyond anyone else's competence. I feel the same way about managing that I do about investing: it is just not necessary to do extraordinary things to get extraordinary results." Most would dismiss Buffett's explanation as nothing more than his special brand of Midwestern humility.