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As of March-2014, Warren Buffett’s net worth was $58.5billion (per Forbes magazine); this is despite giving over $20 billion to Gates Foundation. All this was started with a seed capital of $100. Its said that the first million is always the hardest. This article gives a detailed picture as to how Buffett earned his first million.
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Development of Buffett’s intrinsic value
Roger Federer – All time Tennis legend made his Grand slam debut in 1998 and won his first grand slam title in Wimbledon 2003, since then he has repeated the feat 17 times (As of Mar-2014) If you are a very keen tennis follower you can notice that not much has changed in Federer’s game since 1998. He might have become slightly more mature, but his core game has been the same. Federer was four years old when he watched Boris Becker take his first title. He got fascinated by Tennis right away, he only took the sport seriously when he was 12 years old. Thus one can say that 90% of Federer’s intrinsic value grew in his teen years between the years 1993 and 1998. Like Tennis, Investment is also an art which needs years of hard work and dedication before the artist gets his first public acclamation. Warren Buffett is no different. His core competence was built long before the world first saw a glimpse of it. Warren’s core competence is his ability to grasp enormous amounts of information in very short time. This has helped him to build a mental image of the intrinsic values all the businesses that he follows. Thus when the market values these businesses at a discount, he naturally buys them. Warren’s father owned a securities business called Buffett-Falk. At an age when most children are busy chasing butterflies, Warren would be intrigued with the stock symbols of the S&P 500 guide and the numbers associated with them. His childhood friend Bob Russell would read out the names of cities and Buffett would spit out their populations. It seemed he never forgot any figure once he saw it. But more than everything he had an immense desire to become wealthy. As a kid Warren would go to the local racecourse Ak-Sar-Ben (Nebraska spelt in reverse order) and scout the dusty floors for stubs where once in a while he would get a winning ticket that was thrown out erroneously. Warren was cautious beyond his years. When he learnt to walk , it was with his knees bent as if ensuring that he wouldn’t fall. When Warren was six, his family went for a vacation to Lake Okoboji in Northern Iowa. Warren would buy a six pack coke for 25 cents and would sell them for five cents each, pocketing 20% return in one day. When Warren was seven he was hospitalized, he took a piece of paper and wrote a number with many zeroes and showed it to Nurse, stating that the number represented his future net worth. Such was his confidence!!! As a 10 year old Warren accompanied his dad to Wall Street. This is where he got the first glimpse of the Engine that propels the Capitalistic world. At the age of 11 he made his first stock investment. He bought 3 shares of Cities Services preferred for $38/share. The stock went down to $27 but soon recovered to $40. This is when he sold it, just to see the stock climb to $200. Thus he learnt his first investment lesson of not being impatient. Warren’s passion for probability pulled him to Ak-Sar-Ben Racetrack where he and his friend Russell developed a tipping system for horse players. They called it “Stable boy selections”. They tried selling copies of their system, but the authorities just shut them down as the boys did not possess proper license. At age of 13 Warren moved with his family to Washington as his father was elected to Congress. Warren took up a Newspaper route delivering Washington Post. He was meticulous to track his earnings and file a tax return. Warren’s grades were mediocre and he even once ran from his home. He was a rebellious kid. But his business passion was growing; he soon had five newspaper routes delivering 500 newspapers every day. An excerpt of this young business acumen is visible in his marketing strategy for selling magazines to his newspaper customers. Some of Warren’s customers left their magazines outside and Warren could tell by tearing off the address label when their subscriptions were ending. That is when Warren approached them with new subscriptions. The newspaper business soon blossomed; Warren was making $175 / month (equivalent to $2,625 in 2014). At the age of 14 he had accumulated $1,200 that he invested in forty acres of Nebraska Farmland. Warren and his friend Danly bought a pinball machine, the machine always needed some maintenance and Danly was great at it. Warren noticed Danly’s skills and thought of leveraging it with his business idea. He planned on renting out the machine to a local Barber shop. The deal was that the Barber shop would get the share of the Pinball’s earnings. The business was super success. They soon had seven such machines in different Barber shops. Warren and his friend Danly were making $50 / week. By the time Warren was in his senior year of High school, he had decided on a career in Investing. He would scour through the business page, gleaning at Stock prices. The word of his expertise spread in his school and people were convinced that he knew what he was talking about. Warren graduated from high school in 1947 finishing 16th out of total 347 students. The High School yearbook stated “Likes Math……a future stockbroker”. Chiseling of the great Investment mind By 1950 Warren had accumulated $9,800 from his various little businesses. This is when he stumbled upon Graham’s book “Intelligent Investor”. Graham’s principles struck him straightway. Warren knew that if he wanted to make it big in the Investment world then he needed a mentor, a person who would shower him with the Investment acumen, which would give him that vital extra edge over other investors. They say things happen for a reason, In Warren’s case it was definitely true. He first applied at Harvard and was rejected because the Harvard folks did not find him as a perfect match. Warren then applied at Columbia where Graham was the dean of Securities profession. Warren got the nod from the school and he was heading to New York. Not realizing that his experience there would change his life forever. Graham’s class of 1950 had 20 students; Warren was the youngest amongst them. Graham’s style of teaching involved asking questions to his pupils. Even before Graham had finished his question Warren would raise his hand. Graham wouldn’t say yes or no to the answer, instead would drill down to get the reasoning behind Warren’s answers. Warren passionately followed up with a logical explanation for his answer. The great thing about Graham was that he did not toil on past case studies; instead lectured on stocks those were active. One of Warren’s class mates Marshall Weinberg would later comment that through Graham’s lectures he came to know about cheap stocks like Youngstown sheet & tube, Real Silk Hosiery. He bought these stocks and later profited through them. These stock tips itself paid for his degree. Buffett wanted to know about everything that Graham was associated with. He soon found out that Graham was Chairman of GEICO. On a Saturday morning Buffett boarded a train to its headquarters in Washington. Buffett banged the door of the office until a janitor opened for him. He wanted to know if there was anyone in office he could talk to. Janitor took him to 6th floor where Lorimer Davidson was working. Davvy as he was called by his friends was thrilled to hear complex business questions from a young MBA student. He was impressed with Buffett’s thirst for knowledge and spent four hours going over some intricate topics on Insurance business. Buffett graduated with A+, the only student to have received that honor from Graham in his 22 years of teaching career. Buffett was eager to put his new found Investment knowledge to work. He offered to work for Graham-Newman for FREE. But surprisingly was turned down. Buffett was saddened to hear this, but did not give up his determination. Though he was disheartened to know the reason behind the refusal, it was because Jews were not welcomed in Wall Street firms thus Graham wanted to reserve the spot for a Jew. Buffett headed back to Omaha and joined his father’s investment firm Buffett & Falk. In April 1952 he married Susie and they rented a three room apartment for $65/ month rent. Buffett’s job at his father’s firm was to research investment ideas and sell to his customers. They saw him as a young in-experienced analyst and did not take his investment ideas seriously. Buffett’s best investment that time was the public speaking class at Dale Carnegie. This gave him confidence to speak in public. He made best use of it by teaching a night class on “Investment principles” at University of Omaha. His students were mostly established professionals like doctors who were twice his age. But they immediately were connected to these investment principles that were scooped out of Graham’s playbook. Buffett’s stars again took a turn; he got an offer from Graham-Newman to work for the firm. Graham had dropped the religious barrier. Graham-Newman was operating a mutual fund that bought stocks based on some very rigid principles. One of Graham’s favorites was to look for stocks that were trading at one third less than their working capital. Because of these rigid rules, a lot of Buffett’s investment ideas were rejected by the fund. One such idea was Home protective insurance. Buffett bought it at $15/share and saw it rise to $70/share. His confidence was growing day by day. Graham retired in 1956; his Investment firm had racked 17% annual returns (1936-1956). In the meantime Buffett had laid the solid foundation for his future endeavor. He had successfully tested his investment system by validating its theory; his net worth had grown from $9,800 to $140,000 (equivalent to $2.2mn in 2014) Buffett Partnerships May-1-1956: Warren Buffett, a green 26 year old money manager begins his journey to one of the most spectacular and most followed upon business journeys of American Capitalism. He puts in $100 (Yeah, no zeroes missing, just $100) to form an Investment partnership. His seven initial investment partners were his sister Doris and her husband, Aunt Alice, Doc Thompson, his ex-roommate Chuck Peterson and his mother and Dan Monen his lawyer. Together the seven partners put in $105,000. Very soon few more investors joined in and Buffett was running three small partnerships. PARTNERSHIP’S INVESTMENT STRATEGY (Reference – letters to Buffett Partnership members 01/18/1963) Buffett allocated the assets of partnership into following kinds of investments. Undervalued Securities These he referred to as “generals” , because he had no control over the corporate policies of these companies and no time table as to when the undervaluation would correct itself. By 1962 this had slowly become the largest category of investment and he made more money here than in either of other categories. He allocated 5 % to 10% of total assets in each of five or six generals , with smaller positions in another ten or fifteen. It’s important to note that Buffett did not buy them because he saw any immediate catalyst and had no idea when the prices would appreciate. While investing in this group , he also sometimes followed the strategy of “coattail riding” where he felt that dominating stockholder group had plans for the conversion of unprofitable or under-utilized assets to a better use. In other words he planned his moves with the motive of leveraging on other activist investor's actions. Following are some very interesting words that outline this strategy. “Many times generals represent a form of “coattail riding” where we feel dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.” Workouts These are securities whose financial results depend upon some corporate action like mergers , acquisitions , spin-offs etc. Buffett could predict their time table , within reasonable error limits. An example of this group was sell-outs by oil producers to major integrated oil companies. This category produced stable earnings and whose performance was not related to Dow, hence they seemed to look good when Dow did not do well and vice-versa. This was the second largest category of the investment where Buffett would spread his assets into 5 to 10 of these companies. He was not afraid in borrowing money for investing in these assets because he could somewhat predict the stable earnings. In 1962 the partnership paid $75,000 in interest for a total debt of $1.5 million. These investments generated 10% to 20% return. Buffett was disciplined enough as to not borrow more than 25% of total partnership’s assets. Investments where the Partnership influenced the company’s operations These were investments where the Buffett partnership was the single largest shareholder and could influence the corporate actions. In short term if the prices declined then it worked in the partnership’s advantage as they could increase their holdings at a discount. These investments did not show much gains year over year , but finally yielded large gains when some major corporate action was taken. Following are some notable large investments belonging to this category. Commonwealth Trust co of Union city (Reference – letters to Buffett Partnership members 02/11/1959) The intrinsic value was $125 / share and Buffett bought it for $50 / share (becoming second largest shareholder of the company) However for good reasons, it paid no cash dividends at all despite earning $10 / share, which was largely responsible for a depressed price of about $50 / share. Commonwealth was 25.5% owned by a larger bank (Commonwealth had assets of about $50 million – about half the size of First National or U.S National in Omaha), which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely. The trust had a winning combination of : 1. Very Strong defensive characteristics. 2. Good solid value building up at a satisfactory pace. 3. Evidence to the effect that eventually this value would be unlocked although it might be one year or 10 years. Over a period of a year or so, Buffett was successful in obtaining about 12% of the bank at a price averaging about $51/share. Obviously it was definitely to his advantage to have the stock remain dormant in price. His block of stock increased in value as its size grew, particularly after his partnership became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal. Commonwealth only had about 300 stockholders and probably averaged 2 trades /month. By late 1958 Buffett’s partnership had become the single largest shareholder of the company. He was able to sell his entire block for $80 / share , even though the market price was 20% lower. Thus in around 1 year Buffett made 60% return on this stock. Sanborn Map (Reference – letters to Buffett Partnership members 01/30/61): This was engaged in the publication and continuous revision of extremely difficult maps of all cities in the United States. The map showed minute street details like fire hydrants and composition of roof etc which was used by Underwriters of Insurance companies. The bulk of Sanborn’s customers were 30 Insurance companies. For 75 years the business operated in a very monopolistic way with steady profits with very little in sales expense. But by 1950 the company’s business became to deter because a competitive method of underwriting called “Carding” was introduced. The “after tax profit” fell from $500,000 per year to around $100,000 per year. During early 1930s the company began to accumulate an investment portfolio which blossomed to $2.5 million by 1950s. But market was not giving much weightage to it. In 1938 Dow Jones was at 100-120 range and Sanborn sold at $110 / share. In 1958 Dow Jones was 550 and Sanborn had declined to $45 / share. Yet during the same time the value of Sanborn’s portfolio had increased from $20/share to $65/share. Buffett was smart enough to recognize this and bought large chunk of shares from some disgruntled investors. Once he became the largest shareholder, he pursued the management to separate the map business and the investment portfolio and thus unlocking the hidden value of the investment portfolio. Dempster mill (Reference – letters to Buffett Partnership members 01/18/63): By 1962 Berkshire had bought 73% of Dempster mill manufacturing company. The company was engaged in manufacturing farm implements like water systems, water well supplies and jobbed plumbing lines. On an average Buffett paid $28 / share. The company’s adjusted book value was $35 / share. Initially Buffett tried to work with the management to more efficiently use the capital by planning to reduce the overhead, but these efforts did not bear any considerable result. A friend of Buffett recommended Harry Bottle, a ruthless corporate manager. On Apr-17-1962 Buffett met him and presented a deal which provided for rewards based on objectives, on Apr-23 he was in charge at Beatrice. Harry was like a magician who surpassed all of Buffett’s targets. Harry was instrumental in freeing a lot of capital that was tied to non-performing assets. This helped the company’s capital position and helped it to secure $1.25 million. The company’s overall valuation was $51 / share (This included $16 / share tied to manufacturing) BUFFETT'S FIRST MILLION By Jan-1 1963, the partnership’s net assets was $9,405,400. Buffett and his wife Susie together had a share of $1,377,400. Thus Buffett joined the millionaire’s club. |
