“The Warren Buffett Way outlines his career and presents samples of how his investment techniques and methods evolved and therefore the important individuals within the process. It also details the key investment decisions that produced his unmatched record of performance. Finally, the Article contains the thinking and therefore the philosophy of an investor that consistently made money using the tools available to each citizen regardless of what their level of wealth.”
The World’s Greatest Investor
Every year, Forbes magazine publishes an inventory of the 400 richest Americans, the elite Forbes 400. Individuals on the list come and go from year to year, as their personal circumstances change and their industries rise and fall, but some names are constant. Among those leading the list year in and year out are certain mega billionaires who trace their wealth to a product (computer software or hardware), a service (retailing), or lucky parentage (inheritance). of these perennially within the top five, just one made his fortune through investment savvy.
That one person is Warren Buffett. within the early 1990s, he was favorite. Then for a couple of years, he seesawed between favorite and number two with a teenager named Gates. Even for the dot-com-crazed year 2000, when such a lot of the wealth represented by the Forbes 400 came from the exceptional growth in technology, Buffett, who smilingly eschews high-tech anything, was firmly in the fourth position.
He was still the sole person within the top five for whom the “source of wealth” column read “stock market.” In 2004, he was solidly back within the number two position. In 1956, Buffett started his investment partnership with $100; after thirteen years, he cashed out with $25 million. At the time of this writing (mid-2004), his personal net worth has increased to $42.9 billion, the stock in his company is selling at $92,900 a share, and many investors around the world hang on him every word.
Warren Edward Buffett was born August 30, 1930, in Omaha, Nebraska. His grandfather owned a grocery store (and once employed a young Charlie Munger); his father was a local stockbroker. As a boy, Warren Buffett was always fascinated with numbers and could easily do complex mathematical calculations in his head. At age eight, he began reading his father’s books on the stock market; at age eleven, he marked the board at the brokerage house where his father worked. His early years were enlivened with entrepreneurial ventures, and he was so successful that he told his father he wanted to skip college and go directly into business.
He was overruled. Buffett attended the business school at the University of Nebraska, and while there, he read a new book on investing by a Columbia professor named Benjamin Graham. It was, of course, The Intelligent Investor. Buffett was so taken with Graham’s ideas that he applied to Columbia Business School so that he could study directly with Graham. Bill Ruane, now chairman of the Sequoia Fund, was in the same class.
He recalls that there was instantaneous mental chemistry between Graham and Buffett and that the rest of the class was primarily an audience.1 Not long after Buffett graduated from Columbia with a master’s degree in economics, Graham invited his former student to join his company, the Graham-Newman Corporation. During his two-year tenure there, Buffett became fully immersed in his mentor’s investment approach (see Chapter 2 for a full discussion of Graham’s philosophy).
In 1956, Graham-Newman disbanded. Graham, then 61, decided to retire, and Buffett returned to Omaha. Armed with the knowledge he had acquired from Graham, the financial backing of family and friends, and $100 of his own money, Buffett began a limited investment partnership. He was twenty-five years old.
THE BUFFETT PARTNERSHIP, LTD.
The partnership began with seven limited partners who together contributed $105,000. The limited partners received 6 percent annually on their investment and 75 percent of the profits above this bogey; the remaining 25 percent visited Buffett, who as general partner had essentially play to take a position the partnership’s funds. Over the subsequent thirteen years, Buffett compounded money at an annual rate of 29.5 percent.2 it had been no easy task. Although the Dow Jones Industrial Average declined in price five different years during that thirteen-year period, Buffett’s partnership never had a down year. Buffett, in fact, had begun the partnership with the ambitious goal of outperforming the Dow by ten points per annum.
And he did it—not by ten—but by twenty-two points! As Buffett’s reputation grew, more people asked him to manage their money. For the partnership, Buffett bought controlling interests in several public and personal companies, and in 1962 he began buying shares in an ailing textile company called Berkshire Hathaway. that very same year, 1962, Buffett moved the partnership office from his home to Kiewit Plaza in Omaha, where his office remains today. the subsequent year, he made a shocking purchase. Tainted by a scandal involving one among its clients, American Express saw its shares drop from $65 to $35 almost overnight. Buffett had learned Ben Graham’s lesson well: When stocks of a robust company are selling below their intrinsic value, act decisively.
Buffett made the bold decision to place 40 percent of the partnership’s total assets, $13 million, into American Express stock. Over the subsequent two years, the shares tripled in price, and therefore the partners netted a cool $20 million in profit. it had been pure Graham—and pure Buffett.
By 1965, the partnership’s assets had grown to $26 million. Four years later, explaining that he found the market highly speculative and worthwhile values increasingly scarce, Buffett decided to finish the investment partnership. When the partnership disbanded, investors received their proportional interests. a number of them, at Buffett’s recommendation, sought out money manager Bill Ruane, his old classmate at Columbia. Ruane agreed to manage their money and thus was born the Sequoia Fund.
Others, including Buffett, invested their partnership revenues in Berkshire Hathaway. By that time, Buffett’s share of the partnership had grown to $25 million, which was enough to offer him control of Berkshire Hathaway. What he did with it’s documented within the investment world. Even those with only a passing interest within the stock exchange recognize Buffett’s
THE MAN AND HIS COMPANY
Warren Buffett is not easy to describe. Physically, he is unremarkable, with looks often described as grandfatherly. 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 all things logical and a foul distaste for imbecility.
He embraces the simple and avoids the complicated. When reading Berkshire’s annual reports, one is struck by how comfortable Buffett is quoting the Bible, John Maynard Keynes, or Mae West. The operable word here is reading. Each report is sixty to seventy pages of dense information: no pictures, no color graphics, no charts. Those who are 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 candid in his reporting. He emphasizes both the pluses and the 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. When Buffett took control of Berkshire, the corporate net worth was $22 million. Forty years later, it has grown to $69 billion. It has long been Buffett’s goal to increase the book value of Berkshire Hathaway at a 15 percent annual rate—well above the return achieved by the average American company. Since he took control of Berkshire in 1964, the gain has been much greater: Book value per share has grown from $19 to $50,498, a rate of 22.2 percent compounded annually. This relative performance is all the more impressive when you consider that Berkshire is penalized by both income and capital gains taxes and the Standard & Poor’s 500 returns are pretax.
The Education of Warren Buffett
Very few people can come close to Warren Buffett’s investment record, and no one can stop it. Through four decades of market ups and downs, he has continued on a steady course with unmatched success. What he does is not flashy, even at times very much out of favor, and yet over and over, he has prevailed over others whose exploits gave them temporarily, flash-in-the-pan stardom.
He watches, smiles, and continues on his way. How did Buffett come to his investment philosophy? Who influenced his thinking, and how has he integrated their teachings into action? To put the question another way, how is it that this particular genius turned out so differently? Warren Buffett’s approach to investing is uniquely his own, yet it rests on the bedrock of philosophies absorbed from four powerful figures:
Benjamin Graham, Philip Fisher, John Burr Williams, and Charles Munger. Together, they are responsible for Buffett’s financial education, both formal and informal. The first three are educators in the classic sense, and the last is Buffett’s partner, alter ego, and pal. All have had a major influence on Buffett’s thinking; they have much to offer modern-day investors as well.
Graham is taken into account the dean of monetary analysis. He was awarded that distinction because “before him, there was no [financial analysis] profession and after him, they began to call it that.”1 Graham’s two most celebrated works are Security Analysis, coauthored with David Dodd, and originally published in 1934; and therefore the Intelligent Investor, originally published in 1949. Security Analysis appeared just a couple of years after the 1929 stock exchange crash and within the depths of the nation’s worst depression. While other academicians sought to elucidate this economic phenomenon, Graham helped people regain their financial footing and proceed with a profitable course of action.
Graham began his career on Wall Street as a messenger at the brokerage of Newburger, Henderson & Loeb, posting bond and stock prices on a blackboard for $12 every week. From messenger, he rose to writing research reports and shortly was awarded a partnership within the firm. By 1919, he was earning an annual salary of $600,000; he was twenty-five years old. In 1926, Graham formed an investment partnership with Jerome Newman.
it had been this partnership that hired Buffett some thirty years later. Graham-Newman survived the 1929 crash, the good Depression, war II, and therefore the Korean War before it dissolved in 1956. From 1928 through 1956, while at Graham-Newman, Graham taught night courses in finance at Columbia. Few people know that Graham was financially ruined by the 1929 crash. For the second time in his life—the first being when his father died, leaving the family financially unprotected—Graham set about rebuilding his fortune. The haven of academia allowed him the chance for reflection and reevaluation.
With the counsel of David Dodd, also a professor at Columbia, Graham produced what became the classic treatise on conservative investing: Security Analysis. Between them, Graham and Dodd had over fifteen years of investment experience. It took them four years to finish the book. The essence of Security Analysis is that a well-chosen diversified portfolio of common stocks, supported reasonable prices, are often a sound investment. Step by careful step, Graham helps the investor see the logic of his approach.
The basic ideas of investing are to look at stocks as businesses, use market f luctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.4
WARREN BUFFETT, 1994
While Graham was writing Security Analysis, Philip Fisher was beginning his career as an investment counselor. After graduating from Stanford’s grad school of Business Administration, Fisher began work as an analyst at the Anglo London & Paris commercial bank in San Francisco. In but two years, he was made head of the bank’s statistical department. it had been from this perch that he witnessed the 1929 stock exchange crash.
After a quick and unproductive career with an area brokerage, Fisher decided to start out his own investment counseling firm. On March 1, 1931, Fisher & Company began soliciting clients. Starting an investment counseling firm within the early 1930s may need to be appeared foolhardy, but Fisher figured he had two advantages. First, any investors who had any money left after the crash were probably very unhappy with their existing broker. Second, within the midst of the good Depression, businesspeople had any time to take a seat and talk with Fisher.
At Stanford, one among Fisher’s business classes had required him to accompany his professor on periodic visits to companies within the San Francisco area. The professor would get the business managers to speak about their operations and sometimes helped them solve an instantaneous problem. Driving back to Stanford, Fisher and his professor would recap what they observed about the businesses and managers they visited. “That hour hebdomadally,” Fisher said, “was the foremost useful training I ever received.”5 From these experiences, Fisher came to believe that folks could make superior profits by (1) investing in companies with above-average potential and (2) aligning themselves with the foremost capable management.
To isolate these exceptional companies, Fisher developed some extent a system that qualified a corporation by the characteristics of its business and its management. on the first—companies with above-average potential—the characteristic that the majority impressed Fisher was a company’s ability to grow sales over the years at rates greater than the industry average.6 That growth, in turn, usually was a mixture of two factors: a big commitment to research and development, and an efficient sales organization.
a corporation could develop outstanding products and services but unless they were “expertly merchandised,” the research and development effort would never translate into revenues. In Fisher’s view, however, market potential alone is merely half the story; the opposite half is consistent profits. “All the sales growth within the world won’t produce the proper sort of investment vehicle if, over the years, profits don’t grow correspondingly,” he said.7 Accordingly, Fisher examined a company’s profit margins, its dedication to maintaining and improving those margins and, finally, its analysis and accounting controls.
“Our Main Business Is Insurance”
The Early Days of
When the Buffett Partnership took control of Berkshire Hathaway in 1965, stockholders’ equity had dropped by half and loss from operations exceeded $10 million. Buffett and Ken Chace, who managed the textile group, labored intensely to show the textile mills around. Results were disappointing; returns on equity struggled to succeed in double digits. Amid the gloom, there was one bright spot, a symbol of things to come: Buffett’s deft handling of the company’s common shares portfolio.
When Buffett took over, the corporation had $2.9 million in marketable securities. By the top of the primary year, Buffett had enlarged the securities account to $5.4 million. In 1967, the dollar return from investing was 3 times the return of the whole textile division, which had ten times the equity base.
Nonetheless, over the subsequent decade, Buffett had to return 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 differentiating their products from those of competitors. Foreign competition, which employed a less expensive labor pool, was squeezing profit margins. Second, to remain competitive, the textile mills would require significant capital improvements—a prospect that’s frightening in an inflationary environment and disastrous if the business returns are anemic. Buffett made no plan to hide the difficulties, but on several occasions, he explained his thinking:
The textile mills were the most important employer within the area; the workforce was an older age bracket with relatively nontransferable skills; management had shown a high degree of enthusiasm; the unions were being reasonable; and lastly, he believed that the textile business could attain some profits.
However, Buffett made it clear that he expected the textile group to earn positive returns on modest capital expenditures. “I won’t close a business of subnormal profitability merely to feature a fraction of some extent to our corporate returns,” said Buffett. “I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to possess unending losses in prospect. Smith would afflict my first proposition and Marx would afflict my second; the center ground,” he explained “is the sole position that leaves me comfortable.”1 In 1980, the annual report revealed ominous clues for the longer term of the textile group. That year, the group lost its prestigious lead-off position within the Chairman’s Letter. By subsequent year, textiles weren’t discussed within the letter in the least .
Then, the inevitable: In July 1985, Buffett closed the books on the textile group, thus ending a business that had started some 100 years earlier. The experience wasn’t an entire failure. First, Buffett learned a valuable lesson about corporate turnarounds: They seldom succeed. Second, the textile group generated enough capital within the earlier years to shop for an insurance firm which may be a much brighter story