This was an article by Geoff Gannon which I love, and return to read from time to time.
I decided to make a copy on my blog, so that I could find them easily, instead of digging it out from Google searches.
Do you know which specific investments that Buffett made in his early career gave him his biggest returns and generated his initial wealth?
What did he see in these companies that led him to invest in them?
- Ryan
If you read Alice Schroeder's "The Snowball" you can easily find the investments that generated Warren Buffett 's initial wealth.
Here, I'll talk about just the first $100,000 Warren Buffett made investing in stocks.
We'll start after Warren Buffett first read “The Intelligent Investor” but before he started taking Ben Graham's class at Columbia. Buffett already owned Marshall Wells before he took Ben Graham's class. He still owned the stock when he went asked David Dodd (co-author of "Security Analysis") if he could skip Dodd's class and go to Marshall Wells's annual meeting. This is where Buffett first met Walter Schloss.
Let's take a look at Marshall Wells when Buffett owned the stock.
Marshall Wells
· Biggest hardware wholesaler in America
· $200 stock price
· $62 earnings per share
So, the stock was selling for a little over 3 times earnings. The earnings yield - "E" divided by "P" - was about 30%.
This brings me to the first point I need to make about Warren Buffett 's early investing career. Warren Buffett worshipped Ben Graham. But there's this idea that Warren Buffett started out as a Ben Graham type investor. That's false. Buffett bought some Ben Graham type stocks - like net-nets. Graham had a big influence on which stocks Buffett picked. But Warren Buffett never invested the way Ben Graham did.
More on that later.
For now, the big difference we need to discuss between early Warren Buffett and Ben Graham is that Warren Buffett is, was, and always will be a return on investment investor. He's not a value investor in the sense that he sees some static value and buys at a 50% discount to that.
Buffett is obsessed with the idea of compounding.
When Warren Buffett started taking Ben Graham's class there was already a big difference between Graham and Buffett in that Graham was thinking about earning a good return on his investment capital, protecting the safety of his principal, and beating the market over time. Warren Buffett was thinking about compounding wealth. He was interested in getting rich.
There's a huge difference there. Ben Graham - and later Walter Schloss - made a habit of returning a lot of their partnership's gains. So, if you had $100 invested in Graham-Newman and they earned 15% on your money - the default idea was not necessarily to take that $115 and try to turn it into $132.25 next year. The first idea in Graham's head was: "I can earn 15% on $100 safely". So, he was concerned with how much capital the partnership could operate with and still beat the market while taking less risk.
Graham was never concerned with compounding the partnership's wealth over time.
This is a huge difference from Warren Buffett . When Buffett ran a partnership, he took $1 and turned it into something like $27. That was always his goal. To grow wealth. Not just earn a decent return safely.
This is something Buffett wanted to do even before he knew anything about value investing. Buffett's obsession with compounding wealth over time predates his conversion to value investing. And it was never something he had to "learn" after his time with Ben Graham. He was always obsessed with return on investment as being the key to compounding. That doesn’t mean he was obsessed with the company’s return on its own capital. But, from the earliest days, he thought of stocks in terms of the return they generated for him – not in terms of the discount to some fixed intrinsic value.
This caused Warren Buffett to invest very differently from Ben Graham - even while he was working for Graham.
It's interesting to note that Buffett managed to invest very differently from Ben Graham even while he bought almost the same exact kinds of stocks Ben Graham bought. In fact, sometimes he literally bought the same stocks Graham bought. But Buffett always got much better results.
Why?
Because he focused. Warren Buffett told Charlie Rose that "focus" was the key to his success. He's repeated over and over again that he doesn't necessarily have more good ideas than other investors - he just has fewer bad ideas. Buffett focuses on his very best ideas and puts as much money as possible into those ideas.
If it sounds like I’m exaggerating when I say "as much money as possible" - check out the next stock:
GEICO
Buffett found out that Ben Graham was the Chairman of GEICO. Graham-Newman bought a huge block of GEICO stock in the past. They got the stock at a Ben Graham type price. But GEICO turned out to actually be a wonderful growth stock. Investors who kept their shares of GEICO when Graham-Newman distributed them made a lot of money over time.
GEICO's headquarters were in Washington. So, one Saturday, Buffett took a train from New York (where he was going to school) down to Washington. You've probably heard this story before. Buffett knocked on the door. The only person there was Lorimer Davidson. Davidson later became CEO of GEICO. He put together the Graham-Newman deal.
Anyway, he knew a lot about GEICO. There was no better person for Buffett to meet. So, Buffett started asking him questions. And he kept answering them. And this went on for hours. Davidson explained to Buffett that GEICO was the low-cost operator in the car insurance business because they did not use agents. Buffett was sold on GEICO’s future prospects. Here is Buffett’s response as described in The Snowball:
“That Monday, less than 48 hours after he arrived back in New York, Warren dumped stocks worth three quarters of his net worth and used the cash to buy 350 shares of GEICO…GEICO was trading at $42 per share, a multiple of about 8 times its recent earnings per share…(Buffett) thought the stock would be worth between $80 and $90 per share (within 5 years).”
A few points here. One, we can do some math and see that Buffett believed he was going to make more than 13% a year in GEICO. The low end value estimate ($80) and the longest time Buffett expected the stock to take to reach that value (5 years) would have resulted in about a 14% compound annual growth rate.
It’s likely that Buffett believed he would make at least 15% a year for as long as he held GEICO. Because he meant it would be worth $80 to $90 a share within 5 years. Not that it would actually take a full five years and that $80 to $90 was a perfectly accurate estimate. That’s not what he meant. What he meant is that he thought he was buying something that would most likely return at least 15% a year.
GEICO was not a Ben Graham stock at the time. It was an insurer selling for 8 times earnings. In 1951, an insurer selling for 8 times earnings was probably considered cheap (if it had good growth prospects). But it was not that close to Ben Graham territory. And insurers do sometimes trade for 8 times earnings. Maybe not an insurer with GEICO’s future. But that’s not the way Graham thought about companies.
The issue here is that Buffett believed GEICO was a growth company. He believed its earnings per share would keep rising every 5 years or so. Because he thought they would take share from their higher cost competitors. He thought they had a better model. They didn’t use agents.
Ben Graham never approved of Warren Buffett putting 75% of his net worth into GEICO. That’s something Graham would never do with any stock. And GEICO wasn’t even a liquidation value bargain anymore. It was just a moderately cheap insurance company with a long, wonderful road ahead of it.
Here’s Warren Buffett from The Snowball:
“Ben would always tell me GEICO was too high. By his standards, it wasn’t the right kind of stock to buy. Still, by the end of 1951, I had three-quarters of my net worth or close to it invested in GEICO.”
Buffett worshipped Graham. But it didn’t matter. He went ahead and broke two of Graham’s rules:
1. GEICO wasn’t selling for a Ben Graham price
2. Ben Graham would never put 75% of his portfolio into one stock
Why did Buffett do this?
Because Buffett wanted to get rich. He didn’t want to fill his portfolio with 1 great idea (GEICO) and 4 good ideas and then only have 20% of his money in GEICO.
If GEICO rose 50% next year when Buffett had 75% of his portfolio in GEICO he would grow his capital 37.5% just from GEICO’s contribution. If he spread his portfolio evenly over 5 stocks, then a 50% rise in GEICO’s price next year would only increase his capital by 10%.
Buffett wasn’t interested in compounding his money at 10%. He was interested in compounding his money at 30% or 40%. He wasn’t going to buy something in a way that each idea would contribute that little.
From the very beginning of his career, Buffett always felt safer in his best idea (that would compound his money the fastest) rather than spread out over half a dozen slightly lesser ideas.
He would repeat this GEICO pattern over and over again. While Buffett rarely put 75% of his money in one idea – he did try to buy as many shares as possible of his best idea at several points in his first few years investing.
He also borrowed money. Buffett had too many ideas and too little capital. So, he actually got his Dad to cosign a loan for him so he could put more money into his best ideas.
These are things Ben Graham would not have done. Now, Graham did use margin early in his career – everyone did back then. And Graham would borrow against arbitrage positions in the fund. But that’s not what we’re talking about here. Buffett took out a loan from a bank so he could add to the total investment capital he had.
Why did he do this?
If he had a high degree of conviction in ideas he felt were certain to earn at least 15% a year and might earn something crazy like 50% a year (simply because the stock price rose to meet intrinsic value quickly rather than slowly) then why not borrow money?
If you can get at least a 15% return on your assets, it makes sense to add to those assets by borrowing from a bank at much less than 15%.
If you borrow moderately. From the way the loan is described in The Snowball it was a little hard for me to figure out how big the loan was in relation to Buffett’s portfolio when he took the loan. It was clearly a small amount shortly thereafter – but that’s because Buffett’s capital kept growing really, really fast.
Greif Brothers Cooperage
We know Buffett owned this stock in 1951. It was a barrel maker. And a net-net.
For those of you wondering if Greif Brothers Cooperage has any relation to Greif (GEF) – yes. It has every relation. It’s the same exact company. And it’s still in pretty much the same business. They used to just make barrels. Now they make all kinds of different drums, containers, etc. That’s not a very big change for a company to make over 60 years or so.
Philadelphia Reading & Coal
This was Warren Buffett ’s biggest position at one point. It was a very cheap company. It actually dropped from $19 a share (when he bought it) to $8 a share. And he bought more after the 50% drop. Philadelphia Reading & Coal went on to be bought by Graham-Newman as a control position. This was a lesson in capital allocation for Warren Buffett.
If you don’t understand why Buffett started to build an investment company on the ashes of a textile mill, you should learn more about Philadelphia Reading & Coal. Because Buffett was at Graham-Newman when they were using the capital in this business to diversify into an investment company of sorts.
Philadelphia Reading & Coal bought Union Underwear Company which sold underwear under the “Fruit of the Loom” name. And then they also bought the Acme Boot Manufacturing Company. The company also stopped paying a dividend. For 4 and a half years, Philadelphia & Reading (they dropped “coal” from the name) didn’t pay any dividends. But they didn’t pour more money into the lousy coal business either. Instead, as they slipped into losses for 1954 and 1955, they actually went ahead and spent money on buying new businesses. This would be a lesson for Buffett.
It also raises the issue of management and control of capital allocation. As we’ll see, many of Warren Buffett ’s early investments actually had a strong management aspect to them. Especially where Buffett thought capital was going to be used wisely (or returned to him).
In fact, you could say that in Warren Buffett’s mind management “quality” is synonymous with smart capital allocation. He’s not looking for an operational genius. He’s looking for someone with his kinds of ideas when it comes to return on capital. That’s what he wants in a CEO. Someone who thinks like an investor.
Cleveland Worsted Mills
This one was not a smashing success. Buffett “called it Cleveland’s Worst Mill after they cut of paying the dividend.” It was a net-net with a high dividend yield. The yield didn’t last.
Western Insurance
Buffett sold his GEICO stock to buy Western Insurance. It had earnings of $21.66 in 1949 and $29.09 in 1950. In 1951, the stock’s high price for the year was $13. The low was $3.
“It was the cheapest stock with the highest margin of safety he’d ever seen in his life. He bought as much as he could.”
National American Fire Insurance
This company was controlled by Howard Ahmanson. It’s a strange story. The original stock was pretty much worthless. It ended up being taken over as part of Ahmanson’s empire. Ahmanson was from Omaha. Although he’s most associated with California.
I won’t bore you with the whole story (you can find it on the web by searching for “Howard Ahmanson”, “H.F. Ahmanson & Co.”, “Home Savings of America”, and “National American Fire Insurance, Warren Buffett ”.)
Basically, Ahmanson’s father had owned an insurer in Omaha. Ahmanson got started very young (he was a financial services prodigy) and got extremely rich underwriting insurance in California during the Great Depression. He then bought National American Insurance Company (in Omaha) because it was his Dad’s old company. He was retaking control of the family company.
Through this weird coincidence, National American Fire Insurance ended up with some terrific assets. The Ahmansons were very private. And these assets were controlled through different holding companies, trusts, etc.
Anyway, here’s Warren Buffett explaining what he found when he looked into what NAFI really was:
“I found National American Fire Insurance…NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from (where) I was working as a broker. None of the brokers knew about it.”
What’s weird about this story is that on the surface the stock looked insanely cheap. It was selling for less than 1 times earnings. And about 20% of book value. But that really understates how cheap the company was. The deeper you delved into the story, the cheaper the stock looked. This was a personal holding company for one of the smartest investors in the insurance business. If you look at the book value and the earnings per share in 1950, you can see the company must have had something like a 20%+ ROE. Why would a company with a 20% return on equity ever trade for one-fifth of book value?
Read The Snowball to find out. Basically, it was a super illiquid stock that had once been worth a lot more. The shares ended up spread thinly across a lot of different individual investors. They remembered when the stock was worth $100 a share. That’s where a lot of them bought. And many of them didn’t want to sell until the stock got back to $100 and made them whole. But, because the stock had burned them so bad, they also had no interest in buying more shares. They just clung to what they had.
Now, what’s really fascinating about this story is what Warren Buffett did. So, the stock was last selling for about $27 a share. At first, he tried buying around $30 a share. Then he went to $35. He went to towns where he knew people owned the stock. He talked in person to people to try to get them to sell to him.
Eventually, he offered some people $100 a share. Now, think about this for a minute. That’s still a very, very low price for this stock. At $100 a share, Buffett was paying 3.5 times earnings. And he was still only paying about 75% of book value for what he thought were some of the best insurance companies in America.
But think how many of us would have been unwilling to go up to $100 a share. After all, if you started buying around $27 a share – doesn’t $100 a share seem like too much?
How many times have we thought: “Well, I started buying at $30 a share, do I really want to keep buying at $40 at $50 at…or should I wait for it to come back down to my price.”
Famous last words.
You would probably doubt yourself as you bought and bought and bought at ever higher prices.
But Buffett didn’t. And that’s the difference between Buffett and Graham.
Buffett wanted the highest return on his capital. At $100 a share, he was still going to earn well over 20% a year in this stock. Remember, he was paying less than 4 times earnings and less than 75% of book value for a company that recently earned over 20% on its equity. By either of those measures, you are clearly going to earn more than 20% a year.
So, when you see a clear situation where you will make more than 20% a year in a stock, the right answer is to buy as much of that stock as possible. To compound your wealth, the key is not to focus on whether you are paying $30 or $60 a share or $100 a share. It is to get as much of your money as possible into the stock while it is offering a very high return.
What matters is how high the return on your investment is at the price you pay. Not how much higher or lower the price you pay today is compared to the price the stock was at when you started researching it.
Rockwood
Buffett talks about this investment in his 1988 letter to shareholders.
Rockwood Chocolate had been shopped around to different buyers. Graham-Newman was given a chance to buy the company. But they passed because Rockwood wanted too high a price. Jay Pritzker ended up in control of the company. And he offered 80 pounds of cocoa for each share of Rockwood stock. The exact reasons why he made this offer are complicated.
Cocoa prices spiked in the midst of a shortage. Rockwood used LIFO (Last-in-first-out) inventory accounting. As a result, it carried its cocoa beans at much less than they were worth during the current cocoa bean shortage (prices were about 12 times higher than when Rockwood adopted LIFO). So Rockwood had a big gain on its cocoa beans – but this would be taxable of the beans were sold. However, the transaction would be non-taxable if it was used in a partial liquidation of the business. So, Rockwood initiated a coca bean for stock swap.
Why didn’t they just return beans to shareholders?
Cocoa was tradeable. So why buy back the stock?
Why not just give the beans to shareholders and forget the idea of a stock buyback entirely.
Graham-Newman didn’t ask this question. They, like some others on Wall Street, simply participated in the arbitrage opportunity. Buffett just went ahead and bought Rockwood stock so he could be on the same side of the trade as Jay Pritzker. So, instead of buying his stock, then swapping his stock for beans and then swapping his beans for cash – Buffett just bought Rockwood stock and ignored the offer to sell his shares for beans. Buffett made $58 a share vs. the $2 a share the arbitrageurs made.
At the time of the Rockwood deal Buffett’s two biggest holdings were Rockwood and Philadelphia & Reading. So he was betting on two capital allocation “jockeys” here. Graham-Newman was taking a cheap but misallocated business and turning it into a better business. And Jay Pritzker was taking advantage of high cocoa prices to buy back stock and make remaining Rockwood shareholders rich.
So, capital allocation was very important to Warren Buffett even very early in his career.
Buffett did a lot of “coat tail” riding in those days. He took a lot of other people’s good ideas. Whether it was Ben Graham or Jay Pritzker or Howard Ahmanson.
That’s a strange wrinkle in the early investments by Buffett. It wasn’t always the case that he was betting on superior capital allocation. At GEICO, he was betting on a growth stock. It just happened to be a cheap growth stock.
And at Marshall Wells it didn’t really matter who was allocating the capital. What he cared about there was that the stock was selling for about 3 times earnings. The same thing is true – to some extent – in the last stock we’ll look at: Union Street Railway.
Union Street Railway
This was a bus company. They had some substantial hidden assets. But the most important asset they had was cash net of all liabilities of more than $60 a share versus a stock price of $30 to $35 a share. Graham-Newman had considered the stock. But did not want to take a huge block. Buffett did. He wasn’t interested in diversifying.
The company was also buying back stock at the same time. This was a common feature of Buffett’s investments. Ahmanson was slowly buying up stock around $30 a share when Buffett started buying shares of NAFI. Here, the company was buying back its own stock.
Buffett went to talk to Union Street Railway’s CEO. The CEO told him that they were going to return $50 a share.
Here is my best guess of what Buffett’s investment in Union Street Railway looked like:
· Paid $18,700 for his shares
· Got back $28,800 in cash
· Stock still traded for $11,500 after the special dividend
So, Buffett turned an $18,700 stock purchase into a combination of $28,800 in cash and $11,500 in stock. His return was something like 115%.
Also notice how strange the market’s attitude was toward Union Street Railway’s cash. Before the special dividend it traded at $30 to $35 a share. After $50 a share was paid out in cash, the stock only dropped to $20 a share.
So, even though the company paid $50 in cash, the market only penalized the stock $10 to $15 a share.
The market never gave Union Street Railway full credit for the cash when the company had it. So, it didn’t deduct full value from the stock when the cash was paid out.
From 1949 through 1954 Buffett made his first $100,000. It’s hard to know what his exact annual returns were. That’s because he saved some additional money, paid taxes, took out a loan, etc.
My best guess is that Buffett compounded his money at an annual rate no less than 50% a year and no more than 60% a year.
This is consistent with his own statements. Buffett told students he did make 50% a year on his own portfolio before starting his partnership.
And he said that his returns were lower each decade. Buffett had annual returns on 30% a year when he ran his partnership. It’s clear he did better than that with his own money in the early 1950s.
It’s likely Buffett earned about 50% a year on his investments in his first 5 years as an individual investor.
And he did it in the stocks we just discussed.
Overall, Buffett turned $10,000 into well over $100,000 between the time he first read Ben Graham’s “The Intelligent Investor” and the time he started his partnership.
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