The Real Warren Buffett

Short Division

Warren Buffett divides business into four boxes. One box is filled with the things that cannot be known that are also unimportant. One box is filled with the things that can be known but are not worth knowing. The third box is filled with the things that are important but cannot be known. Warren Buffett disregards all three of those boxes and spends his time rummaging only in the fourth box, which is labeled important and knowable.

This box, he believes, defines his margin of safety, his circle of competence and the limitations of his "strike zone." Within the fourth box, holding that which is known and that which matters, Buffett meets the expectations of his shareholder and partners, and operates according to those truths he holds self-evident.

“Standing alone holds no fear for him: it never has. This is why he has the resolve to step away when prices deteriorate, why he glories in the loneliness of being logical.”

One of the most important of those verities is that the market may be efficient in the long run, but it is not always efficient and it cannot be relied upon to provide a stock price equal to any given company’s intrinsic value. This represents an evolution in Buffet’s thinking; it was not always thus.

Early Buffett

Warren Buffett spent almost 20 years walking the path described by his first mentor, Ben Graham, author of The Intelligent Investor. Graham rated a stock’s value in relation to the company’s assets. He did not base his valuation on the company’s ability to create and sustain value over time. Buffet had a knack for identifying companies that were undervalued according to Graham’s formula. He called this "cigar butt investing," saying, "A cigar butt found in the street that has only one puff left in it may not offer much of a smoke, but the bargain purchase will make that puff all profit." In an era - during the 1950’s and 60’s - when many stocks were undervalued, cigar butt investing made Buffett a success.

“In that era of capitalism in which we had scaled the intellectual barriers to progress but not yet torn down the walls of psychology and emotion, Buffett will stand out as the man who did.”

From 1956 to 1969, the value of the Buffett partnership grew at a compound annual rate of almost 30%. The Dow did 10%. By age 26, Buffett had assembled the three partnerships that would provide seed capital for his future projects. He decided to take the cash flow from Dempster Mills, a manufacturer he had acquired, and invest it in other companies on behalf of the partnership. In furtherance of this goal, in 1961, Buffett became chairman of the board at Dempster. But try as he might, he couldn’t make Dempster Mills’ managers shut down their assembly lines to release capital for his investments. He sold his stake in Dempster and bought up the stock of Berkshire Hathaway, a textile manufacturer. By 1965, Buffett owned enough of Berkshire to take over its operations.

Buffet had met his second mentor and continuing partner, the often-abrasive Charles Munger, in 1959, and was already listening to him by the time the Berkshire deal was done.

Meister Munger

By 1970, Buffett was ready to dissolve his partnerships and eliminate the pressure they created to exceed previous achievements, over and over. He was ready to abide by Munger’s frequently repeated lessons, which contradicted Graham’s philosophies.

“Ben Franklin once said: ’Never confuse motion for action.’ Warren Buffett doesn’t. The trick is, he says, ’When there is nothing to do, do nothing’.”

Buffet, who calls Munger his west coast philosopher and "the abominable no-man," says that although Munger lacks formal training in business or economics, he has a powerful intellect and an instinctive grasp of investing. Because of these qualities, Buffet ultimately took his advice.

Dempster and Berkshire Hathaway were similar. They made products as cheaply as possible and sold them at competitive prices. To remain competitive, they consumed capital for new tooling, improved distribution and expanded marketing. Instead of harvesting Berkshire’s capital to invest in other businesses, Buffett became entangled in the textile business - where every brand’s products shared the same relative low value. In that industry, investment capital was the only barrier to new competition.

“Buffett believes that transforming an area of knowledge into a Circle of Competence, and keeping it that way, can only be achieved if he constantly stress tests what he believes to be true.”

Buffett stayed in the business too long because of the same competitive hopes that entrap many managers. However, when Buffett finally closed the Berkshire mills, he told his stockholders he should have done so a decade earlier.

This interaction between Munger and Buffett led to a revelation about the difference between being in business and, instead, managing capital. What matters is how investors are motivated to act, or to not act in moments of strategic stillness. Munger warned against having a corporate mindset that serves the good of investors above and beyond the good of a corporation and its operations. Often, this approach - prioritizing stockholder profit above a company’s ongoing needs - is so entrenched in corporate life that a board of directors will sanction it as part of a strategic plan.

Buffett came to hate strategic plans because they often block essential changes and they never call for strategic inaction. Buffett says that Berkshire Hathaway’s greatest advantage today is that it doesn’t operate with a strategic plan, except for waiting for the phone to ring with fresh opportunities.

The Aha! Moment

Back in the early days of Berkshire, Munger asked Buffett if he was keeping the mills open because of his ego. He asked if Buffet was holding on to them because one day they would become sufficiently profitable. He cautioned Buffet against trying to understand an unfamiliar industry without obtaining first-hand knowledge of it. In this ongoing search for answers, Munger inspired Buffett to construct mental models outlining various scenarios, based on his experiences, and to refer to them with confidence. Munger convinced Buffett to examine his decision-making processes. Munger taught Buffet to look at each situation backward, that is, to invert it. In other words, first think of the best way to ruin a company. Contrast your plans and practices with that, and you will see what not to do - and what to do.

“Commitments to business manifest their own dynamics, divorced from their original conception, aggregated around self-interest.”

Munger told Buffett that intelligence was not sufficient; he had to rely upon information and experience, not just on his intellect. In the face of this counsel, Buffet began a period of rigorous self-evaluation and mental discipline. As Munger showed Buffett examples of what he had done wrong and offered him alternative ways of thinking, Buffett realized that he could have been far more successful - even though he had made Dempster Mills and Berkshire Hathaway profitable. Eventually, the businesses were able to generate an average of 15% profit a year.

“If he were to grow at the same rate as Buffett has managed to grow the value of Berkshire, by the time he is 37, he would be taller than the Empire State Building!”

Nevertheless, Buffet experienced an explosion of understanding. He knew what he was going to do. Buffet changed his entire approach to business, began to view its possibilities more widely and started working primarily not as an entrepreneur, but as an allocator of capital.

Ted Williams’ Eyes

Buffett likes baseball metaphors. From baseball great Ted Williams, he learned a great metaphor, expressed as the fundamental benefit of subdividing the strike zone into the most productive cells and then swinging, not just only at strikes, but only at strikes that flew into the sweet spot: fat pitches with the highest odds for an extra base hit. Buffett did not want to be a successful investor; he wanted to be in the investors’ equivalent of the Baseball Hall of Fame.

Buffet stopped looking for a fair business to buy at a good price and began investing in good businesses at fair prices. Under his leadership, Berkshire selected Coca Cola, Gillette, the Buffalo Evening News, Executive Jet, GEICO, Flight Safety, Sees Candy and International Diary Queen because they all offered low costs, managerial excellence and the assurance they could not be overcome by any important, unknowable event lurking at the margins of technology.

“The law of the economic jungle is that high returns revert to the mean.”

Buffett did not invest in the technological revolution of the 1990s, specifically because it was beyond his circle of competence. Dot.coms, as it turns out, were unknowable. So he confidently stayed away. No harm, no foul. With each solid acquisition, Berkshire’s bulletproof corporations grew armor plating. Pepsi might compete with Coca-Cola, but it could never muster the resources to displace Coke. Who would start a competing newspaper in Buffalo when Buffett was already buying ink there by the barrel? Buffett says, "Our job really is to focus on things we can know that make a difference. If something can’t make a difference or we can’t know it, then we write it off. I look for what is permanent and what is not."

“This is the objectivity that Buffett is seeking: business processes that generate statistical backgrounds allowing him to bring calibrated confidence to bear, to produce forecasts that can be made.”

For several years, observers hotly debated the wisdom of Buffett’s move to merge with General Re in 1998. General Re promised a vast float. It also held about 20% of its $24 billion in assets in equities. Berkshire held 80% of its $50 billion investment assets in equities. With the merger, Buffett reduced his exposure to risk-intensive equities by almost 20% without paying a dime in taxes. That was the good news.

As the market tanked, Berkshire was flush and purchased most or all of Jordan’s Furniture, MidAmerican Energy, CORT Business Services, U.S. Liability with its two high risk insurance adjuncts, Justin Industries, Ben Bridge Jewelers, Shaw Industries, Benjamin Moore Paint, Johns Manville, MiTek Inc., XTRA Corporation, Garan and Fruit of the Loom, all for a total of around $10 billion.

“However, basing judgments on signals flashed by prices and informing decisions by deferring to contagious emotion are natural when investors have not set bounds to their Circle of Competence.”

This was the ultimate example of Buffett and Munger’s embrace of volatility. Berkshire Hathaway stock lost half its value from June of 1998 to March of 2000. They could not have cared less.

Catastrophe Hits

On Sept. 11, 2001, the world’s major catastrophic insurance companies were confronted with a loss scenario no one had imagined, certainly not even Buffett, who owned several of the insurance and reinsurance carriers that had the greatest liability. Buffett saw the unanticipated terrorist strikes as an opportunity for his catastrophic insurance operations. Few could withstand the blow Berkshire had endured. Now Berkshire had proven itself to be the dominant and indomitable insurance seller in a market where a huge tragedy had driven premiums justifiably sky high.

“Consequently, management to expectations has become endemic in the CEO community. Far more companies generate linear streams of earnings than can be explained by chance.”

In May of 2002, as the fretting reached a frenzy, Buffett invented the world’s first negative interest loan vehicle. Berkshire had endured beyond anyone’s expectations, except Buffett’s and Munger’s. Now Buffett devised a negative coupon security designed to offer something unavailable to investors in the credit crunch of the time. He raised $400 million. In return, investors got 3% a year and a warrant to buy Berkshire stock in five years, at a 15% discount in the price of Berkshire’s shares at the time they bought the negative coupon. Buffett (or more likely Munger) named it a SQUARZ. The best part was that the SQUARZ investor paid Berkshire a 3.75% installment premium on the warrants each year.

Berskire Fundamentals

Such activity would bedraggle other CEOs and frighten off ordinary shareholders. Not so at Berkshire. Buffett thinks that analysis based on "year ago this time" stock price comparisons is meaningless. The company pays no dividends. It counts its benefits and incentives as actual costs. It keeps its annual report as simple as possible by refusing to use a marketing firm or spin doctors to communicate with investors or analysts. It refuses to split its stock. It does everything possible to make its investors comfortable and to deflect any investors who are not willing to stay with Berkshire over the long haul.

Buffett has remarked often that a CEO should wonder what is wrong with his company and his management when investors are constantly buying and selling his company’s stock. Buffett sees his investors as partners and says he would be concerned if his partners wanted to sell their shares frequently. Does this defy every principle originally propounded by Graham, every corporate norm? "I’d be a bum on the street with a tin cup if the market were efficient," Buffett replies.

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About the Author

James O’Loughlin, a resident of Wirral, England, is investment manager and head of global equity strategy for the $36 billion (at press time) Cooperative Insurance Society.