April 2019 Letter
Earlier this year, Warren Buffett celebrated the 77th anniversary of his entry into the capital markets. On March 11, 1942, at the age of 11, Buffett purchased 6 shares of Cities Service at $38. Buffett had convinced his sister, Doris, that the oil service company was undervalued. Unfortunately, within a few weeks the stock was trading below $30. Doris berated the young investor, however, convinced he was right, Buffett hung on and eventually sold the stock at $40, for a small profit. He then watched it go to $200, proving both Warren and Doris wrong. Buffett didn’t get rich on internet IPOs, biotech discoveries, or even bitcoin, he’s made his career with bets on some of the most mundane everyday necessities, from insurance to appliances. In this letter, we’ll dig through some of Buffett’s annual letters from the past fifty years and tell you the stories of some companies in his portfolio that don’t garner the headlines of some of his largest public company holdings, but nonetheless have been critical to his investing success since 1942. We’ll conclude with some thoughts on how we use lessons from Buffett’s past and apply them to investing today.
The Security I Like Best
From an early age, Buffett understood the value of kicking the tires and understanding what he was investing in. In 1951, at age 20, Buffett was a student of legendary value investor Ben Graham and wanted to learn more about an insurance company that Graham chaired called Government Employees Insurance Company, today known as GEICO. One Saturday morning, Buffett went to the company’s offices in Washington, D.C. only to find the building locked. He persuaded a custodian to let him in and was directed to Lorimer Davidson, an executive who would later succeed company founder Leo Goodwin as CEO. Impressed by what he heard, Buffett returned to Omaha and penned a research report titled; “The Security I Like Best.” In it, Buffett made the case for GEICO as an undervalued stock.
GEICO was founded in 1936 as an auto insurance provider targeting government employees, military personnel, and university faculty members. In his report, Buffett noted the necessity of auto insurance and the ability to reprice annually based on claims experience. He also noted that GEICO had no agents or branch offices and was able to price well below the competition. 1950 and 1951 were painful years for the insurance industry and GEICO’s industry leading profit margins were not immune to the downturn. Buffett thought pricing would catch up in 1952, leading to an earnings rebound for the company. He also saw the value of investing the float from premiums as GEICO’s investment income quadrupled between 1947 and 1950. Buffett concluded that with the stock priced at eight times 1950’s earnings “it appears that no price is being paid for the tremendous growth potential of the company.”
By the next year the market had begun to notice GEICO’s growth potential and Buffett sold his stock for a nice 50% profit. At the age of 21, Buffett had yet to learn the virtues of “buy and hold.” In 1976, with GEICO on the verge of bankruptcy, he bought 1/3 of the company for $47 million. Twenty years later, he completed his acquisition of GEICO with the company then valued at over $4.6 billion. Last year, GEICO wrote over $33 billion in premiums, earning nearly $2.5 billion in pretax profits.
Blue Chip Assets
As investors, sometimes we end up being right for the wrong reasons, and Buffett was no exception. Younger readers not familiar with Blue Chip Stamps may not know that Blue Chip and competitor S&H Green Stamps were the original shopping rewards programs. During the 1960’s, shoppers across America were collecting stamps at grocery stores, pharmacies, and gas stations, pasting them into books in an effort to earn enough points to redeem for merchandise. Buffett took notice of Blue Chip Stamps in 1970, no doubt attracted to the customer loyalty and duopoly position with S&H. In his 2006 annual letter Buffett wrote “When I was told that even certain brothels and mortuaries gave stamps to their patrons, I felt I had finally found a sure thing.” Blue Chip’s revenues were $126 million in 1970. Buffett went on to finish the Blue Chip Stamps story in his ’06 annual letter writing “By 1980, sales had fallen to $19.4 million. And, by 1990, sales were bumping along at $1.5 million…..Last year, in Berkshire’s $98 billion of revenues, all of $25,920 (no zeros omitted) came from Blue Chip.”
Despite the obvious downward trajectory in Blue Chip’s business prospects, in 1983, Buffett bought the remaining 40% of the company he did not already own. Why would he double down on a declining business? Sometimes the answer to an investment decision lies on the balance sheet, not the income statement, particularly for a shrewd value investor. In 1972, Buffett used Blue Chip’s strong financial position to buy 99% of See’s Candies and consolidate it onto Blue Chip’s balance sheet. Buffett noted the success of the See’s investment in his 2011 annual letter saying, “Last year See’s had record pretax earnings of $83 million, bringing its total since we bought it to $1.65 billion. Contrast that figure with our purchase price of $25 million…..”
Similarly, in 1973, Buffett used Blue Chip’s balance sheet to buy 80% of Wesco Financial, a savings and loan holding company based in Pasadena, CA. In the early 70’s, Wesco found itself in tough times and Blue Chip initially bought 8% of the company for $2 million, valued at less than half the company’s book value. Later, Buffett’s investing partner, Charlie Munger, took over leadership duties at Wesco.
Despite both being Omaha natives, Buffett and Munger didn’t meet one another until 1959. At the time, Munger was practicing law in Pasadena, CA and Buffett was forming his investment partnerships in Omaha. Munger would go on to develop his own investing prowess and in 1978, he formally teamed up with Buffett. Buffett was already successful on his own, but teaming up with Munger proved that investing was hardly a solitary endeavor. They became trusted partners, able to bounce ideas off of one another and unafraid to play devil’s advocate. They share the ideal of buying quality businesses at a reasonable price, but like most good partnerships, they may differ on what is quality and what is a reasonable price.
If you invest long enough, you’re bound to make some mistakes, and Warren Buffett has been no exception. In his 2007 annual letter he described his 1993 acquisition of the Dexter Shoe Company as “the worst deal that I’ve made.” Buffett thought he was getting a high quality, domestic, shoe company still owned and operated by its founders, typical of a lot of Buffett’s acquisitions. Companies like that had long track records, consistent management, and a solid competitive position. But the 1990’s became a cruel decade for U.S. based apparel companies. A series of trade deals dropped import restrictions and tariffs on apparel, leaving U.S. manufacturers at a significant cost disadvantage. Less than ten years after acquiring Dexter Shoe, Buffett was forced to liquidate the company and fold what remained into another subsidiary.
But, what made the whole episode especially painful to Buffett was how he financed it. Rather than using $433 million in cash, he used Berkshire stock. Historically, cash has at best returned the same as inflation, meaning cash has a low hurdle rate to judge an investment’s success. However, if you fund an investment with another investment, the hurdle rate is unknown because you don’t know how well the investment you’re giving up will do. In this case, Buffett gave up 1.6% of Berkshire to fund the $433 million deal. By 2007, 1.6% of Berkshire was worth $3.5 billion and Dexter was worthless. Today, 1.6% of Berkshire is worth over $8 billion.
Need a House?
Buffett’s portfolio of private and public holdings are too numerous to cover them all here, but he can put you in a new home if you’d like. First, you may consider a home loan from one of his public bank holding companies; Bank of America, JPMorgan, U.S. Bancorp, or Wells Fargo. Next, you’ll need a builder and Buffett’s Clayton Homes out of Tennessee would be happy to build it. Clayton Homes could use building materials such as insulation and heating, ventilation and air conditioning (HVAC) from Buffett’s Johns Manville unit. Wallboard and ceilings could be provided by USG Corp. Once built, Buffett’s Shaw Industries could provide the flooring and Benjamin Moore & Co. could provide the paint. To fill the house, Buffett’s Nebraska Furniture Mart could meet all your furnishing and appliance needs. Finally, to fill the garage you might want a new car from one of Berkshire Hathaway Automotive’s 82 dealerships across the country. And, if a new house is not for you and you’re looking to move into an existing home, one of Buffett’s 1,600 HomeServices locations nationwide can help you find a place. After that, call a friend on your iPhone and enjoy a Coke, he owns those too!
At the heart of investing, is knowing what you own. Be it stocks or bonds, the better you understand a company, the more perseverance you’ll have in tough times. One reason Buffett has enjoyed long term success is he understands and accepts cyclicality. For us, the longer we can hold a growing company, the more likely it will produce a superior return, particularly on an after tax basis. In fact, we have clients today that started with us in 2004 that still hold some of our original stock investments, despite the economic cycles we’ve seen since then.
Like Buffett, we strive to build knowledge over time, by gaining as much exposure to a company as we can, monitoring quarterly earnings reports, studying financial statements, and reading regulatory filings and credit reports. Buffett has unique access that most investors can’t match, but with tighter public disclosure rules put in place over the past twenty years, the information gap has shrunk for regular investors. We know that adequate information about a company and its competitors exists. Our job is to find it, analyze it and when prudent, act on it.
We share Buffett’s wisdom that it’s better to buy “a wonderful business at a fair price, than a fair business at wonderful price.” Great businesses have superior balance sheets and profit margins, as well as the ability to self-finance growth from internally generated cash flow. These businesses don’t always have to be purchased at rock bottom prices.