This article originally appeared on Quora: What’s the shrewdest, smartest maneuver you’ve ever seen in business?
One of the smartest maneuvers I’ve seen in business comes in the form of two somewhat simultaneous decisions made by Warren Buffett.
Please consider the following table:y
In this table, I want to emphasize that: (a) Buffett started to earn money from an early age, and (b) had an uncanny ability of compounding his net worth. In other words, he wasn’t ordinary and was admittedly aware of his talent and supremely confident in his abilities.
In 1969, at age 39, Buffett was coming off one of his best years as an investor. He’d become somewhat of a local celebrity, his net worth hovered in the $25 million range, and most of his investment partners could not have been more satisfied. Also, it didn’t hurt that the stock market was experiencing the greatest bull market since the 1920s.
In the midst of this, Buffett was uneasy because – in staying true to his discipline in following yet evolving his investment methodology – he was having a difficult time finding opportunities to put his and his investor’s money to work in intelligent ways; stocks seemed mostly overvalued to him. Peter Lynch, the successful former mutual fund manager of Fidelity’s Magellan Fund, described what happened next.
“What makes him [Buffett] the greatest investor of all time is that during a certain period when he thought stocks were grossly overpriced, he sold everything and returned all the money to his partners at a sizable profit to them. The voluntary returning of money that others would gladly pay you to continue to manage is, in my experience, unique in the history of finance.”
Buffett gave his investment partners some insight into his thinking in an October 1967 letter: “My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner…I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean forgoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully, and which, possibly, could lead to substantial permanent loss of capital.”
A few years later, the 1973-74 bear market marked one of the worst stock market downturns of the twentieth century and Buffett, who had taken a step back to gain perspective, was well positioned to take advantage of the opportunity.
Warren Buffett began buying shares in Berkshire Hathaway on December 12, 1962 at $7.50 a share. His initial intention was to flip his shares for a relatively quick profit, but changed his mind upon having some problems with Berkshire’s president, Seabury Stanton, and ultimately bought enough Berkshire stock to control the company. Buffett’s investment in Berkshire Hathaway would go down as arguably the worst investment of his career.
He would later explain: “So I bought my own cigar butt, and I tried to smoke it. You walk down the street and you see a cigar butt, and it’s kind of soggy and disgusting and repels you, but it’s free…and there may be one puff left in it. Berkshire didn’t have any more puffs. So all you had was a soggy cigar butt in your mouth. That was Berkshire Hathaway in 1965. I had a lot of money tied up in the cigar butt. I would have been better off if I’d never heard of Berkshire Hathaway.”
- Berkshire Hathaway was undervalued for the wrong reasons; nine years of losses and had closed more than a dozen textile plants over the previous decade
- The textile business in the US at that time was not a good business and was going downhill; in large part as a result of foreign competition, which was squeezing profit margins to the point of no return
- Berkshire’s financial position was unlikely to improve
What came next?
Here’s an overview of some of the tactics used by Buffett in transforming Berkshire Hathaway:
- Swap. He issued a swap of a 7.5% debenture—debt security—in exchange for stock. This allowed him to rid Berkshire of shareholders who wanted an income-producing security, while keeping those who were more interested in growth. The fewer shares outstanding gave him an even tighter grip on Berkshire.
- Rationality. He refrained from modernizing Berkshire Hathaway’s equipment to better compete in its treacherous industry because it would have been the equivalent of capital allocation suicide to throw good money after bad.
- Capital allocation. This is where Buffett stumbled into somewhat of a different sort of business model. He figured it made more sense to take any profits from Berkshire, a failing business whose last textile operations were eventually shut down in 1985, and to use those funds to finance the purchase of other stocks or entire businesses that had a brighter future. And he figured that he could do the same with those other businesses that were purchased, thus creating for himself and later Charlie Munger—Berkshire’s Vice Chairman—the roles of capital allocators that could add substantial value to Berkshire’s equity-base by virtue of directing funds to more favorable investments.
- Insurance and taxes. Sensing an opportunity that resonated with its strengths, Berkshire made insurance a core aspect of its operations. One of the major benefits of this is that it allowed Berkshire to use the float—insurance premiums that have yet to be paid out as claims—to finance some of their investments. This essentially became a form of leverage, a way of legally using other people’s money, virtually for free, to invest for their own benefit. As far as taxes, since there have generally been substantial tax benefits in purchasing a business outright versus buying the common shares of the same business, Berkshire has focused on buying entire businesses that meet its criteria, and it saves further on taxes by adopting a long-term investment horizon that begets a favorable long-term capital gains tax, not to mention reduced commissions.
- Methodology. Warren Buffett and Charlie Munger’s investment thesis for Berkshire Hathaway can be summed up as: they look for businesses that are simple and understandable, with durable competitive advantages, run by able and trustworthy people, and selling at a reasonable price. As for corporate governance, Berkshire is emblematic of a pro-shareholder public company. It focuses on increasing the intrinsic value of its shares, with almost negligible equity dilution, and views ROE—return on equity—with little-to-no debt as a better metric in evaluating their own performance and that of other managements than the easier to manipulate EPS—earnings per share. Additionally, Berkshire is highly decentralized, meaning that they rarely get involved in the day-to-day operations of the businesses that they own. Instead they focus on purchasing businesses that are already run by a world-class manager who will continue to run the business beyond their purchase, thus creating two main tasks for Warren and Charlie: (a) efficient capital allocation, and (b) keeping the managers of their businesses, most of whom are independently wealthy, motivated in coming to work everyday and performing to the best of their ability. Because of Berkshire’s performance track-record, the large amounts of cash that it has coming in every year (much of it insurance related), and the integrity with which it has sought to conduct its business, it is one of the few businesses in the world that can offer reputation-based financing on a grand scale during a crises to those companies that meet its investment criteria. Think Goldman Sachs during the sub-prime crises. This is the sort of large financing that restores confidence in the financial markets as a result of the reputation and track-record of the entity making the investment. Finally, a corollary of this reputation element and some of the corporate governance measures that were mentioned above is that Berkshire is often sought after by well-run private businesses that care about their business and think may be a good match for the Berkshire culture. A purchase agreement gives the owners of the private business some liquidity, while still keeping a minority stake in the business in most instances, and allows them to continue to run the business that they’re passionate about just as they had before, with the exception that they’re likely to have to send profits above capital expenditures and other imperative needs back to Berkshire’s corporate office.
To put things into perspective, a $1,000 investment in 1962 in an investment yielding a 15% annual return would have compounded to about $1.3 million today. The same investment in Berkshire Hathaway would be worth around $23 million.
To summarize, Warren Buffett, a person who from an early age demonstrated a special ability to amass wealth, was able to manage his ego to the point of allowing himself to make a decision at the height of his success that was considered legendary by one of his main competitors, and this may very well have been indicative of the character and rationality that later assisted him as the main author of one of the greatest business turnarounds in modern history, whereby he maneuvered the worst investment of his career into one of the most profitable enterprises of all-time.