The Evolution of Warren Buffett

by: Tom Au, CFA

After a very fruitful and successful investment career, Warren Buffett has reached what might be considered an "endgame" position. His original 1956 investment partnership of $105,000 has morphed into Berkshire Hathaway Corporation (BRK.A, BRK.B), worth well over $100 billion. Depending on the market values on a given day, Berkshire is now one of the ten or so largest market cap stocks in the United States, having passed up former stalwarts like Citigroup (NYSE:C) and General Electric (NYSE:GE). As such, Berkshire can make meaningful investments in only stocks of say, the S&P 100, or outright purchases of stocks in the S&P 500, or their equivalents abroad. It will be difficult for Buffett to continue to beat the market, assuming that he can do so.

There are basically three ways for him to try. The first is to substitute faster-growing foreign stocks for large cap U.S. stocks. That is, he may try to beat Exxon Mobil (NYSE:XOM) using the stocks of PetroChina (NYSE:PTR) (owned in the past), or Petrobras of Brazil, to play the emerging markets theme.

The second way to try to beat the market is to try to time purchases near lows. or obtain special terms, as Berkshire did with its large stakes in General Electric and Goldman Sachs (NYSE:GS).

The third way is to avoid stocks of clearly dying "leading" companies such as International Paper (NYSE:IP), General Motors, and Eastman Kodak (EK), a quasi-index strategy that, if successful, would still lead to modest outperformance. All in all, Buffett has come a long way from his early days.

Imitating Ben Graham

Buffett's early investments were clearly in the Graham and Dodd mold. The first major one, in 1957, was National Fire American Insurance, operated by the Ahmanson brothers (the older, H.F., also gave his name to a savings and loan). The brothers tried to buy in the stock for $50 a share (just above its annual earnings), but Buffett sent an agent all over to Nebraska with a counteroffer of $100 a share. Even at this higher price, he just about doubled his money.

In 1958, Buffett put 20% of the partners' money in Commonwealth Bank of Union City, at a price of $50 a share, because he estimated its stock value at $125 a share, and the company was growing at 10% a year. This was a more than adequate (60%) "margin of safety." If the gap between price and value closed in 10 years, he would realize some $325, or a return of about 20% annualized. But he sold a year later at $80 a share, earning 60% in a year, while the ten-year return had fallen to "only" an annual 16%.

In 1959, he placed 35% of the partners' money in Sanborn Map, a company that produced detailed city maps of buildings, whose users were insurance companies, fire stations, and the like. This had been a prosperous business in the 1930s and 1940s, before a cheaper substitute rendered it unprofitable in the 1950s. Nevertheless, the stock had fallen from $110 a share to $45 a share in 20 years, even though the company had built up an investment portfolio worth $65 a share during that time using excess cash. In Ben Graham style, Buffett's partners and two allies obtained 46% of the stock and forced management to distribute most of the portfolio to shareholders, at a 50%-ish (pre-tax) gain to the investors who elected this option.

Going into the 1960s, Buffett continued to buy companies at a discount to asset value Graham style. These included Berkshire Hathaway, a struggling textile producer with per-share working capital approximating its $15 share price, Dempster Mills, and Diversified Retailing. Buffett bought all of these companies with the expectation of getting the underlying businesses for "free." This was true only for Dempster, a badly-managed company that was turned around in less than three years for triple the investment. In the case of Berkshire, at least, even "free" was too much to expect.
But Buffett eventually used Berkshire's cash flow to acquire Diversified, and then redeployed the two companies' cash elsewhere. What's more, when he distributed partnership assets pro rata in 1970, he had effectively changed the form of his investment vehicle from a partnership (where capital gains were taxed every year), to a corporation (where gains were taxed only when realized).

There was one investment during this period that signalled Buffett's eventual departure from the Graham style. That was the purchase of the stock of American Express, whose main business was credit cards, but whose stock suffered when the firm's warehousing operation vouched for the value of "salad oil" deposited by a crook. This man,Tino deAngelis, borrowed (and lost) money on the strength of phony collateral, leaving Amex holding the bag. The stock took a hit when Amex paid out $60 million, its entire net worth, to settle the resulting claims.

But Buffett realized that he was really getting the credit card business at a discount. Late in the 1960s, he sold his Amex stock for between three to five times his acquisition cost, three to five years after he had bought it.

Transition to a "GARP" Style
Warren Buffett then evolved into what we would call a "GARP" (growth at a reasonable price) investor, albeit one with a strong value bent. This transition occurred during the early years of his "new" (post Buffett partnership) incarnation, after he had hooked up with Charlie Munger, who believed that it was better to buy a great company at a good price, rather than a good company at a great price..

What happened in the early 1970s was that certifiable growth companies got not only into value, but deep value territory (great companies at great prices). One of them was Washington Post That company had publishing and broadcasting assets worth perhaps $400 million in 1970, but which sold in the market for $80-$100 million. Buffett bought some 12% of the company, which not only closed the gap between market value and asset value, but also grew earnings per share in excess of 15% over the next decade.

GEICO, a low cost insurer, had represented one of Buffett's first investments as a boy. Started with $100,000 in seed capital in 1936, it was worth about $3 million when Ben Graham bought a controlling stake in 1948. From there, it advanced in spectacular fashion to a peak of over $500 million, over 100 times, in two and half decades, before falling onto hard times in the early 1970s.

By 1976, it was near bankruptcy when Buffett had Salomon Brothers organize a rescue via a $76 million capital infusion. Berkshire provided $19 million of it, and basically co-underwrote the convertible preferred offering with Salomon. Adding this to an earlier $4 million investment in common gave Buffett a 33% stake in a company that would grow per-share earnings at about 15% a year over the next two decades.

Other, less celebrated, long term holdings from the period include Affiliated Publications, the Interpublic Group (NYSE:IPG), Media General, and Ogilvy and Mather.

Buffett also experimented with cheaply priced leaders of their respective industries: Safeco for insurance, General Foods (NYSE:GIS) in food, and the former Exxon in energy. There was a group of inflation hedges in the form of Alcoa (NYSE:AA), Cleveland Cliffs Iron (OTC:CLFQM), GATX, Handy and Harman, and later Reyolds Aluminum. Finally, there were arbitrage operations in Arcata Corporation and Beatrice Foods.

Buffett also dabbled in larger media companies such as ABC (NYSE:DIS), Capital Cities, and Time Inc (NYSE:TWX). He made a proposal to the management of the latter company that he take a large blocking position, to prevent a takeover, which Time rejected, to its later regret. (A takeover attempt by Paramount forced it into an ill-advised merger with Warner Communications.)

Both ABC and Capital Cities came back onto Buffett's radar screen when the chairman of the former retired, and the chairman of the latter, Buffett's good friend Tom Murphy, wanted to acquire the former, a move that had the blessing of the outgoing chairman. On its own, Capital Cities had no chance to acquire ABC, but an over $500 million investment from Berkshire provided the "equity" slice that made the leveraged deal possible. It also had the effect of making Berkshire a nearly 20% shareholder in the combined company, discouraging a takeover. At 16 times earnings, it was not a Graham investment, and had no margin of safety on the balance sheet.

But Tom Murphy reduced the combined companies' debt by over $1 billion (nearly half) within a year, while growing earnings at a mid-teens rate. (The stock grew at nearly 20% a year for a decade, because of multiple expansion, before the company was taken over by Disney.

Buffett's next moves were among the most controversial of his career (and foreshadowed his recent purchases of General Electric and Goldman Sachs preferred). Not finding any cheap common stocks around the run-up to Black Monday (1987), Buffett bought converitble preferred stocks in Champion International, Gillette, Salomon Brothers and US Airways (UAUA) issued specifically to him.

Champion was a mediocre investment and U.S. Air was a money-losing one. Salomon fell onto hard times and had to be personally rescued by Buffett. Gillette was a fundamentally strong company that paid out essentially all of its net worth in a special dividend to avoid a takeover (before Buffett's investment recapitalized it). In this regard, it was much like American Express (NYSE:AXP) of the 1960s. Buffett returned to American Express in the mid 1990s with a similar $300 million investment in convertible preferred.

During this time, Buffett completed his transformation as a GARP investment by buying Coke (NYSE:KO). With a mid-teens P/E ratio, this was not a classic Graham and Dodd investment, but the company was selling at "only" 1.25 times the market multiple, a ratio that expanded to 3 times in a decade, tripling the absolute multiple. Earnings more than tripled during this time, making Coke a huge winner for Berkshire.

In recent years, Buffett has added "international" to his repertoire, investing in Guinness (drinks) and Tesco (OTCPK:TSCDY) (retail) of Britain, Posco (NYSE:PKX), the South Korean steel company, PetroChina and the Brazilian real.

Disclosure: I hold a long position in BRK.A. I have a token amount (a few hundred dollars) of puts on American Express (AXP) expiring July 2010 (strike price 30) and January 2011 (strike price 10).