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Buffett's Graham and Dodd Roots

Warren Buffett is one of the few students that "aced" (Professor) Ben Graham's investing course at Columbia University. Even so, he had a hard time getting into Graham's investment firm, because he and Graham (who had anglicized his surname, Grossbaum) belonged to "opposite" (WASP and Jewish) sides of "Wall Street." Eventually, Graham let him in, where he became a star performer. But the much older Graham and his partner Jerry Newman wanted to retire and break up the firm before Buffet was deemed ready to take it over.

Buffett showed how "ready" he was by returning to this native Omaha, Nebraska in 1956 to start an investment partnership with $105,000 of "friends and family" money at the tender age of 25. A few of Graham's old investors, particularly a physicist named Homer Dodge, visited Buffett to Omaha to invest with him. 

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 builit up an investment portfolio worth $65 a share using excess cash during that time. 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 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.