I thought I knew everything there was to know about the world’s greatest-ever investor, Warren Buffett - it turns out that I was wrong.
There are thousands of books on Buffett, outlining how he was mathematically gifted as a child, how he studied economics and business at Columbia University and the University of Pennsylvania, how he joined the firm of his idol, Ben Graham, out of university, how he formed his own investment partnership at age 25 and went on to crush the market (achieving 32% annual returns vs the Dow’s 9% over 11 years), and how he bought into Berkshire Hathaway and expanded it into a now US$1 trillion company, with famous investments in the likes of American Express, See’s Candy, Washington Post, Coca-Cola, and Apple.
Buffett has also been incredibly generous with his knowledge in his Berkshire shareholder letters since penning his first one in 1977.
Yet a new book manages to break new ground on Buffett and unearth some hidden gems. Brett Gardner, in Buffett’s Early Investments, looks at 10 of the companies that Buffett invested in between 1950 and 1966, when he was in his 20s and 30s. In a unique twist, Gardner analyzes each of the companies using only the financial information that was available to Buffett before he bought them - annual reports, analysts’ research, manuals of corporate financial data, and other little known sources. Gardner did this because he wanted to understand why Buffett invested in these stocks, and why many of them turned out successfully.
The 10 investments that Gardner profiles are Marshall-Wells, Greif Bros. Cooperage, Cleveland Worsted Mills, Union Street Railway, Philadelphia and Reading Coal and Iron, British Columbia Power, American Express, Studebaker, Hochschild, Kohn & Co., and Walt Disney.
Five of the investments were made during Buffett’s investment partnership from 1957-1969, and the other five were from before that time.
Let’s look at one of these bets in detail because I think it had a large influence on Buffett’s investment philosophy and why Berkshire Hathaway is set up the way it is.
Philadelphia and Reading Coal and Iron
Philadelphia and Reading was an anthracite coal company. Anthracite coal was central to America’s energy production up until the early 1900s. At its peak, it contributed about 20% of the country’s energy output. Yet competition from more efficient energy sources, including other types of coal, resulted in hard times for Philadelphia and Reading. The company had filed for bankruptcy on multiple occasions, including in 1937.
Philadelphia and Reading was run by local businessmen. They owned few of the company shares and they continued to invest cash (unwisely) into the barely breakeven coal business.
That didn’t stop Buffett from buying shares in the company in 1952. At the time, Philadelphia and Reading was US$19 per share. The stock then fell to US$9 per share. This didn’t seem to faze Buffett because he proceeded to buy more of the stock. By 1954, the company had a market capitalization of US$18 million – it was tiny. However, Buffett had made it his largest personal position, having invested US$35,000.
At first glance, the company’s financial statements didn’t make for pretty reading. Revenue had dropped by 40% over the previous five years, and profit had deteriorated to almost zero.
But it was in the balance sheet rather than the profit and loss statement where Buffett saw value. The company had net assets of US$9 per share and Buffett estimated that it had off-balance sheet assets of US$8 per share.
Thus, Buffett was buying at close to US$9 per share, when he thought the company was worth almost double that.
That’s only half the story, though. It turns out that Buffett’s mentor and investment idol, Ben Graham, was on Philadelphia and Reading’s board – which is how Buffett is likely to have become interested in the stock in the first place. Like Buffett, Graham had stated buying the company’s stock in 1952.
In 1954, a group of investors from Baltimore bought more than 11% of stock in Philadelphia and Reading and they sought an alliance with Graham and his partner, Mickey Newman. Both parties were unhappy about the company continuing to invest in the coal business. Newman had also detected significant tax losses on the company’s balance sheet which could be used to acquire profitable businesses whose income would be shielded from future taxes.
Obtaining three of nine board seats, the alliance set about transforming the company. They changed the company’s name from Philadelphia Reading Coal Iron Company to just Philadelphia Reading Corporation. Newman then did a private deal to buy Union Underwear, the country’s largest manufacturer of men’s and boys’ underwear, operating as a licensee of the Fruit of the Loom trademark.
The other board members were infuriated by the deal and it went to a shareholder vote. The stockholders approved the purchase.
Philadelphia and Reading paid US$15 million for Union Underwear, which was earning US$3 million in pre-tax profits. Those profits would be partly shielded by the tax losses of Philadelphia and Reading. And the deal was struck on highly attractive terms, using US$9 million from a non-interest bearing loan.
Soon after, Graham became the company’s Chairman, Newman its President, and it appointed the former head of Union Underwear as its CEO. Thus, the group obtained full control of Philadelphia and Reading.
The company then acquired Acme Boots for US$3.2 million at a valuation of just 4x earnings. Again, much of the purchase was financed with non-interest bearing debt.
By 1956, the company was earning US$7 per share.
Newman and Graham ended up making numerous purchases of cheap companies, including the aforementioned Fruit of the Loom. And Newman eventually bought 73% of the company in 1965 for about US$64 million (valuing the whole company at US$88 million). That compares to the company’s $18 million market cap when Buffett was buying in 1952-1954. However, it’s not known when exactly Buffett sold his shares in Philadelphia and Reading.
Two footnotes to the story. The first is that Berkshire Hathaway ended up buying Fruit of the Loom and still owns it today. The second is that it isn’t hard to see the similarities between Philadelphia and Reading and Berkshire Hathaway, a struggling textile mill that Buffett started buying in 1962 and took full control of in 1965.
Four factors behind Buffett’s early success
Gardner goes into detail on the other nine investments, and the opportunities that Buffett saw in them. From illiquid asset plays like Union Street Railway to investing in the visionary leadership of Walt Disney (and selling out too early after Walt died) to backing a great company in American Express hit by a temporary scandal, the book shows Buffett’s willingness to be bold and take big bets, to have the patience to see many through, and to be ruthless when necessary, as he was with management when taking over Berkshire Hathaway.
Gardner concludes that Buffett’s success early in his career came down to four factors:
- Activism. Buffett wasn’t afraid to take significant stakes in companies and then push for management changes to bridge the gap between the stock price and its underlying value.
- A concentrated portfolio. Buffett was confident enough to make large purchases in companies he knew were undervalued. For instance, American Express became 40% of his investment partnership at one stage. Not many fund managers would have the brass to do this.
- His extensive research. Buffett read voraciously on companies, he talked with management, and he visited factories. He wanted to know everything about the business before investing.
- Filtering ideas. While well-read, Buffett was also able to simplify industries and companies and figure out their key drivers.
*Gardner’s book has been released in the US and is due for release in Australia next month.
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My article this week looks at the challenges of building a dividend portfolio with ASX 200 dividend yields hitting near 25-year lows. I explore several conventional and not-so-conventional ideas that offer opportunities for income investors.
James Gruber
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Curated by James Gruber, Joseph Taylor, and Leisa Bell
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