In 2008, Alice Schroeder, author of “The Snowball: Warren Buffett and the Business of Life,” gave a very interesting talk to the Darden School of business at the University of Virginia. The talk is fascinating. Schroeder spendt a ton of time with Buffett and people who are close to him while researching for her book, and she has a level of insight about Buffett that we rarely have access to.
Schroeder uses her talk to highlight a private investment Warren Buffett made in the Mid-Continent Tab Card Company.
Below is a video of the talk and also a transcript of the talk. Watching this talk made me a better investor, and I recommend investing some time in watching or reading this talk.
Here are some of my takeaways from the talk.
Deeply Ingrained Concepts
Hearing Schroeder talk about how deeply the core principles of his investing style are ingrained in Buffett was very instructive. It’s like second-nature to him. It is him. He’s so into his style of thinking and investing and his principles, that he’s never off. He’s always on. Reading, learning, and thinking clearly and rationally, he’s always doing those things. They’re like breathing to him. I want to be that way with the principles of Graham, Buffett, Munger, and Pabrai.
Schroeder highlights four concepts specifically.
- Intrinsic value, and especially applying the Phil Fisher qualitative investing concept to intrinsic value.
- Ignoring Mr. Market’s manic-depressive behavior.
- The performance drag of too much turnover and too much diversification.
- The Ben Graham margin of safety concept.
Buffett’s Hard Work
I enjoyed being reminded of Buffett’s hard work. Giving through files, showing up at offices for research, talking, learning, asking questions. We cannot do enough of the hard work of reading and researching. Despite the how available and easily accessible business and investment information is these days, I still think research work is under-appreciated. Always be thinking, always be researching, and sometimes get off your butt and make things happen (Buffett sending a lieutenant to buy up shares of National American Insurance in person from small shareholders all around the state of Nebraska, Buffett researching consumer behavior at a restaurant in Omaha during the American Express salad oil scandal, and Buffett showing up at GEICO headquarters as a very young age to ask questions in person). What more can I do? What more can I do to get an edge on Mr. Market?
Schroeder said the main thing he worked at was learning. And his learning has been cumulative (compounding).
3 Concepts Schroeder’s Talk Focuses On
Her talk uses a personal investment Buffett made in a private company to highlight three concepts: handicapping, compounding, and the margin of safety.
Mid-Continent Tab Card Company
This is the late 1950s. Buffett is two and a half years into running his partnership.
IBM had a monopoly problem with the government. The government made IBM spinoff their punch card business.
Mid-Continent Tab Card was set up but two of Buffet’s friends to compete with IBM’s spinoff company.
They invited Buffett to invest with them in this new company.
He said no.
It did not pass his always-first hurdle, which is handicapping the likelihood of a catastrophic risk, a risk of a wipeout.
This is the opposite of what most investors do. Most investors find a nice idea and then ask “what could go wrong.” Buffett starts with “what could go wrong.”
Buffett asked “what could go wrong.” And he decided that a startup business competing with IBM could fail. As soon as an investment opportunity doesn’t pass that first hurdle or handicapping wipeout risk, it’s end of story, “no,” and moving on.
His friends start the business anyway, and a year into it they were printing 35 million tab cards a month. At this point they needed money to buy more Carroll presses to keep up with demand. They said “Warren, we need money to buy these presses, would you like to come in?”
This reminds me how Peter Thiel said investing in Facebook was an easy decision because they needed his money to buy computers to keep up with demand.
Buffett decides to go in.
He did not create a model. He did what you would do with a horse. He found the one or two factors that would make the investment work, which here were sales growth and continuing to have a price advantage (based in midwest, closer shipping to customers).
He looked at quarterly financial information back to the beginning of the company and for the competitors he could find too. This company had 36% net profit margins on $1 million of sales. And it was growing 70% a year.
And he said to himself, “I want 15% return on $2 million of sales.” He decided yes, he could get that.
No earnings model, no discounted cash flow model. None of that. It was all incorporated into the one sentence, “I want 15% on $2 million of sales.”
Why 15%? Warren is not greedy. He always wants just 15% day one return on investment and then it compounds from there.
Buffett invested $60,000 of his personal non-partnership money into the company, which was around 20% of his net worth.
He got 16% of the company’s stock, plus some subordinated notes.
Simple process. Consider the wipeout risk hurdle, if you get past that, then look at historical data, work in a margin of safety, then price it to get the generic 15% return on investment in year one. And look only at historical data. That was the process.
They changed their name to Data Documents. Buffett ended up putting in another million dollars into the company over time. He owned his share for 18 years until the company was bought out in 1979. Buffett got a 33% compounded annual return.
Always start with wipeout risk hurdle.
You don’t need discounted cash flow formulas or earnings projections if you don’t want them.
Look at historical data.
Work in a margin of safety.
Aim for a 15% year one return on investment.
Be patient and ruthless with Mr. Market.
Go in big when you have a good situation.
Video of Alice Schroeder’ talk:
Below is the transcript of Alices Schroeder’s talk:
Ken: I mentioned earlier that Ken Shubin Stein did double duty, he was our first panel, well, John McFarlane, who was also on the panel, is going to do a little double duty right now as well. What I didn’t tell you about John, I told you that he was COO of Tudor Investments, but I did not tell you is, I’m proud to say, that he has an MBA from the Darden School. Yeah. In fact, he’s currently serving as the Chairman of the Board of Trustees of the Darden School Foundation. John has served the school in many different ways. For this conference, the reason I want John to come up now is that, he is heavily responsible for getting Alice Schroeder to come here tonight. Let’s welcome John back up to introduce Alice.
John Macfarlane: Thank you, Ken. It’s a great pleasure to be here. Before I introduce Alice to you, I’d like to thank both Carl and Bob and their respective staffs, Everett and David, and in particular Dan Anglin and John Griffin from the McIntyre School for putting this together. This really is what Darden McIntyre should be doing to enhance their brand and scope. This is a wonderful way to start and I look forward to watching this grow.
John Macfarlane: In that vein, as Alice and I were walking into the theater this afternoon, we looked at it and said, “That looks an awful a lot like the Orpheum Theater in Omaha.” For those of you who have been to the Berkshire Hathaway meetings, that is over 10 years ago, you know exactly what that is. We used to go to the meetings when shareholders could fit into that theater, which was probably about the size, maybe a little bit larger. Of course, that was before the B shares. We’ve been going back for years and watched it migrate to Saban, and then ultimately to Qwest Center. To Carl and Bob, I look forward to coming back to this conference in the future in JPJ arena. So, well done.
John Macfarlane: Before I get to my comments about Alice, most of you guys probably know more than I’ll say about her, that is those of you are under 30 because she has a Facebook fan page, which I can’t view because my kids won’t let me, or my wife, be on Facebook. You guys already know more than I do about Alice. I’ll attempt to fill in for those of us who are over 30, 40, 50, 60.
John Macfarlane: Rarely do practitioners had the opportunity to watch the undisputed master of their discipline in real-time. We are truly fortunate to live in the age of Warren Buffett, as rare is to have the work of a master chronicled in exacting detail during their lifetime. Alice Schroeder accomplished just that with Snowball. In 838 pages, she provides unique insight into the individual who has largely shaped the field of value investing over the past three to four decades. For that, Alice, we’re deeply indebted to you for your work.
John Macfarlane: Alice’s career began in accounting and, while working for FASB, she drafted some of the most important accounting standards affecting the insurance industry. She subsequently moved onto investment banking and, ultimately, as many of you know, to research at Morgan Stanley where she became Institutional Investor’s top-ranked property and casualty insurance industry analyst. It was in that capacity that she met Warren and, as a result of a strong mutual respect, he granted her full access to his papers, to his family and friends to write his biography.
John Macfarlane: What makes Snowball so special, in my opinion, are in combination for distinguishing characteristics. First of all, Alice has very deep understanding of finance and the insurance industry. Secondly, the unprecedented access that she had to Warren and his work. Thirdly, her persistence and attention to detail. Fourthly, and most importantly, the integrity with which she undertook the task.
John Macfarlane: Based upon our countless conversations over the past several years, I can assure you that she was relentless in her verification of fact. For those of you who have read the book, or at least flipped through it, that footnotes are certainly testimony to that. Not surprisingly, after a little more than a month on the shelves, Snowball is now ranked by Amazon as the number one business publication or business book of 2008. It’s getting the recognition that’s deserved. For those of you have read it, you know why.
John Macfarlane: So without further ado, it’s my pleasure to introduce to you Alice Schroeder.
Alice Schroeder: John, thank you. Thank you so much for that wonderful introduction, and thank you all for having me here at the University of Virginia, and all of the people who are so welcoming. It’s really terrific.
Alice Schroeder: I especially want to say thank you to John because, he was very modest in not playing up his role, but he was one of my important sources in writing the Snowball because of his role at Salomon Brothers as the treasurer. I found one of the things that occurs when you write a biography is you do get a lot of conflicting information. John was my sounding board. I would call him and say these two people have said this and that, which one should I believe? He would tell me and I trusted him. He was an invaluable resource and also gave me a lot of great facts and information.
Alice Schroeder: It’s a real privilege to come before you tonight to talk about Warren Buffett, especially at this time of financial turmoil and crisis. As you all know, Warren Buffett is the only person of our time who’s managed to accomplish his wish of becoming so rich that when he writes a check it’s the bank that bounces. These days it doesn’t take quite so large a check to make the bank bounce, but it’s interesting to see that when it does happen, it’s Warren Buffett that they run to to cover the overdraft. He is really a singular figure in these times.
Alice Schroeder: When I started working on the Snowball, of course, things were very different, the internet bubble had just imploded and it was just after the aftermath of Enron. I never anticipated anything like this occurring. But I knew what he was like and, of course, much of the importance of him is that his ideas and principles haven’t really changed in 50 years.
Alice Schroeder: I thought that writing a book about him would actually be a fairly simple matter. When you ask Warren a question, he always had the answer. When I would present him with a business problem, he always would have the solution, so the job was just to write it down. What I didn’t realize was how quickly I would encounter something called Sevaraid’s law, which is that the cause of problems is solutions.
Alice Schroeder: Having asked all my questions, having listened to his stories, and having gotten all of his solutions, very quickly, I was presented with a problem, which was that I had far more solutions material, questions answered than I knew what to do with. I began casting about for a way to construct a narrative and to come up with how to put together a book about this man’s life that would be meaningful and present a set of ideas.
Alice Schroeder: I had a few attempts that failed that I thought you might like to hear about them. Here’s my first shot at it. The story began with a journey through the life of a 78-year-old man. It traveled back through the decades, tracing and uncovering a common truth that lies at the core of the most powerful investment philosophies, teachings, and models in the world.
Alice Schroeder: What you will learn today is the single secret underlying law of the Snowball, a set of principles based on the most powerful law in the universe. All that Warren Buffett ever accomplished or attained in the business of life was done in full accordance with this most powerful law. Using this simple universal law, the Snowball offers the knowledge of how to create intentionally and effortlessly a joyful life. This is the secret. The secret to everything. The secret to unlimited happiness, love, health, and prosperity. This is the law of attraction. The secret of Warren Buffett.
Alice Schroeder: Okay. Well, I passed on that idea. I thought it was not too good. But somebody else went there.
Alice Schroeder: My next attempt, the Snowball’s action kicks off in modern-day New York where a blood-stained copy of the Intelligent Investor is found symbolically laid at the foot of the New York Stock Exchange. The quest for the holy grail of investing led to a search that spanned the globe from London to Los Angeles, leaving a gruesome trail of interview subjects behind this evidence. The result was an exhaustively researched page-turner about a secret investing cult, cover-ups of ancient mistakes and savage vengeance against those who tried to capture the holy grail for themselves. In the end, I found the grail guarded by ancient 78-year-old heretic buried deep in a maze of files under a pyramid in Kiewit Plaza.
Alice Schroeder: I loved that idea, but then there was this guy named Dan Brown who went ahead and used it before I got there. I was sure, however, that somewhere hiding in Kiewit Plaza, there was a holy grail because I spent 2,000 hours with Warren Buffett. I did get to go through all his files and I got to ask him all of the questions and business problems that I wanted to.
Alice Schroeder: I thought there had to be a holy grail because I had heard from so many investors a little bit of, “irritation” might not be the right word, but Warren always says that it’s very simple, there’s a few simple principles, and if you were only working with a smaller amount of money, he could earn 50% returns a year. Well, I’ve had a lot of people say to me, “I am working with a smaller amount of money. If it is really that simple, why am I not earning 50% returns a year?” So, the question is, is it just that Warren Buffett is a genius? Is it just that we’re all dumb? Or, “Is the truth somewhere in between? I think the truth is somewhere in between.
Alice Schroeder: I was sure that hiding somewhere in his office was the holy grail. In fact, while Warren is brilliant, and he is definitely different from everybody else, there is something more to it, because he does have a way of making the difficult look easy. He also has a hard time understanding, or perhaps even admitting, how hard he works. It’s sort of like asking a fish to describe water. There are some concepts that are so ingrained in him and so embedded in him that he doesn’t really understand them himself, it’s just they’ve been there for so long.
Alice Schroeder: For example, take the rule that he follows about asset turnover. “No real investor likes to trade. It is never pleasant to part probably forever from an old friend.” Okay. Well, that probably sounds like something that Warren would say, right? Or it sounds like something that Ben Graham would say. But it’s not. That is from a book called Bond Salesmanship by Townsend, which Warren read when he was seven years old. He asked for this book for Christmas, by the way.
Alice Schroeder: Whenever he reads a book, especially as a child, he usually read them four or five times and memorized them. Some of these ideas have been so ingrained in him from an early age, it’s hard to know whether their innate, whether he invented them, or whether he picked them up from sources like this when he was very young. But he got a lot of reinforcement at a very early age.
Alice Schroeder: Now for those of us who didn’t, the question is: what in Warren’s papers and mental files will help us be better investors even though we can’t be the next Warren Buffett? I did find some things, but let’s first start with reviewing. There’s four concepts that you hear over and over that are kind of the basics of value investing. They are: intrinsic value, and especially applying the Phil Fisher qualitative investing concept to intrinsic value; second, ignoring the Mr. market manic-depressive behavior; third is the performance drag of too much turnover and too much diversification; and fourth is the Ben Graham margin of safety concept, which arguably is the most important idea ever developed in investing. All of these are very important.
Alice Schroeder: When I studied and spent so much time with Warren Buffett, what I actually saw is that he invests and applies his investing. He uses these concepts, but what he actually does is a little bit different. So what I’d like to do is take you on a little bit of a journey using a specific investment that I did not write about in the book, it was cut for length. I’ll illustrate principles that I talked about in the book, but it’s a little bit too technical and too high-level to have been put into the Snowball, which is for more of a mass audience.
Alice Schroeder: Also, just as an overview, I should just say that so much of Warren’s success has come from just in training himself into good habits. It’s worth just saying that because he always says that the chains of habit are too light to be felt until they’re too heavy to be broken, and he’s talking about bad habits. But it was Aristotle who said that we are what we repeatedly do and that excellence is not an act but a habit.
Alice Schroeder: Warren is a creature of habit. He’s the ultimate creature of habit. His first habit was hard work. I write over and over in the book about the fact that he was at the Securities and Exchange Commission digging up documents before they were electronically available. He was down at the State Insurance Commission in the bowels of the basement looking up files. He was knocking on doors of businesses talking to the managements when they were saying, “You’re a pest. Go away.” He was sending Dan Monen around the state buying up shares of National American Insurance. He was always thinking and working. A lot of his work was not obvious, it was not repetitive or routine. What he was doing, was he was always thinking, what more can I do? Especially, what more can I do to get an edge on the other guy?
Alice Schroeder: Importantly, I know a lot of people will point out that a lot of what he did you can’t do these days because either the information is so available electronically that everybody has it, or it’s insider information, that would be illegal to use. But the principle of the hard work that he did is still the same. I was talking to somebody earlier and we were just sort of talking in awe of how hard Warren Buffett worked and the fact that most people would not work that obsessively. But for those of you who do, there is a reward.
Alice Schroeder: The main thing that he worked out was learning. The guy is, as Charlie Munger puts it, a learning machine. His learning has been cumulative. It’s been a tremendous advantage to him in business. He’s got this mental file cabinet that’s been built up, starting when he was a very small child sitting in his stockbroker father’s office, reading the financial statements and descriptions and studying of thousands of businesses and dozens and even hundreds of industries over and over and over.
Alice Schroeder: This is really why, when people call him with a business proposition, he can say yes or no instantly, because he’s got that file cabinet in his mind that is so deep. It does help to have a photographic memory or near photographic memory, which he has, but at the same time, that knowledge that, that learning is the second part of what makes him Warren Buffett. The learning was cumulative. I think that’s worth mentioning, too. That he’s chosen to learn in a field where the knowledge adds and builds on top of each other. I think we could all be better investors for knowing that.
Alice Schroeder: Well, up to this point, there’s not any great mystery to it. I think everybody knows that Warren Buffett has, or everyone who’s read the Snowball knows, how hard he’s worked and how much learning he’s done. But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is handicapping, compounding, and the margin of safety. These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly. They’re all discussed in the book.
Alice Schroeder: I’d like to take you through a little case study on an investment called Mid-Continent Tab Card Company. This was a private investment that he did in his personal portfolio. Just kind of show you how I saw him and that’s based on his personal files and what he actually does, and then I’ll update that to the present day. This company was an outgrowth of IBM. As you all know, in the 1950s, Warren did not use computers. But he was very aware of them. IBM was the only computer company of any size or importance at that time.
Alice Schroeder: Warren’s Aunt Katie and her Uncle Fred had decided to invest in Control Data, which was a startup company that was going to compete with IBM. Katie’s brother, who was Bill Norris, was founding Control Data because he wanted to create a business. He thought IBM was slow and bureaucratic. Warren told Katie and Fred not to invest in Control Data. He said to them, “Don’t do it. Who needs another computer company?” Those were sort of his famous last words. They invested in Control Data anyway and they made a huge amount of money.
Alice Schroeder: What was notable about this incident is that Warren told them not to invest because he actually knew a lot about IBM. He’d been studying IBM since 1952. It had been in court embroiled in an antitrust case for being a monopoly. Warren studied its financials, even though by then he’d already declared IBM outside his circle of competence. He felt that even though IBM might have to be broken up some day, that its monopoly was so overwhelming, and, of course, he likes monopoly businesses, that to compete with it would probably be futile.
Alice Schroeder: What happened was that IBM did actually settle with the Justice Department. As part of that settlement, it was required to divest of a business making tab cards. Now I can’t really see you very well, but there must be a few people who could throw their hands up in the air that are old enough to know what a tab card is. Anybody know what a tab card is? Yes, I see two people. Okay, that dates me. Okay.
Alice Schroeder: A tab card is before computers were digital, they actually read off the punch cards, they were called mark sense cards. These were big decks of cards that had holes punched in them and they would be stuck in the computer and they would be read manually-, not manually, they were not electronic, they were sent mechanically through the computer.
Alice Schroeder: This company was formed because IBM had to divest of this business. It was an incredibly, incredibly profitable business. In fact, because these cards were trivial compared to the mainframe computers that IBM sold, it marked them up to get more than a 50% profit margin. This was IBM’s most profitable business.
Alice Schroeder: Wayne Eaves and John Cleary, who were two friends of Warren’s, saw that IBM was going to have to divest in this business and they thought, “We’re going to buy a Carroll Press,” which was the press that makes these cards and were going to compete with IBM. “Because we’re based in the Midwest, we can ship faster. We can provide better service.” They went to Warren and they said, “Should we invest in this company and would you come in with us?” Warren said, “No.”
Alice Schroeder: Well, why did he say no? He didn’t say no because it was a technology company. He said no because he went through the first step in his investing process. This is what I think what he does that’s very automatic, but isn’t well understood. He acted like a horse handicapper. The first step in Warren’s investing process is always to say: what is the odds that this business could be subject to any kind of catastrophe risk, that could make it just fail? If there is any chance that any significant amount of his capital could be subject to catastrophe risk, he just stops thinking. No. He won’t go there.
Alice Schroeder: It’s backwards the way most people invest. Because most people find an interesting idea, they figure out the math, they look at the financials, they do a projection, and then at the end they ask themselves, “Okay. What could go wrong?” Warren starts with what could go wrong. Here, he said a startup business competing with IBM could fail. Nope, sorry, and he didn’t think another thing about it.
Alice Schroeder: But Wayne Eaves and John Cleary went ahead anyway. They started up this business and within a year they were printing 35 million tab cards a month. At that point, they needed to buy more Carroll presses. They came back to Warren and they said, “We need money. Would you like to come in?”
Alice Schroeder: Okay. Now, Warren is interested because the catastrophe risk element of the equation is gone. They are competing successfully against IBM. He asked them the numbers and they explained to him that they are turning their capital over seven times a year. As Carroll Press costs $78,000, every time they run a set of cards through and turn their capital over, they are making over $11,000. Basically, their gross profit on a year on a press is enough to buy another printing press. At this point, Warren’s very interested. Their net profit margins are 40%. It’s the most profitable business that he’s ever had the opportunity to invest in.
Alice Schroeder: Notably, people are now bringing Warren special deals. It’s 1959, he’s been in business for two and a half years running the partnership. Why are they doing that? It’s not because they know he’s a great stock picker, they don’t know that. He hasn’t yet made that record. It’s because he knows so much about business and because he started so early that he has a lot of money. This is something interesting about Warren Buffett. By 1959, people were already bringing him special deals, like they’re still doing today with Goldman and GE.
Alice Schroeder: He decided that he would come in and invest in this company Mid-Continent Tab Card company. But interestingly, he did not take Wayne and John’s word for it. The numbers they gave him were really enticing, but again, he went through and he acted like a horse handicapper.
Alice Schroeder: Now, here’s another point of departure from what almost anybody else would do. Everybody that I know or knew as an analyst would have created a model for this company and would have projected out its earnings and would have looked at its return on investment and ta-da-da-da in the future. Warren didn’t do that. In fact, in going through hundreds of his files, I’ve never seen anything that resembled a model.
Alice Schroeder: What he did is he did what you would do with a horse. He figured out the one or two factors that could make the horse succeed or fail and, in this case, it was sales growth and making the cost advantage continue to work. Then, he took all the historical data quarter-by-quarter for every single plant. He got the similar information as best he could from every competitor they had. He filled pages with little hidden scratches of all this information and he studied that information.
Alice Schroeder: Then, he made a yes/no decision. He looked at it, they were getting 36% margins, they were growing over 70% a year on a million of sales. That was the historic numbers. He looked at them in great detail, just like a horse handicapper would studying the tip sheet. Then, he said to himself, “I want a 15% return on two million of sales,” and then he said, “Yeah, I can get that.” Then, he came in as an investor.
Alice Schroeder: Okay. What he did is he incorporated his whole earnings model and compounding just kind of cash flow into that one sentence – I want 15% on two million of sales. Why 15%? Because Warren is not greedy. He always wants a mere 15% day one return on investment and then it compounds from there. That’s what all he’s ever wanted. He’s happy with that.
Alice Schroeder: You’re not laughing. What’s wrong?
Alice Schroeder: It’s a very simple thing. There’s nothing fancy about it. I think that’s another important lesson because he’s a very simple guy. He doesn’t do any kind of discounted cash flow models or anything like that. For decades, he just says, “I want a 15% day one return on my investment and I wanted to grow from there.” Ta da, and the two million dollars of sales was pretty simple too. It had a million, it was growing 70%, there was a big margin of safety built into these numbers. It had a 36% profit margin, he said, “I’ll take half that.” He ended up putting $60 million-, I’m sorry, $60,000. I’m thinking in more modern terms. He ended up putting $60,000 of his personal non-partnership money into this company, which was about 20% of his net worth at that time. He got 16% of the company stock plus some subordinated notes.
Alice Schroeder: The way he thought about it was really simple. It was a one-step decision. He looked at historical data and then he had this generic return that he wants on everything. It was a very easy decision for him and he relied totally on historical figures with no projections. I think that that’s a really interesting way to look at it because I saw him do it over and over in different investments.
Alice Schroeder: What happened? Well, the company changed its name to Data Documents. He owned the investment for 18 years. He ended up putting another $1 million into it over time. It was bought out by Dictograph in 1979 and he earned a 33% compounded return over the 18 years that he owned the investment. So, it was not too bad.
Alice Schroeder: That was typical. I gave you this example in part because it was the other time, besides Geico, that he got a Philip Fisher-type growth company and a Ben Graham-like price. It was the most vivid example of that that I found. But it was a private investment and there’s not a lot of public information about it available.
Alice Schroeder: Fast-forwarding a little bit, why he thinks so much about catastrophe? Firestone’s forecasting is always on his mind. Firestone said that Chicken Little only had to be right once. That’s always the first thing that Warren thinks about. So, why is Berkshire Hathaway today not dealing with some of the problems that other people are? It’s because Warren passed on investing in a lot of things that he could have because the first question he always asks himself is: what’s the cat risk? If the business or investment has cat risk, then he just says no.
Alice Schroeder: We could probably get into an interesting discussion about some things like AIG. That was a stock that I was wrong on for a long time until I finally turned around. He never invested in AIG because of the cat risk. People brought him Bear Stearns and Lehman and he never invested in them because of the cat risk. He saves himself a lot of time and energy this way, because if you ask yourself the cat risk question first, then you don’t have to do any of the other work, all those pages of numbers, historical data.
Alice Schroeder: Because Warren is basically focused on efficiency, that’s why he does that. He’s also very good at being realistic. Once he figures out that something does have the cat risk, he never ever kids himself and tries to talk himself out of changing a decision.
Alice Schroeder: Today, when you think about what’s happening right now, with deals like GE and Goldman Sachs, people are still bringing him special deals that nobody else could get. He’s still making sure they don’t have the cat risk as best he can. He’s making a bet on the management, but also his own reputation as an investor, to some extent, can cat-proof these deals. They’re giving him a 10% guaranteed return and that’s the minimum, but he’s going to get his 15%. He still wants the 15%. At times, he’s taken less and lowered his standards, and he’s usually been sorry when he has.
Alice Schroeder: When it comes to the market as a whole, he uses somewhat the same technique. He recently said that he finds the stock market attractive now. In his 1999 Sun Valley speech, he talked about investing in the market when the stock market’s value was between 70 and 80% of GDP. It’s somewhat the same method because, at that level, obviously, the whole stock market is not going to go to zero. He’s got a huge margin of safety built into that. Just as the 15% return and the two million included a huge margin of safety versus how fast Mid-Continent Tab Card Company was actually growing and the margins that it was actually getting.
Alice Schroeder: He’s put his margin of safety into the return expectations and he’s using only historical data. He’s gone back in his years and years and years of data to arrive at the conclusion that, again, probabilities, he’s handicapping that it’s the right price to buy. He doesn’t really care if it goes up or down or up or down for the next year or two, he just knows that, at this price, the odds are that it will do well.
Alice Schroeder: I do think it’s really amazing that right now, three weeks later, there are pundits out there who are saying that the greatest living investor of our time, and possibly ever, is wrong for having made these investments and having predicted that the stock market is a buy right now. It is really ironic and interesting that somebody, who as far as I know has never been wrong in making a prediction, that people who make wrong predictions everyday and have been in the past wrong in saying he’s wrong are out there once again saying that he’s wrong.
Alice Schroeder: Also, I think it’s worth mentioning, because we’re talking about this handicapping concept, something else, this is just a little quote from the Intelligent Investor, which is that, “The margin of safety is always dependent on the price paid. If as we suggest the average market level of most growth stocks is too high to provide a margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.” That, obviously, applies to the market as a whole.
Alice Schroeder: One thing I think that Warren Buffett should get a huge amount of credit for and a round of applause for is never ever having advocated dollar-cost averaging because it’s wrong. It’s led many people off a cliff. It’s not right to buy the market in any price and you’ve never heard him suggest that anybody should do it. I think he should get a lot of credit for that.
Alice Schroeder: In the end, I’d like to just say thank you for listening to this story. I hope it gives you a little bit of insight into how he thinks. But it’s also indefinable. There are certain things about him that are a mystery and will never be explainable. There’s one thing about him that you can emulate, but only if it comes from the right place inside you. It’s been said, and this came early to Warren that, “The only person really qualified to advise you as to what you can do is yourself.” He calls this his inner scorecard.
Alice Schroeder: “You know yourself better than anyone else does. You and you alone know how determined you are to make a success of any undertaking. In the last analysis, about 90% of being successful in business is that indefinable thing, which for a lack of a better name, we call guts.” That is from the book A Thousand Ways to Make $1,000.
Alice Schroeder: Thank you and I’d be very happy to take any questions now.
Ken: Thank you, Alice. We have our first question.
Student: Hi, I’m Josh Liang Sam. I’m a first year student from Darden. Your book has been extremely well-received, do you have plans for a future work? If so, what subject might you look to cover and why?
Alice Schroeder: Okay. I do. I’m sure that I’ll write another book. I don’t expect to write another biography similar to this one, because a subject worthy of following this one, I can’t think of what would be. I have enough material to write a very interesting investment book and I would be very likely to be writing about some of what I talked about tonight. But I’ve thought about some other ideas and it’s best to just kind of keep them here.
Alice Schroeder: Okay. Yes?
Student: Hey, Alice. Thank you for the insights on the book. One of the things I thought was interesting is, given your background as an insurance analyst and his experience with Geico, when he stepped in the early ’70s, it was considered, I think you mentioned in the book, he said to somebody, “I might have put money to work where I could lose all of it.” But also, if I remember correctly, you talked about how he said to Salomon, he said to Gutfreund, “You know what I’ll backstop this.” Although that sounds contradictory, it also sounds like maybe he was gaming it because he could recapitalize it if they still have durable competitive advantage, even net of their gross liabilities. Is that the right interpretation or did I missed something?
Alice Schroeder: I think there was a similarity between the two situations in that in both cases he knew that his reputation was the backstop. He said “I put something into a situation where I could lose all my money tomorrow,” but honestly, the margin of safety was himself. With Salomon, he’d have to call upon it, but basically he was selling his reputation to them and that’s why he got the high price. In the end, he actually had to reach in and pull that reputation out and use it, something that was very painful for him. I don’t think he ever thought he would have to do it. But I think that’s what the situations actually have in common, he was the margin of safety.
Student: Okay, thanks.
Alice Schroeder: Okay. Anybody else?
Student: I have one more, I guess. A lot of Berkshire’s success has come from Warren Buffett’s partnership with Charlie Munger. Can you describe the dynamics of that and how that contributes to the company’s success?
Alice Schroeder: Yeah. Historically, Charlie Munger was somebody who kind of kept Warren on the straight and narrow because he’s one of the few people that really will challenge Warren’s thinking. Warren is sort of awe-inspiring and there aren’t a lot of people who will tell him that he’s wrong. Warren does not listen to advice. I mean, he really doesn’t even listen to advice from Charlie. He has this saying “When I get up in the morning I look in the mirror, and at that point everybody’s had their say.” That’s the truth. I mean, you should try giving him advice. I have. Believe me. I mean, you’ll literally see his eyes kind of go off into some weird direction. I mean, he does not listen.
Alice Schroeder: Charlie is somebody that he actually listens to. In the early days, of course, that changed Warren’s investing style because Charlie kept getting him to focus on good companies, quality companies, good companies, quality companies. These days, you know, they’re social friends. Charlie doesn’t have any role at all in running Berkshire and he kind of makes jokes about that, but they’re social friends.
Ken: Step to the mic.
Student: What messages and teachings that Mr. Buffett gives to younger folks like me and just college students in general? Thank you.
Alice Schroeder: Well, I think that the most important thing that he tells students that I’ve heard him say, that I hope people really listen to, is to follow your passion, to do what you really want to do, and not waste time with resume filling jobs, and not work for anybody who makes your stomach turn, because you can’t really get ahead that way. I mean, it may seem like it for a while, but in the end the odds are better, if you really love what you’re doing, that you’ll really, really succeed.
Ken: All you have to do is walk to the mic. John Mcfarlane, that’s good for a question.
Student: Thank you. Question, I mean this is something that really surprised me and you touched on it, Alice. Having watched how painful the Salomon experience for Warren was, were you surprised that he invested in Goldman, and why do you think he did it?
Alice Schroeder: I was a little surprised, because he’s taking some of the same risks. I think he’s had a longer time to get to know Goldman’s management over decades. I think he’s more comfortable that he understands the inner workings of that bank. But it’s still an investment bank. I think that Warren has been impulsive once or twice in his career. Salomon was a case where he fell in love with John Gutfreund. Warren loves Goldman’s management. He’s getting another rich premium to do it, just like with Salomon. I do think the one factor that’s different is that Goldman is going to be transformed into a deleveraged commercial bank and it’s going to be operated with different regulation. That is enough of a factor that I could say, “Okay, I can understand this.” But, yeah, it is kind of similar.
Student: [Inaudible 00:39:50]
Alice Schroeder: Yes. The other problem is that Warren doesn’t love paying people, to begin with. I mean, that’s something that he does, I won’t say reluctantly, but you’ll hear him say, so and so, it would take three people to replace them, and then that’s true and then they wonder, why am I not getting paid three times as much? I mean, the people who work for Berkshire Hathaway are not paid like Wall Streeters, or even they might make somewhere else.
Alice Schroeder: When he started being on the board of Salomon he was just stunned at the way people in Wall Street are paid and really almost with a moral kind of repugnance at it. There was some justification to that because it’s a heads they win, tails they don’t lose situation. Goldman, yeah, I mean, he’s not on the board and somehow he’s reconciled himself to this. Yeah.
Student: Alice, we talked about this a little the other day, but given the deep dive you did with Buffett and Berkshire and given your background in the insurance industry, I don’t know the industry that well, but it certainly appears the company is trading in a meaningful discount to the group. Just what are your thoughts, I mean, it just seems like there’s tremendous disconnect, particularly the way you described the company, they don’t take cat risk. There’s a disconnect for me. What am I missing?
Alice Schroeder: Well, I always found as an analyst that the way Berkshire traded and the actual value of the company didn’t have much connection to each other. There just wasn’t a connection. Particularly, it was rare that you ever saw, and I think this is true of stocks in general, companies that don’t … There’s not a penalty for taking excessive risk, which also means there’s not a reward for taking less risk. The only way you see it is over a long period of time where a company like Berkshire is able to build its book value and that Warren and Charlie have the same don’t go back to go.
Alice Schroeder: Well, you see, these other companies that are losing billions of dollars because they’ve taken the risk, their stocks are getting killed, what, Berkshire isn’t. To some extent, they’re not going backwards, but in terms of the value, it’s trading at what you could argue as a discount to its fair value. It’s not the cheapest it’s ever been, but it’s certainly not getting the kind of premium that you might think, that maybe because of Warren’s age.
Student: I was interested in hearing more about your relationship as a research analyst and some of the content of your research reports, specifically your philosophy for valuation of Berkshire, that kind of thing.
Alice Schroeder: Well, it’s been five years since I’ve done any research on Berkshire. But I had a model that I used where I basically valued the float of the company and looked at its future growth, and then in effect added that to the book value, or put a p/e on the rest of the earnings. I suggested that people use their own growth assumptions because it could be anything. I don’t have it in front of me, but I believe it’s published on the internet, if anybody would like to have a copy of it. Yes.
Student: Alice, I’m really interested in your view of the managers of Berkshire and the ability of Berkshire to retain them after Warren Buffett.
Alice Schroeder: Yeah. A lot of them are actually quite old and they won’t be retainable anyway, because it’s time for them to be retired. There are some that I think are just hanging around because they like working for Warren. That’s going to be a very significant challenge that the next CEO will face. Now they’ve got successors that they’ve identified for Warren. I think another challenge the next CEO will face is, are those the right people? Because he’s let the managers name their own successors. It’s going to be a challenge. Really a lot of it depends on who they pick. They could make a great or a terrible decision of choosing the next CEO. The board could.
Student: Hi, I’m Joseph Matthew. I’m a first year at Darden. At the risk of getting too granular, I’m kind of interested in the scratch notes that you were talking about in the one case you were talking about. If someone who was who was very quantitatively oriented and knows Excel looked at that and put it into a model, do you think that people could understand what’s going on inside Warren’s head when he’s trying to value a company and actually replicate that?
Alice Schroeder: Yes. I mean, what you would see is a column that said sales and a column that said expenses and a column that said profits. It would have Kentucky plant, Louisville plant, Kansas City plant, this plant, that plant. It would have first quarter, second quarter, third quarter, fourth quarter 1958, ta da da da, then it would end with the last quarter that was reported. That’s all it is. That the difference from a model is it would not add the quarters up and it would not project anything into the future. Nothing.
Alice Schroeder: In other words, he looked at what had been reported and he said they’ve had a million in sales, they’ve earned this many thousand, I want this much. They’ve earned this, I want this. Can they do it? Yes, no. That’s the decision and the margin of safety.
Alice Schroeder: I mean, there’s a saying, let me call it to mind, I think it’s from the Intelligent Investor that, “The purpose of the margin of safety is to render forecast unnecessary.” Yeah.
Ken: Let’s do one more question.
Student: I’m a little bit of a different note. Number of political pundits are throwing out Mr. Buffett’s name as potential candidate for the next Secretary of Treasury under President-elect Obama. From your experience with Mr. Buffett, do you really think this would be something he would be willing to leave Berkshire for, that is to take a role in Mr. Obama’s cabinet?
Alice Schroeder: He would have to be shot with a blowdart and dragged in chains to Washington to do this. I think they’ve already in sort of semi-announced who the candidates are and the reason he’s not one of them is because he would never be taken away from Berkshire. He would never spend his day in meetings. He would never let somebody else schedule his time. But there’s going to be kind of a kitchen cabinet of informal advisors. He did that for Schwarzenegger, he’ll do it for Obama.
Student: Okay. Thank you.
Alice Schroeder: Okay.
Ken: Alice, I want to thank you so much. I mentioned earlier, a couple things, one, was that we have gifts for all our presenters, but they weren’t going to receive those in real-time. We’re making an exception in your case, so we do have a small gift for you. I also said earlier when we started the conference, that Mr. Jefferson, as we referred to him, would be very proud of what we’re doing here as part of his academical village, his university. He also said in a relationship he had with another of our forefathers some 200 years ago, I don’t think the parallel between Warren Buffett and Charlie Munger would work, but he had very interesting relationship with John Adams. He once told John that, “I cannot live without books,” and I think that’s appropriate.
Ken: This gift has that quote replicated. We thank you so much for being with us.
Alice Schroeder: Thank you so much. Thank you. Thank you very much.