Supermoney, page 20
For the first six years, the office was an upstairs bedroom in the rambling house Warren had bought for $30,000, located in a relatively unfashionable section of Omaha. “This was the fashionable part of Omaha maybe forty years ago,” Warren said, when we drove out to the house. “Now everything’s moved on much further west. I think most of my neighbors make ten to fifteen thousand a year. You can be anywhere in five minutes from here.” The house is on a pleasant, Midwestern, tree-shaded street; it looks like the same section of Kansas City or Indianapolis or Des Moines; you would need only a jalopy and some high school youngsters and that street and those trees and those houses to have a 1947 Saturday Evening Post cover. Warren’s house is a rambling affair, more rambling because the Buffetts added on another room when they wanted to, and an indoor paddle-ball and handball court. The house is full of books, and the walls of posters (War is unhealthy for children and other living things); it is the obvious gathering place for neighborhood children. The Buffetts have two children in Central High School (one of them is named after Benjamin Graham), where Warren’s father and grandfather went, and one at the University of Nebraska. Suzy works energetically for Planned Parenthood and for the Panel of Americans. Among all the books is a shelf on Bertrand Russell. Warren can quote Bertrand Russell almost as well as he can quote Ben Graham.
Obviously, as the Buffett partnership grew, so did Warren’s contacts on Wall Street, and some of those contacts must have asked him why Omaha, for his answers show the question has occurred to everybody.
“I can be anywhere in three hours,” Warren says, “New York or Los Angeles. Maybe a little longer, since they took the nonstop off. I get all the excitement I want on those visits. I probably have more friends in New York and California than here, but this is a good place to bring up children and a good place to live. You can think here. You can think better about the market; you don’t hear so many stories, and you can just sit and look at the stock on the desk in front of you. You can think about a lot of things.”
“What did Ben tell you?” Warren asked before dinner one night, as I stirred my Scotch and he stirred his Pepsi-Cola.
“He told me medius tutissimus ibis,” I said, “which he explained is what Phoebus Apollo told Phaeton about chariot-driving, and the bum didn’t listen. You go safest in the middle course.”
“That’s Ben all right,” Warren said. “Gee, Ben really knows languages. Ben really liked learning things. The one thing he didn’t care much about was money. I don’t think Ben ever knew how much money he had.”
To win, the first thing you have to do is not lose. That is my own distillation of one of Graham’s first principles. It sounds absolutely simplistic. Of course you shouldn’t lose if you want to win. There is more to it than that. This is a rational statement in a rational world, even though Keynes once said there was nothing more disastrous than a rational investment policy in an irrational world. And it excludes all the people who really do want to lose, because their parents once told them they were losers, or for whatever psychological fulfillment they might get.
Graham does not do much to feed the fantasies of those who would, say, turn five thousand into a quarter of a million. He starts with the supposition that your money is at risk; the first thing you must do is not lose your money, even before you think about making more with it. The joys of compounding are there if you keep your stake growing, but all you need have is one year in which you give back half, and your program, at the same growth rate, must stretch out years and years longer. And he is not sanguine about your ability to judge the market, or even to judge individual stocks.
Everyone knows that most people who trade in the market lose money at it in the end. The people who persist in trying it are either unintelligent, or willing to lose money for the fun of the game, or gifted with some uncommon and incommunicable talent. In any case, they are not investors.
A great deal of brain power goes into this field, and undoubtedly some people can make money by being good stock market analysts. But it is absurd to think that the general public can ever make money out of market forecasts. For who will buy when the general public, at a given signal, rushes to sell out at a profit?
Too many clever and experienced people are engaged simultaneously in trying to outwit one another in the market. The result, we believe, is that all their skill and efforts tend to be self-neutralizing, or to “cancel out,” so that each experienced and highly informed conclusion ends up by being no more dependable than the toss of a coin.
Graham had little faith that even stock market analysts themselves could, as a group, prove consistent winners: We once likened the activities of the host of stock market analysts to a tournament of bridge experts. Everyone is very brilliant indeed, but scarcely anyone is so superior to the rest as to be certain of winning a prize. An added quirk in Wall Street is that the prominent market analysts freely communicate and exchange their views almost from day to day. The result is somewhat as if all the participants in a bridge tournament, while each hand was being played out, gathered around and argued about the proper strategy.
Modern stock market movements, in fine, are the result of a concentration of tremendous skill in a limited area, where profits can be made by smart people only at the expense of of other people who are almost equally smart.
The metaphor is very much like Keynes’ market metaphor of musical chairs. You can see why I was the wrong choice to work on the next edition of Graham. In Graham’s view, the stock market is what the game-theory economists would call a zero-sum two-person game: that is, one person wins what the other one loses, as in a gin rummy game, or one team wins over another team, as in a bridge game. But my own apprenticeship was geared to the recognition of small, rapidly growing companies. The company was worth $20 million when it was small and $600 million after it grew up. Someone else did not have to lose in order for you to win. Of course, over a long period of time, and with enough participants, there is a zero-sum game simply because there is a buyer for every seller. (This concept, it should be added, is relative to the market. If the whole market moves up, then the losers have lost only relative to the winners; they still may have more than they started with. Conversely, if the market moves down, even the winners may have less than they started with.) Mathematicians everywhere are undoubtedly working on the final and complete equation for the whole thing.
Well, all right, not to lose is a very good ambition. It will be hard for optimistic young tigers to bother with, or even people looking for increments to their life from the market other than the ones they might rationally expect. How not to lose?
“There is one important proviso,” Graham wrote. “The shares must be purchased at reasonable market levels. That is, levels that are reasonable in the light of fairly well-defined standards derived from past experience.”
Nothing wrong with that. Some of Graham’s critics say that properly applied, this would have kept him out of most of the market from 1949 to 1969, because the market levels never looked reasonable in terms of the way they had looked from 1929 to 1949. IBM, for example, was never right to Graham; a dollar of 1949 earnings on IBM was valued “3.4 times as liberally as a dollar earned by Atchison, and 4 times as a dollar earned by Atlantic Refining . . . the price itself of IBM precludes the margin of safety which we consider essential to a true investment.” IBM, said Graham, was a speculation; it might turn out all right, but that was speculation.
To Graham, a stock had Intrinsic Value. In the Dark Ages of the Thirties, it was not so hard to find Intrinsic Value. Some companies were selling for less than the cash they had in the bank, and many for less than their true book value, or for their cash and net assets. You could buy a stock for $10, and that share of stock would have behind it $10 in cash. Ideally, you would buy a stock for no more than two-thirds of its Intrinsic Value. That way you would have a Margin of Safety—a stock selling at two-thirds of its Intrinsic Value would have to be counted as depressed. It might not rise immediately from that discount from Intrinsic Value, but sooner or later it would have to.
One might wonder why, if the market undervalues the issue at the time he purchases, it should not continue indefinitely to do so and perhaps even increase the measure of undervaluation. There is no theoretical reason why these unpalatable results could not occur. The comfort and encouragement to the intelligent investor are to be found in practical experience. In the long run, securities tend to sell close to a price level not disproportionate to their indicated value. This statement is indefinite as to time; in some cases the day of vindication has actually been deferred for many years.
You can see why Benj. Graham never sold like Anyone Can Make a Million or How I Made $2 Million and so on. Telling a game player that he might make some money in two years is like betting him on how tall the corn will grow and then letting him sit on a camp chair in the corn field watching it. And in the long run, Keynes said, we are all dead.
Benj. Graham would never buy a growth stock, or what has been recognized as a growth stock, because growth stocks seemed to be betting on a future market judgment and the continuation of those growing earnings. The growth stock would not turn out to be one after all, and one has only to look at the “growth stocks” of the fifties—chemicals and aluminums—to realize that growth in many, probably most, companies is not a permanent stage, but a dramatic burst in early adolescence.
But, of course, in other instances growth was quite real. Not only would Benj. Graham have steered clear of IBM in 1949, he would have avoided it at any time, and IBM has been the source of many fortunes. The same could be said of Xerox, Polaroid, and innumerable other growth companies. They simply do not look like the value is there; it is certainly not there in assets, related to market value; it may be there in patent protection or reputation, but how do you measure that? Money has been lost in growth companies which stopped growing, and at market peaks, it has been possible to pay too much for even the true growth companies. The growth companies rarely have the cash in the bank, and the more true the growth, the more they have deprived both their own current profits and current balance sheets to the benefit of some future payoff. And as the companies get more technical, the assessments become more difficult. Sperry Rand preceded IBM into computers, and American Photocopy preceded Xerox into copying, and it was possible to lose handsomely in either case. All you can say is that there are multiple theologies.
Another of Graham’s tests was the Value to the Private Owner. Would a private purchaser pay the same price as the market? In depressions, or market bottoms, a private purchaser could find great bargains that way. The rest of the time he would not pay cash and debt; there would be too much of a premium assigned by the market to future earnings or good will or a future buyer even more eager. The private owner would have to have Supercurrency of his own or not pay.
In any case, the investor was to ignore the market, the current price quotation:He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage . . . price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
Dividend returns! Dirty words to an aggressive investor in the fifties, and certainly to a swinger in the sixties. Happiness when stocks decline!
And ignore the market! Not watch the tape? Not trade stories? Not press the buttons on the quote machine?
Benj. Graham was studied with respect by generations of analysts, but not with affection. What was one to do all day, if the market was to be ignored? That would not get you rich. How could anybody ignore IBM? How smart could somebody be if he had missed IBM—not because he didn’t know about it, but because he had considered it, measured it and turned it down?
Graham was well aware that he was himself selling at a discount from Intrinsic Value. Through a number of editions of Security Analysis, the final sentence to the “Summary of the Valuation of Common Stocks” warned that “our judgment on these matters is not necessarily shared by the majority of experienced investors or practicing security analysts.”
But the judgment was shared by one bright student. Warren sat in his bedroom office, reading through the manuals—the statistical manuals of Moody’s and Standard & Poor’s. There are all the statistics, the balance sheets, the debt, and the contingent reserves, and slumbering on the forest floor, if you could but recognize them, were the truffles.
“I always knew I was going to be rich,” Warren said. “I don’t think I ever doubted it for a minute. There was Western Insurance earning sixteen dollars a share, and selling at sixteen dollars a share. There was National Insurance selling at one times earnings. How could it miss?”
Warren wrote to his partners every year, and what he wrote was in line with the teachings of Benj. Graham. “I cannot promise results to partners,” he wrote, every year.
What I can and do promise is that:a. Our investments will be chosen on the basis of value, not popularity;
b. Our patterns of operation will attempt to reduce the risk of permanent capital loss (not short-term quotational loss) to a minimum; and,
c. My wife, children and I will have virtually our entire net worth in one partnership.
The foundations of the operation were almost straight from Graham: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.”
There is this about Graham: If you have bought at less than True Value, if you have a comfortable Margin of Safety, you are going to sleep better. Then, as the stock starts to work its way up from the discount from its Intrinsic Value to that Value, you will have a gain, and when gains compound, you do very nicely. Warren’s letters to his partners usually carried a small table to show how compound interest, the growth of money from the increment, can grow. Here is a compound interest rate table showing the gains from $100,000, compounded at various rates.
Now, you can do better than 4 percent at a savings bank. And a 16 percent gain—two points on a ten-point stock and pay the taxes—does not seem unusual as a goal. But look what happens toward the right-hand corner! It is hard to believe that the professional managers running hundreds of millions in the late sixties ever looked at such a table, or they would not have been able to declare confidently that they expected to do 20 percent a year. Eighty times the original stake is better than any professional I know has done with other people’s money in the last thirty years. The point is that a 16 percent compound can be a pretty exciting figure.
Over a long enough period of time, the effect of compounding can be a bit ridiculous and you can play any historical game you want. The Manhattan Indians sold their island to Peter Minuit in 1626 for $24. Who got the better deal? Well, at $20 a square foot, Peter Minuit’s island is now worth $12.4 billion. Could the Indians have gotten 7 percent, they now would have more than $225 billion, and they would be twenty times better off. Or take Francis I—the French Francis I—who is reported to have paid four thousand écus for a painting called “Mona Lisa.” Local scholars translate that écu rate out at about $20,000. Had Francis been able to find, in 1540, a 6 percent after-tax investment, his estate would be more than $1,000,000,000,000, a quadrillion, three thousand times the U.S. national debt. (Try that on your art dealer the next time he says art is a hedge against inflation.)
You do have to have a very long life in order to enjoy the greatest benefits of the compound table. Warren wrote them up for his partners to illustrate “the enormous benefits produced by relatively small gains in the annual earnings rate . . . every percentage point of investment return above average has real meaning.”
Warren had a relative, not a finite, goal from the beginning of the partnership: it was to beat the Dow Jones averages by ten percentage points a year. If the market was up 20 percent, the partnership should be up 30 percent; if the market was down 30 percent, the partnership should be down only 20 percent. Because of the investment approach, it would be easier to beat the Dow in a down market than in an up market, which was the reverse of the very aggressive so-called swinging managers. The record demonstrates that: in the five years that the Dow was down, the partners were up, and the Dow was comfortably beaten by ten percentage points except for two years in which that average was up rather sharply.
All through the sixties, Warren stayed away from the stocks that dominated the financial headlines and provided the excitement in the board rooms. The partners bought an old textile company called Berkshire Hathaway because its net working capital was $19 a share and their cost was about $14; they ended up owning most of the company, and Warren put new management in.
“While Berkshire is hardly going to be as profitable as Xerox, Fairchild Camera, or National Video in a hypertensed market, it is a very comfortable sort of thing to own . . . we will not go into the businesses where technology which is way over my head is crucial to the decision.”
In some of the partnership’s investments, the partnership did end up controlling the company. A second category was “work-outs”—that is, situations in which a merger or reorganization has already been announced. Usually the market has recognized the first ninety-five cents on the dollar in such a case, but even the last 5 percent, two or three times a year, on an annualized basis, builds up to a respectable compound.
