Becoming Berkshire: 1964 - Buffett's Folly
Issue 6| 1964
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Welcome to Issue 6 of Becoming Berkshire, where we give a year-by-year account of Berkshire Hathaway from 1962 to the present.
The year is 1964; Lydon B. Johnson defeated Barry Goldwater in a landslide victory to secure the Presidential Election. The 24th Amendment to the Constitution was ratified, prohibiting poll taxes in federal elections. U.S. military forces launched attacks on North Vietnam in response to an alleged attack on a U.S. destroyer off the Vietnamese coast. Anchorage, Alaska, had a 9.2 megathrust earthquake, which remains the most powerful earthquake recorded in the United States. Cassius Clay (Muhammad Ali) defeats Sonny Liston to win the heavyweight boxing title. Disney released Mary Poppins, nominated for 12 Academy Awards and the year's highest-grossing film. Jeffrey Preston Bezos was born in New Mexico, and the Dow Jones returned 18.7%.
All this happened while Warren Buffett toiled away on his partnership and continued to build a stake in Berkshire Hathaway and American Express.
Our General category now includes three companies where Buffett Partnership Limited is the largest single stockholder. These stocks have been bought and are continuing to be bought at prices considerably below their value to a private owner. We have been buying one of these situations for approximately eighteen months and both of the others for about a year. It would not surprise me if we continue to do nothing but patiently buy these securities week after week for at least another year and perhaps even two years or more. What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it. This doesn't do much for our short-term performance, particularly relative to a rising market, but it is a comfortable and logical producer of longer-term profits.
In 1964, Buffett had yet to seize control of Berkshire Hathway. Therefore, I will pay closer attention to the Buffett Partnership Limited (“BPL”) shareholder letter. The letter touched on various topics, such as Institutional Management Performance, Compounding, Investment Strategy, and Taxes.
Investment Management Performance
Buffett’s stated goal of the partnership was to best the dow by 10% per annum on average. He questioned how so many of the great money managers failed to beat the Dow.
"Why in the world does this happen to very intelligent managements working with (1) bright, energetic staff people, (2) virtually unlimited resources, (3) the most extensive business contacts, and (4) literally centuries of aggregate investment experience?"1
He reasoned that groupthink and risk aversion were the culprits.
In the great majority of cases the lack of performance exceeding or even matching an unmanaged index in no way reflects lack of either intellectual capacity or integrity. I think it is much more the product of: (1) group decisions - my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is "safe" and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.2
Buffett prided himself on disregarding what those on Wall Street believed and set his own policies and framework for managing money. He did not derive any comfort from important people, vocal people, or great numbers of people who agreed with him. Nor did he derive comfort if they didn't. “A public opinion poll is no substitute for thought.”3
Wall Street’s conventionality was indistinguishable from conservatism; the Street believed that playing it safe was adhering to “certain diversification practices.” Buffett believed this represented erroneous thinking. “Neither a conventional nor an unconventional approach, per se, is conservative.4
“Truly conservative actions arise from intelligent hypotheses, correct facts, and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corners of the world, they are probably still holding regular meetings of the Flat Earth Society.”5
Compounding
Warren Buffett was fascinated with the joys of compounding, and he would create tables indicating the gains from compounding $100,000 at various rates.
Investment Strategy
Buffett generally utilized four categories of investment operations.
“Generals -Private Owner Basis” is a category of generally undervalued stocks determined by quantitative standards, but considerable attention is also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price, that is, an overall valuation of the enterprise substantially below what careful analysis indicates its value to a private owner. Again, let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management, a decent industry, and a certain amount of “ferment” in a previously dormant management or stockholder group. But, we demand value.6
"Generals -Relatively Undervalued" - this category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards but (usually because of large size) do not feel value to a private owner to be a meaningful concept. Of course, it is important in this category that apples be compared to apples - and not to oranges, and we work hard at achieving that end. In the great majority of cases, we simply do not know enough about the industry or company to come to sensible judgments -in that situation, we pass.7
"Workouts" - these are the securities with a timetable. They arise from corporate activity - sell-outs, mergers, reorganizations, spin-offs, etc. In this category, we are not talking about rumors or "inside information" pertaining to such developments but publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc. The gross profits in many workouts appear quite small. It's a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces decent average annual return rates after allowance for the occasional substantial loss. This category produces more steady absolute profits from year to year than generals do. In years of market decline, it should usually pile up a big edge for us; during bull markets, it will probably be a drag on performance. On a long-term basis, I expect the workouts to achieve the same margin over the Dow attained by generals.8
"Controls" - these are rarities, but when they occur, they are likely to be of significant size. Unless we start with purchasing a sizable block of stock, controls develop from the general-private owner category. They result from situations where cheap security does nothing price-wise for such an extended period that we can buy a significant percentage of the company's stock. At that point, we are probably in a position to assume a degree of or perhaps complete control of the company's activities, whether we become active or remain relatively passive at.9
Taxes
Buffett believed that paying the least amount of taxes should be a factor to consider in achieving the end. However, those “means and end should not be confused; the end is to come away with the largest after-tax rate of the compound. The policy of BPL is to try to maximize investment gains, not minimize taxes.”10
One of my friends - a noted West Coast philosopher (Charlie Munger), maintains that most of life's errors are caused by forgetting what one is trying to do. This is certainly the case when an emotionally supercharged element like taxes enters the picture.
Buffetts’ Folly
The following excerpt is from Buffett’s special letter titled Berkshire – Past, Present and Future.
On May 6, 1964, Berkshire Hathaway, then run by a man named Seabury Stanton, sent a letter to its shareholders offering to buy 225,000 shares of its stock for $11.375 per share.
I had expected the letter; I was surprised by the price. Berkshire then had 1,583,680 shares outstanding. About 7% of these were owned by Buffett Partnership Ltd. (“BPL”), an investing entity that I managed and in which I had virtually all of my net worth. Shortly before the tender offer was mailed, Stanton had asked me at what price BPL would sell its holdings. I answered $11.50, and he said, “Fine, we have a deal.” Then came Berkshire’s letter, offering an eighth of a point less. I bristled at Stanton’s behavior and didn’t tender.
That was a monumentally stupid decision.
Berkshire was then a northern textile manufacturer mired in a terrible business. The industry in which it operated was heading south, both metaphorically and physically. And Berkshire, for a variety of reasons, was unable to change course.
That was true even though the industry’s problems had long been widely understood. Berkshire’s own Board minutes of July 29, 1954, laid out the grim facts: “The textile industry in New England started going out of business forty years ago. During the war years this trend was stopped. The trend must continue until supply and demand have been balanced.”
About a year after that board meeting, Berkshire Fine Spinning Associates and Hathaway Manufacturing – both with roots in the 19th Century – joined forces, taking the name we bear today. With its fourteen plants and 10,000 employees, the merged company became the giant of New England textiles. What the two managements viewed as a merger agreement, however, soon morphed into a suicide pact. During the seven years following the consolidation, Berkshire operated at an overall loss, and its net worth shrunk by 37%.
Meanwhile, the company closed nine plants, sometimes using the liquidation proceeds to repurchase shares. And that pattern caught my attention.
I purchased BPL’s first shares of Berkshire in December 1962, anticipating more closings and more repurchases. The stock was then selling for $7.50, a wide discount from per-share working capital of $10.25 and book value of $20.20. Buying the stock at that price was like picking up a discarded cigar butt that had one puff remaining in it. Though the stub might be ugly and soggy, the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.
Berkshire thereafter stuck to the script: It soon closed another two plants, and in that May 1964 move, set out to repurchase shares with the shutdown proceeds. The price that Stanton offered was 50% above the cost of our original purchases. There it was – my free puff, just waiting for me, after which I could look elsewhere for other discarded butts.
Instead, irritated by Stanton’s chiseling, I ignored his offer and began to aggressively buy more Berkshire shares.
It is funny that the conglomerate we see today comes from Buffett being one petty son of a gun over 12.5 cents a share.
Berkshire Hathway 1964 Annual Report
The 1964 Annual Letter was the last written by Seabury Staton, then President of Berkshire Hathaway. Seabury would later resign in May of 1965 when Buffett and his Partnership sized control of the Company.
Berkshire ended the fiscal year with $49,982,830 in sales and a profit of $175,586. The Company had $27,887,046 in total assets and $5,748,293 in total liabilities, with a net working capital of $12.75 per share. All divisions of the Company were operating on a profitable basis at the end of the final quarter. The Company repurchased 469,602 shares, leaving a total of 1,137,778 outstanding.
King Philip Plants A and E in Fall River continued to operate at a loss after the end of the 1963 fiscal year, and as a result, the directors voted to discontinue these operations.11 The buildings and most machinery were sold, an approach Buffett would continue. The Company continued to maintain four operating divisions - the King Philip D Divisions in Warren, Rhode Island, the Hathaway Synthetic, the Box Loom, and the Home Fabrics Divisions in New Bedford, Massachusetts.
Prior Becoming Berkshire Issues
Issue 5| 1963/64 - The American Express Salad Oil Swindle
Issue 4| 1963 - I Want to Hold Your Hand
Buffett Partnership, LTD. Shareholder Letter 1964.
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Berkshire Hathaway 1964 Annual Report.
Buffett is the best example of how powerful compound interest is. He's been in the market for 80+ years, longer than anyone else on planet Earth. I understand he's not been invested in index funds. Even then, he would've made a fortune incomprehensible to the human mind.