Becoming Berkshire: 1966- Hochschild, Kohn & Co.

Issue 8 | 1966 Part 1

Mar 20, 2024

The Good, the Bad and the Ugly (1966): Sergio Leone's Epic Tale of Greed and Betrayal - A ...

The year is 1966, and the U.S. now has 500,000 troops in Vietnam; as the war continues, American deaths increase, and the anti-war movement grows across the country. Batman and Star Trek make their television debuts. America experienced its first modern mass shooting in 1966 when sniper Charles Whitman shot and killed 16 people from atop a tower at the University of Texas. Clint Eastwood stars in his iconic Italian spaghetti western role, The Good, the Bad, and the Ugly. General Motors, Standard of New Jersey, Sears Roebuck, Dupont, U.S. Steel, Aetna, American Telephone & Telegraph, and Bank of America are the largest companies. And on December 15, Walt Disney passed away from cancer.

Death of Walt Disney... - RareNewspapers.com

On January 18, 1966, the Dow breached the 1,000 mark for the first time, peaking at 1,000.50, but it failed to hold and closed lower. The Dow would end the year at 762.95 and not finish above 1,000 until 1972.

Having just taken control of Berkshire Hathaway, Buffett had a hectic year. He became more familiar with the Company, took a 4% position in the Walt Disney Company, and partnered with Charlie Munger for the first time on a business venture. Please note that 1966 will be broken up into two issues as we have much to cover.

Buffett Limited Partnership

As we have done over the last few issues, we shall start the Buffett Limited Partnership Letter.

The Partnership celebrated its 10th anniversary by beating the Dow by 36 points. The Partnership returned 20.4%, while the Dow fell 15.6%. With $54 million in capital, the Partnership had come a long way from the initial deposit of $105,100 in 1956.

In keeping with tradition, Buffett discussed the merits of institutional investment "conservatism."

I believe that conservatism is more properly interpreted to mean "subject to substantially less temporary or permanent shrinkage in value than total experience." The Dow declined in 1957, 1960, 1962, and the first half of 1966. Cumulating the shrinkage in the Dow during the three full year periods produces a decline of 20.6%. Following a similar technique for the four largest funds produces declines of 9.7%, 20.9%, 22.3% and 24.6%. Such funds (and I believe their results are quite typical of institutional experience in common stocks) seem to meet the first definition of conservatism but not the second one.
Most investors would climb a rung intellectually if they clearly delineated between the above two interpretations of conservatism. The first might be better labeled "conventionalism" - what it really says is that “when others are making money in the general run of securities, so will we and to about the same degree; when they are losing money, we'll do it at about the same rate." This is not to be equated with "when others are making it, we'll make as much and when they are losing it, we will lose less.” Very few investment programs accomplish the latter - we certainly don't promise it but we do intend to keep trying. (I have always felt our objectives should be somewhat loftier than those Herman Hickman articulated during the desperate years when Yale was losing eight games a season. Said Herman, "I see my job as one of keeping the alumni sullen but not mutinous.”)1

Buffett’s take on institutional conventionalism gives credence to the saying, “No one ever got fired for buying IBM.”

Hochschild, Kohn & Co.

Hochschilds was a good match for Baltimores unpretentious and thrifty personality.

During the first half we, and two 10% partners, purchased all of the stock of Hochschild, Kohn & Co., a privately owned Baltimore department store.2

Alice Schroeder gives a wonderful account of how the investment came to be in her book The Snowball: Warren Buffett and the Business of Life:

In January 1966, Gottesman brought Buffett an idea: Hochschild-Kohn, a venerable department store headquartered in downtown Baltimore. Buffett and Munger flew into Baltimore, and they liked the Kohn family immediately. Lous Kohn, who had a financial background, was going to run the business for them … Buffett and Munger looked at the balance sheet and made a $12 million bid on the spot.
On January 30, 1966, Buffet, Munger, and David “Sandy” Gottesman formed a holding company, Diversified Retailing Company, Inc. (“DRC”), to “acquire diversified business, especially in the retail field.” The Partnership owned 80% of DRC. Gottesman and Munger each took 10%. Buffett and Munger then went to Maryland National Bank and asked for a loan to make the purchase.
Buffett had never borrowed any significant money to buy a company. But they figured the margin of safety reduced their risk, and interest rates were cheap at the time. 3

The Hochschild joint venture would mark Buffett and Munger's first investment; however, the investment was as successful as Berkshire Hathway.

Buffett revisited Hochschild, Kohn & Co. in his 1989 Berkshire Hathaway Shareholder Letter:

To quote Robert Benchley, “Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down.” Such are the shortcomings of experience. Nevertheless, it’s a good idea to review past mistakes before committing new ones. So let’s take a quick look at the last 25 years.
My first mistake, of course, was in buying control of Berkshire. Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit. Unless you are a liquidator, that kind of approach to buying businesses is foolish.
First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.
Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.
You might think this principle is obvious, but I had to learn it the hard way – in fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras – unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o – three years later I was lucky to sell the business for about what I had paid. After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, “My Wife Ran Away With My Best Friend and I Still Miss Him a Lot.”4

“We thought we were buying a second-class department store at a third-class price”- Buffett.

“Buying Hochschild-Kohn was like the story of a man who buys a yacht; the two happy days are the day he buys it and the day he sells it” - Munger.

Buffett had lowered his standards to justify the investment, given the environment of few investment opportunities. Buffett attributed this to “(1) a somewhat changed market environment, (2) our increased size, and (3) substantially more competition.”5

Charlie Munger

You are likely wondering where the hell Charles T. Munger has been all this time, and this may be the perfect time to fill you in. We turn next to Janet Lowe’s book Damn Right!

In 1961- the same year Buffett started buying shares in the beleaguered New England textile manufacturing company Berkshire Hathaway — Charlie Munger helped establish two new ventures in Los Angeles. The first was a law firm, and the second was a securities firm called Wheeler, Munger, and Company. By this time, Munger and Buffet often talked, discussed approaches, and spun investment ideas with one another.6

Buffett and Munger met in 1959 when Dr. Eddie Davis, Buffett’s neighbor and an early investor in Buffett Limited Partnership, said to Warren, “You remind me of Charles Munger.” The two quickly hit it off, and the rest, as they say, is history.

Unlike Buffett, who mainly worked with securities since age 11, Munger had an unusual path to Berkshire Hathaway. Munger enrolled at the University of Michigan to major in mathematics but left during his sophomore year to enlist in the Army after Pearl Harbor. He was stationed in Alaska as a meteorologist and missed much of the action. He then attended Harvard Law School without ever graduating from college. He had three children with his first wife, Nancy, and subsequently divorced. His 8-year-old son, Teddy, was shortly diagnosed with Leukemia. He later remarried to another woman named Nancy and had several more children after the death of his son.

Charlie would visit, hold Teddy in his arms, then walk the street of Pasadena, weeping. He found the combination of his failed marriage and his son’s terminal illness almost unbearable. His son died in 1955. Munger later stated, “I can’t imagine any experience in life worse than losing a child inch by inch.”
When things went wrong, Munger would set out toward new goals rather than let himself dwell on the negative. “I had a considerable passion for getting rich, Munger said, “Not because I wanted ferraris— I wanted the independence, I desperately wanted it.”7

Munger eventually formed an investment partnership in Los Angeles, modeled after Buffett’s.

It is comforting to know that Munger was reunited with his son Teddy after his passing.