Another Warren Buffet Book

Buffett: Rock Star of American Capitalism
Knowledge@Wharton, 15-Jul-09

Warren Buffett's rock star status is evident from the fact that each year tens of thousands of fans from all over the world travel to Omaha, Nebraska, to listen to him speak at his company Berkshire Hathaway's shareholder meeting. For many at this event, which Buffett calls the "Woodstock for Capitalists," it is an annual ritual of paying homage to the man who made them money through Berkshire's stock and from his investing and business insights. Little wonder that Alice Schroeder's insightful biography titled, The Snowball: Warren Buffett and the Business of Life, has proved popular among readers. She seeks to explain how Buffett became one of the world's richest men and why he is admired for his business ethics and for uniquely pledging most of his money to philanthropy.

Buffett's annual letters to shareholders (see Warren Buffett's Letters to Berkshire Shareholders on berkshirehathaway.com) are widely read. The letters analyze good and bad businesses, give examples of managers who treat customers and employees fairly while also making good profits, and expose accounting tricks that fool many investors. Some letters have noted that executives should be paid bonuses only if their company's long-term performance is better than that of industry peers; others have warned of looming disasters – such as the red flag he raised about derivatives morphing into "weapons of mass financial destruction." During the subprime mortgage crisis that led to the global financial collapse, one of Buffett's letters pointed out that rich people like him should be made to pay a higher tax rate than wage earners like his secretary.

Buffett's most important act has been to donate much of his wealth to the Gates Foundation, to be spent over 20 years mainly on health care and education. As he states: "The idea of passing wealth from generation to generation so that hundreds of your descendants can command the resources of other people simply because they came from the right womb flies in the face of a meritocratic society." Also, unlike most other philanthropists, Buffett has not set up a foundation nor paid for buildings at hospitals or museums to try to perpetuate his name.

Rational Money Machine

By the late 1970s, according to an earlier biography, Buffett had spent $15.4 million to buy 46% of Berkshire, including 3% for his wife Susan, paying an average $32.45 per share. (See Roger Lowenstein, Buffett: The Making of an American Capitalist.) With Berkshire stock recently around $87,200, Buffett has grown his wealth nearly 3,000-fold in some 30 years. This massive capital accumulation is based on an investment discipline he learned from Benjamin Graham. Buffett's approach to investment involves using seventh grade math and common sense to analyze a company's underlying economics; buying a business not a stock; ignoring the fluctuations of the stock market; and, most importantly, maintaining a margin of safety.

After initially attending business school at Wharton, Buffett got his MBA degree from Columbia University in 1951 so that he could study under Graham. Buffett modified Graham's process of holding a widely diversified portfolio of statistically cheap stocks, and made concentrated investments in a few easy to understand, stable, growing businesses run by good, shareholder-friendly managers. Berkshire's earnings and value have risen due to a mutually reinforcing combination of investing the policy premiums of its insurance and re-insurance operations in buying companies such as See's Candies, Borsheim's fine jewelry and electric utility MidAmerican Energy, and investing their free cash flow, low turnover and hence low taxes on investments like The Washington Post, Coca-Cola, American Express and Procter & Gamble. Of course, the mathematical magic of compounding gains over time have also helped Berkshire Hathaway multiply its wealth.

Buffett's three rules of portfolio management are: 1) Don't lose money; 2) Don't forget rule one and 3) Don't go into debt. His focus, an intellect which is a perpetual learning machine, rationality, confidence and an ambition from childhood to become rich are identified by Schroeder and others as personal traits that drove his success. Moreover, he attracts talented people to work, partner and deal with him due to his honesty, fairness, letting them do their job without interference and crediting them for success.

Buffett freely acknowledges making several errors. The biggest was his purchase of Dexter Shoes for $433 million in 1993, and then compounding the error by paying with 1.6% of Berkshire stock, effectively costing shareholders more than $2.2 billion at the current stock price. Also, following years of losses, Buffett liquidated Berkshire's original textile operations in 1985. While the textile business provided the capital for entry into the insurance business -- "the cornerstone of Berkshire," as Buffett puts it -- the employees who lost their jobs got minimal severance compensation.

Obviously Buffett's successes are far more numerous than his failures. In the stock market, notes Schroeder, his strategy has been strict adherence to Graham's main principle of margin of safety. In frothy bull markets, Buffett is fearful while others are greedy, taking profits on some holdings and piling up the cash generated by Berkshire's businesses. For instance, Berkshire sold its stake in PetroChina for $4 billion in 2007 amid rapidly rising oil prices and the craze for investing in emerging markets, having bought it in 2002 and 2003 for $488 million. Then, during severe stock market or industry declines, he is greedy when others are fearful, buying good businesses at attractive prices. His reputation and large cash holdings also get Berkshire favorable terms, which benefited him in deals with Goldman Sachs and General Electric during last year's stock market panic.

Lucky Man

While the likeable qualities of Buffett have been widely publicized, Schroeder reveals a far more complex person who caught some lucky breaks. In the 1940s, while a teenager, Buffett avoided getting caught while repeatedly stealing things like golf balls and clubs from a Sears store in the Washington, D.C., area. The family lived there while his father, Buffett's close friend and role model, served as an ultra conservative Republican Congressman from Nebraska. Buffett was a street smart teenager, not getting into any trouble while buying coin operated pinball machines and installing them in barber shops in poor neighborhoods, with whose owners he split the money from the machines.

Later, in the mid 1970s, he got lucky again over Securities and Exchange Commission charges about his purchases of Wesco Financial stock, after the failure of a buyout attempt. The failure was engineered by Buffett and partner Charles Munger since they wanted to buy Wesco, which they ended up doing. In 1976, one of their companies paid a $115,000 fine to settle with the SEC, without admitting or denying any wrongdoing. Buffett avoided being named and fined, a potentially "terrible, irreversible damage" on a budding reputation. Two weeks after the settlement, the SEC put Buffett on a panel to study corporate disclosure practices.

The SEC settlement led Buffett and Munger to dissolve their structure of interlocking partial ownerships in numerous businesses, eventually folding them all into Berkshire. While Schroeder writes that Buffett got the idea for the structure from another investor he admired, the question remains whether Buffett was also attempting to minimize paying taxes by copying what the late Jay Pritzker, one of his business idols whose family owns the Hyatt Hotels, was then doing through a maze of holdings.

Right Side of the Edge

Buffett criticizes the high fees charged by investment managers, especially of hedge and private equity funds. Last year, he took a bet with a fund of hedge funds predicting its high fees would result in long-term performance worse than that of the S&P 500 Index. (See: "Buffett's Big Bet," Fortune, June 9, 2008.) Yet, Buffett himself accumulated much of his initial capital from the fees he charged a hedge fund-type partnership, pocketing half the gains over 4%. Buffett's partnership began in 1957 with $105,000 from family and friends and only $100 of his own money. When he closed it in 1969, Buffett's share was $26.5 million of the partnership's $100 million in assets, entirely due to the retention and compounding of his fees on a growing asset base. However unlike the high fee-charging fund managers of today, Buffett also agreed to bear a quarter of the losses, which he did not have to do since his partnership had a 31% compound annual gain over its 12-year life.

In the 1980s, Buffett publicly opposed the greenmail tactics of corporate raiders who threatened to dislodge management but went away if the company bought their stock, enabling them to make a profit. Some of Buffett's investments for his partnership were also made based on the expectation that managements would buy back his stock at a higher price. In fact, in 1965 he would have sold his stock in Berkshire Hathaway, then a Massachusetts-based high cost manufacturer in the declining textiles business, had he not been angry at being offered 12 cents less, $11 3/8 per share instead of the $11 ½ promised by the management. The greenmail operators often pushed company managements to take on huge debt to finance the buy back of only their stake. In contrast, Buffett's activism was aimed at companies which could enhance shareholder returns by using the cash or other assets not reflected in the deeply undervalued share price.

By 1989, Berkshire owned 6% of Coca-Cola stock, then worth about $1.2 billion. Coke was Berkshire's largest holding and Buffett joined Coke's board. In the mid 1990s, after Coke's stock had risen by several multiples, Coca-Cola chief executive Roberto Goizueta was promising mid- to high-teens earnings growth to Wall Street analysts. But as Schroeder writes, by then Goizueta was using financial engineering to "maintain the illusion of the company's rapidly rising earnings flow." Schroeder writes that Buffett knew Coke was buying and selling bottlers in order to time the profits and boost earnings.

This was "neither illegal nor technically deceitful," observes Schroeder, and Buffett remained silent about it on the board. Buffett says Goizueta "was just not a guy you questioned," adding that "as a board member, you can do practically nothing." His son, Howard Buffett, who was on the board at Berkshire as well as Coca-Cola Enterprises, the major Coke bottler, said, "he had no problem challenging Coca-Cola on behalf of CCE." But Howard eventually got off the CCE board, says Schroeder, since "there was just too much potential for conflict between the CCE and Berkshire board." What kind of conflicts? Did Buffett also face any conflicts since he was running Berkshire and was on Coke's board?

Since 1993, Buffett has argued for the expensing of stock options, which many chief executives liberally give as incentives and bonuses to themselves, other managers and employees. Only in 2002, going against the views of most CEOs, Buffett found the time was right to push Coke's board to make it the first major company to expense stock options. Coke's action, which was allowed but not required by accounting rules, was soon followed by the boards of The Washington Post, Microsoft and others. Buffett draws a token $100,000 annual salary from Berkshire and awards himself or other managers no stock options, grants or warrants.

Personal and Family Life

Schroeder confirms that Buffett owns no fancy houses, cars or yachts. He wears cheap clothes, craves hamburgers, French fries and cherry Coke and appears awkward in social situations. Buffet also spends hours playing bridge online, enjoys golf, handball and table tennis and plays the ukulele. Schroeder describes Buffett as a showman who avoids confrontation and hides his true opinions behind coy remarks, if being blunt may hurt his business or other relationships.

In his family life, writes Schroeder, since Buffett was consumed with his work -- "a sort of holy mission" to find more ways to make more money -- he had little extra time for his wife and three kids. "While he was friendly with his kids, he hadn't really gotten to know them" while they were growing up at home in Omaha. On occasion Buffett's secretary blocked even his family's access to him, not on explicit but on implicit orders, a typical Buffett method of operating, notes Schroeder.

In the 1970s, while his youngest child was in high school, Buffett found time to go to black tie parties at embassies in Washington, D.C., and mansions on Fifth Avenue in New York where they mostly served French food. He went to these events accompanying Kay Graham, then publisher of The Washington Post. Schroeder uses Buffett's term, "elephant bumping," to describe these events.

In 1978, after all the children had grown and left home, his wife Susan moved to live permanently in San Francisco. In addition to being a nurturing mother and generous with time and money to friends and strangers in need, Susan boosted Buffett's confidence, enhanced his people skills and expanded his social conscience, Schroeder notes. Susan wanted him to stop being consumed with making more money once he had made his initial millions. His actions that led Susan to leave their home in Omaha are the major regret of Buffett's life, Schroeder writes. Later in 2003, while helping care for Susan, who was being treated for cancer, Buffett, 73, told a group of students at Georgia Tech: "If you get to my age in life and nobody thinks well of you, I don't care how big your bank account is, your life is a disaster." In 2006, Buffett married longtime companion Astrid Menks.

Unlike most other capitalists, Buffett believes that children should not inherit money just because of the lottery of their birth. He says children should be left "enough money so that they feel they could do anything, but not so much that they could do nothing." Implementing his views, in June 2006 Buffett announced the donation of 85% of Berkshire stock, then worth about $40 billion. Five sixths of the shares were to go to the Bill and Melinda Gates Foundation and the rest to foundations run by his three children – including one named "Sherwood," after the forest in the Robin Hood story -- and one named after his late wife Susan. Buffett also plans to give his remaining Berkshire shares to philanthropy.

As with his business projects, in philanthropy Buffett has found willing partners in Bill and Melinda Gates to try and fulfill shared goals of eradicating major diseases like malaria and HIV/AIDS in developing countries, and improving high school education standards in the U.S. Buffett and Bill Gates, friends since 1991, were one and two on the Forbes list of the world's richest people in 2008. Buffett's views on inheritance and on capitalists giving their money back to society, to which he believes they owe their wealth in the first place, influenced Bill and Melinda Gates to set up their foundation. "Buffett's ideal was a world in which winners were free to strive, but narrowed the gap by helping the losers," writes Schroeder. The Gates foundation had around $30 billion before Buffett began adding his billions.

Melting Snowball

According to Schroeder, Buffett has often spoken with other wealthy people about the poor history of most foundations, where managers stray from the vision of deceased donors or, even worse, use the money for their own goals and salaries. So, while Buffett expresses confidence in the Gates Foundation and others he is donating to, his plan forces them to spend his money as they receive it each year over 20 years. It is one of the few philanthropic donations where the money will run out relatively quickly, contrary to the self-interest of foundation bureaucracies to survive as long as they can.

Other self-made American billionaires who are known to have pledged much of their wealth in their lifetimes include George Soros and Charles Feeney. Funding by the Soros Foundation, set up by the highly successful hedge fund manager, is said to have helped undermine the apartheid regime in South Africa and communist rulers in the former Soviet Union and Eastern Europe. (See Soros on Soros.) Feeney, a founder of the duty free shopping business, is said to have played a major role in bringing about peace in Northern Ireland. Since 1982, unknown to even his close friends, Feeney had given away more than $4 billion anonymously, including $600 million to his alma mater, Cornell University, and $1 billion to schools in Ireland. Feeney owns no homes, flies coach and rides subways and cabs. Feeney's foundation, which does not identify him in any way, plans to give away its remaining billions by 2017. (See The Billionaire Who Wasn't, an authorized biography by Conor O'Clery.)

Schroeder was the only Wall Street analyst covering Berkshire whom Buffett spoke to before she began writing this book. She was the first biographer to have full access to him, his family and his extensive archives. She was also aware that "Buffett always avoided or limited his time with anyone he feared might criticize him." Given these facts, Schroeder's work comes across as fair and honest, though it would be a better read if at least 100 of its 976 pages were cut.

As Buffett has often noted, the American economy in the second half of the twentieth century provided the ideal environment – lots of wet snow and a long hill to roll and grow his snowball -- for someone of his skills, temperament and personality to become immensely wealthy. As Buffett's huge snowball quickly melts, it should turn into a gushing stream that fulfills his philanthropic goals.