"From Cigar Butts to Business Supermodels" (BRK.B; BRK.A)

From The Rational Walk:

Note to Readers: The following essay is part of an introductory section of an upcoming analysis of Berkshire Hathaway to be published by The Rational Walk shortly after the 2009 Berkshire Hathaway Annual Report is released at the end of February. The full analysis will be available for purchase as premium content with certain excerpts to be provided on The Rational Walk blog free of charge.

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From Cigar Butts to Business Supermodels

There are numerous books and publications that provide detailed accounts of the history of Berkshire Hathaway as well as Warren Buffett’s life and career. It is also impossible to fully understand Berkshire without studying the life and career of Vice Chairman Charles T. Munger. A list of resources for those interested in a comprehensive history of the company and its leaders is provided as an appendix to this document (available in the forthcoming full analysis). This section merely attempts to provide some context regarding the remarkable history of Berkshire Hathaway and Warren Buffett’s investment approach.

Warren Buffett’s Early Investment Philosophy

Warren Buffett’s early investment philosophy was largely based on the principles developed by Benjamin Graham. Mr. Buffett has stated on many occasions[1] that his view of investing changed dramatically when he first read Mr. Graham’s book, The Intelligent Investor, in early 1950. Up to that point, Mr. Buffett had read every book on investing available at the Omaha public library but none were as compelling as Mr. Graham’s straight forward approach summarized in the phrase: “Margin of Safety”.

Benjamin Graham’s approach is more fully documented in Security Analysis which, in contrast to The Intelligent Investor, is more targeted toward professional investors. Mr. Graham’s approach involved examining securities from a quantitative perspective and making purchases only when downside risks are minimized. This approach rarely involved speaking to management since doing so could adversely influence the analyst’s impartial view of the data. In particular, Mr. Graham was a proponent of purchasing stocks selling well under “net-net current asset value” arrived at by taking a company’s current assets and subtracting all liabilities. In such cases, the buyer was paying nothing for the business as a going concern and had some downside protection due to liquid assets far in excess of all liabilities.

Mr. Buffett was able to leverage the “deep value” approach advocated by Benjamin Graham throughout the 1950s. In the five year period ending in 1961, the Buffett Partnerships trounced the Dow Jones Industrial average with a cumulative return of 251 percent compared to 74.3 percent for the Dow[2]. While Mr. Buffett employed multiple strategies, one approach involved finding companies that fit the “cigar butt” mold, meaning that they had “one puff left” and could be purchased at a deep bargain price. This approach led Mr. Buffett to begin acquiring shares of Berkshire Hathaway, a struggling New England textile manufacturer, in late 1962. While Berkshire Hathaway was trading well under book value at the time, Mr. Buffett would later say that book value “considerably overstated” intrinsic value[3].

From Cigar Butts to Insurance

Berkshire Hathaway, as it existed in 1963 when the Buffett Partnership became the company’s largest shareholder, was a cheap company from a quantitative perspective but it was not a good company in terms of offering a business that had durable competitive advantages. In fact, over the next two decades, Berkshire Hathaway continued to invest in the textile mills but would never gain sufficient traction to complete with overseas competitors with lower cost structures. Textiles are a commodity business and the low price producer has the advantage. In retrospect, Mr. Buffett’s purchase of Berkshire Hathaway was a mistake[4]....MORE