Regular readers of my work will know that I like to look back at Warren Buffett (Trades, Portfolio)'s early investments and see how the famous investor's strategy was formed and built in the first part of his career.
I think these investments are much more interesting than his later deals because they are traditional deep-value investments. He worked hard to find companies that were trading at a significant discount to the value of their net assets.
Due to the size of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), that's something he's been unable to do for many decades now.
One of Buffett's earliest investments that we know a lot about was the Western Insurance Securities Co. The young investor wrote about the company in the Commercial and Financial Chronicle in a column titled, "The Security I Like Best."
Cheap, with limited downside
As Buffett went on to explain in the piece, he liked the stock because it was cheap.
Specifically, he noted that the "price range in Moody's financial manual was $12 to $20" at the time.
Meanwhile, the company was reporting earnings per share of $16. As well as this low multiple of earnings, the shares were only trading at "a discount of approximately 55% from the Dec. 31, 1952, book value of $86.26 per share."
As Buffett later explained in a lecture to students of the Notre Dame University in 1991, this valuation did not guarantee a positive result from the investment, but it dramatically increased the chances of such an outcome:
"I saw Western Insurance Services, in Fort Scott, Kansas, looking in Moody's Bank and Finance Manuals. I'd never heard of Western Insurance Services until I turned that page that said Western Insurance Services. It showed earnings per share of $20 and the high was $16. Now that may not turn out to be something you can make a lot of money on, but the odds are good. It's like a basketball coach seeing a guy 7'3" walk through the door. He may not be able to stay in school, and may be very uncoordinated, but he's very large."
As the Oracle of Omaha went on to explain, he didn't buy the stock just because it looked cheap. He spent a great deal of time and effort in researching the business to try and understand if it was worth acquiring and more about the insurance industry.
Buffett put in the extra effort because he wanted the reduce the risk of making a mistake with the business. He wanted to know everything about the company before investing even though it looked cheap:
"I went down to the Nebraska Insurance Department, and I got the convention reports on their insurance companies, and I read Best's. I didn't have any background in insurance. But I knew I could understand it if I worked at it for a while. And all I was really trying to do was disprove this thing. I was really trying to figure out something that was wrong with this. Only there wasn't anything wrong. It was a perfectly good insurance company, a better than average underwriter, and you could buy it at one times earnings."
After establishing his outlook, Buffett said he ran ads in the local newspaper to try and buy the stock from other investors.
There are two things we can learn from this case study, even though it relates to a scenario that happened many decades ago.
First, buying stocks at cheap prices dramatically increases your chances of a positive outcome over the long run, though it doesn't guarantee it. And second, investors need to research every opportunity they come across rigorously. By establishing if there's anything that could go wrong with the company and why the company is trading at such a low multiple, we can significantly reduce risk.
These two core principles have helped Buffett establish a reputation as one of the greatest investors of all time.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Charlie Munger's Thoughts on How to Value Wesco Financial From 2009
- The Difference Between Warren Buffett and Berkshire Hathaway​
- Warren Buffett: Ignore Asset Allocation, Focus on Value Stocks and Education​
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