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Rupert Hargreaves
Rupert Hargreaves
Articles (742)  | Author's Website |

Warren Buffett's Salomon Experience

The 'Oracle of Omaha' helped repair the company's reputation

July 12, 2018

During the market crisis of 1987, Warren Buffett (Trades, Portfolio) made an unprecedented (at the time) move. He decided to open his wallet and invest $700 million in bond trading powerhouse Salomon Brothers. Buffett's investment nearly turned out to be a huge mistake.

A few months after the deal closed, Salomon disclosed a surprise $70 million write-down from bad bets made by trading junk bonds. Then came the market crash of 1987 and, in 1991, the company was dealt another blow.

Salomon was caught up in a bond trading scandal, where it was accused of trying to manipulate the U.S. Treasury market. The company was brought to its knees by the initial findings of the investigation and subsequent fines. It was nearly forced out of business and Buffett nearly lost everything.

Rather than watch his investment vanish, however, the "Oracle of Omaha" decided to get involved and became interim chairman of the board in 1991, steering the business through the storm.

Buffett tried to restore the company's reputation by changing the mentality of the staff, reigning in risk-taking and making employees more responsible for their actions. I thought it would be interesting to highlight some sections of the letter Buffett wrote to shareholders of Salomon at the end of 1991, which explained how he wanted to go about this.

On compliance:

"Since August 18, we have installed rules and procedures at Salomon Brothers Inc., our securities subsidiary, that we think set a standard for the industry. In addition, we have begun to monitor what goes on in Salomon Brothers in new ways-for example, by setting up a Compliance Committee of the Board-and expect in that area also to be a leader. Even so, an atmosphere encouraging exemplary behavior is probably even more important than rules, necessary though these are. During my tenure as Chairman, I will consider myself the firm's chief compliance officer and I have asked all 9,000 of Salomon's employees to assist me in that effort. I have also urged them to be guided by a test that goes beyond rules: Contemplating any business act, an employee should ask himself whether he would be willing to see it immediately described by an informed and critical reporter on the front page of his local paper, there to be read by his spouse, children and friends. At Salomon we simply want no part of any activities that pass legal tests but that we, as citizens, would find offensive."

Employee compensation and making employees "owner-operators" of the business:

"In 1991 and in the future, the top-paid people at Salomon Brothers will get much of their compensation in the form of stock, pursuant to the Equity Partnership Plan (EPP), which previous management instituted last year and which we heartily applaud. The EPP motivates managers to think like owners, since it obliges them to hold the stock they buy for at least five years and therefore exposes them to the risks of the business as well as the opportunities...In Salomon Brothers' business, which combines leverage with earnings volatility, it is particularly necessary and appropriate that the financial equation applying personally to managers be comparable to that applying to the ordinary shareholder. We wish to see the unit's managers become wealthy through ownership, not by simply free-riding on the ownership of others, I think in fact that ownership can in time bring our best managers substantial wealth, perhaps in amounts well beyond what they now think possible."

On reducing leverage and investing in the right areas of the business:

"Nonetheless, we have deliberately brought our balance sheet totals down to reduce our leverage, and you will see the totals come down further in the months ahead. I am no fan of huge leverage in general, and in Salomon's case I believe that the swelling of the balance sheet that took place in the past was often done for the sake of all-too-marginal returns. Larger totals can actually lead to smaller profits: Undisciplined decision-making is a frequent consequence of ultra-easy access to funding, as both commercial and investment banks have learned in recent years."

On making "good profits" without breaking the rules:

"I noted earlier that there may well be future benefits that arise from our current problems. We have the prospect of correcting certain weaknesses at Salomon Brothers that were likely to remain unaddressed absent a change in management; meanwhile, the firm's strengths in large part remain intact. Though earnings volatility will always be high, Salomon Inc has the capacity amid favorable market conditions to earn substantial slims. Furthermore, I believe that we can earn these Superior returns playing aggressively in the center of the court, without resorting to close-to-the-line acrobatics. Good profits simply are not inconsistent with good behavior.

Our goal is going to be that stated many decades ago by J.P. Morgan, who wished to see his bank transact 'first-class business-in a first-class way.' We will judge ourselves in fact not only by the business we do, but also by the business we decline to do. As is the case at all large organizations, there will be mistakes at Salomon and even failures, but to the best of our ability we will acknowledge our errors quickly and correct them with
equal promptness."

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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