In his quest to convince readers that deep-value investing beats conventional value investing, Tobias Carlisle turned to the history of Warren Buffett (Trades, Portfolio) in his younger years. For a dozen years, between 1957 and 1969, Buffett operated a hedge fund called the Buffett Partnership. And it was very successful; as the guru explained to Business Week in 1999:
“The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers… I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
During the years he operated the fund, it averaged annual returns of 31% and made his investors rich. Carlisle provided this dramatic chart:
Buffett’s first big investment was in a 75-year-old map-making company, Sanborn Map. It had once been a power stock, averaging $7 million a year in profits. By the 1950s, though, its competitors had used new technology to provide a better product and profits had slipped to less than $1 million per year. In addition to the profit slipping more than 80%, it had also cut its dividend five time in the previous eight years.
Not surprisingly, the market did not like what it saw and zagged, as Carlisle might put it. Buffett, on the other hand, looked more deeply and zigged. What he saw was $65 per share in cash and investments, while shares could be bought for $45, so without even considering the company’s business operations, shares could be bought for 69 cents on the dollar. That was right in line with the advice of his mentor, Benjamin Graham, who taught the simple idea that investors should buy dollars for 50 cents.
Buffett began buying all the shares he could in 1958, which ended up being more than 43% of the company. He asked the board to pay out the $65 per share to shareholders. The board refused and Buffett used his fund’s shareholding to get elected to the board. Once on the board, he discovered one of the reasons the stock was cheap was because the other board members were employed by Sanborn customers. They owned little stock and simply wanted to ensure the maps remained cheap.
His next move was to propose the company buy out any investors who wanted to exit. Fearing a proxy fight with him, the board agreed and paid out $65 worth of investments. For Buffett, this meant a 44.4% return on his $45 shares. As Carlisle noted, this was a typically profitable investment for the Sage of Omaha. The market saw a failing map company, while Buffett looked to the asset value and found gold.
Buffett’s second major hedge fund deal involved Dempster Mill Manufacturing, a company that manufactured windmills, pumps, tanks and farming and fertilizing equipment. When he first found the company, it was making windmills faster than customers were buying them. As a result, inventory was bloated, but the company kept churning them out.
That pushed profitability down, leading the market to sell and push the price down. Buffett estimated the tangible book value to be between $50 and $75 per share—and he could buy the stock for $16. He did not expect the company to generate much of an operating profit, but thought it could be a profitable investment if inventory was brought under control.
He was patient and disciplined, buying blocks of stock over five years, starting in 1956. His average share cost was $28, still well below the intrinsic value. Again, he saw poor management and a difficult industry situation. The poor management was because the company kept ignoring the inventory issue.
He used his now-controlling share of Dempster to get a board seat, and then forced the company to sell down the inventory and other assets. Proceeds of the sales were converted into cash and invested in stocks. It was another huge success for the young Buffett—his hedge fund had tripled its original investment of $20 million.
Dempster was one of the stocks in his portfolio, a portfolio divided up into three plus one groups:
- Generals: These were regular, undervalued stocks that became available at a discount price.
- Workouts: These came out of corporate actions, board-level decisions such as a return of capital, a liquidation or a stock buyback.
- Control situations: These were undervalued stocks that seemed stuck, so Buffett would buy enough shares to be able to control the company, as he did with Dempster.
- Coattails: This is the plus group, since it involved Buffett taking a position after other investors, such as activists, were already working to turn a company around.
Just how well did young Buffett do as a hedge fund manager? As we’ve noted, his returns averaged 31% per year for 12 years. Much to the regret of his investors, no doubt, he wound up the Buffett Partnership in 1969 because his firm had grown too large: more than $100 million of assets under management.
That meant he had to invest at least $3 million in any investment—in 1969—to make a difference to his portfolio return. The stock market was also hot at the time, perhaps similar to 2018, and few undervalued stocks were available.
Author Carlisle addressed the young Buffett’s success with the goal of showing the guru’s returns during his “cigar-butt” days were even better than his returns as a mature investor. In other words, Carlisle wanted to emphasize that “buying fair companies at wonderful prices” can be a better strategy than “buying wonderful companies at fair prices.”
In turn, it is part of Carlisle’s advocacy of deep-value investing, as discussed in the digest of chapter one. And, as noted in that chapter, the author called “fair companies at wonderful prices” the “Acquirer’s Multiple.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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