By Dayanand Menashi  [email protected]   Safe Multiple  – learn more from Buffett- The Making of an American Capitalist – By Roger Lowenstein

Chapter I here

Chapter II here

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In 1970 after the dissolution of Buffett’s partnership, Buffett’s net worth was $25 million. He and his wife Susie together owned 36% of Berkshire Hathaway’s stock. Other than that they also owned 44% of Diversified retailing’s outstanding stock and 13% of Blue chips’ outstanding stock. Buffett was truly in the driving seat now. But he had inherited a company that very badly needed a new direction. The writing was on the wall that Textiles’ days were numbered. Following were its operating earnings in 1970.

Even though Buffett is considered of having nerves of steel and a true capitalist, but by heart he is more human than any other business figure. He could sense the hard work and passion put by Ken Chace and his team in keeping the lights on for the Textiles mills. Thus he decided not to pull the plug for the textile operations.
In Early 70s Wall Street was at its peak and Berkshire was flush with $100 million in FLOAT. But out of that only $17 million was in stocks and the rest was Cash. Buffett had stuck to his principle of “Be Greedy when others are fearful and be fearful when others are greedy”. But the Go-Go era seemed to be coming to an end and by 1973 the stocks started becoming cheaper again.
Buffett’s first association with Newspaper industry was when as a little boy he had a paper route. This bonding grew stronger when Berkshire acquired “THE SUN”. Buffett was looking for bigger acquisitions in Newspaper business. Washington Post’s stock was in a slide. This gave him an opportunity to build a large position in it.
Berkshire’s own stock was also under fire. After hitting a high of $87 / share , it had lost 50% value and by 1974 had slided to $40 / share. Berkshire’s investments told a similar story. Its equity holdings were worth $40mn with a cost of $52mn. Buffett, for the first time was seeing a negative return for his investments.
Blue Chip Stamps : Buffett and Munger were independently buying the stock of Blue Chip stamps for Berkshire and Munger Partnerships respectively. Blue Chip stamps’ customers were large supermarkets who bought stamps from Blue chip. These were more or less like coupons . The Super markets in turn distributed the stamps to the valuable customers who then redeemed the stamps to Blue chip in exchange for household items like a toaster , mixer etc. Thus Blue chip collected money upfront and then delivered goods when the customer redeemed there stamps. This was somewhat like FLOAT and the best part was that it was not even regulated like an insurance company. So there was no hassle of having to maintain reserves and dealing with state bureaucrats. Its business was quite formidable. It was bringing in $120mn revenues per year.
See’s Candies : Blue Chip Stamps made use of its FLOAT by investing in other companies. One such opportunity came up when See’s Candies, a prominent California Chocolate co was up for sale. Buffett initially did not have much insight about company’s brand. He valued it at $25mn and See’s owners were demanding $30mn. But Luckily Buffett got his way around and the company was sold for $25mn. Till this date Buffett feels that he was lucky to have his way, because the company was way more valuable than the $25mn he paid for it.
Value of loyal customers: As per Buffett’s 1990 shareholder’s letter. After 15 years of operations, See’s store at Albuquerque, NM was endangered. The landlord refused to renew the lease. On top of it the landlord wanted the store to move to an inferior location and pay higher rent. Store’s manager Ann Filkins urged her customers to protest the closing. Some 263 folks threatened to boycott the mall. After the story appeared in local newspaper the landlord offered See’s a satisfactory deal. Chuck Huggins (CEO of See’s) thanked the customers personally and also published a public thank you note in local newspaper with names of all 263 customers.
In his 2007 letter Buffett further highlighted the economic value of See’s Candies brand. In 1972 See’s sold 16 million pounds of candies. In 2007 it sold 32 million pounds, a paltry growth of 2% per year. In 1972 when Berkshire bought the company, See’s sales were $25 million and pre-tax earnings was $5 million The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
In 2007 See’s sales were $383 million, and pre-tax profits were $82 million. The capital required to run the business was just $40 million. This meant that Berkshire had to just re-invest $32 million back to See’s Candies since it had acquired it in 1972. The Pre-Tax earnings of See’s from 1972-2007 was $1.35 billion. Thus Berkshire pocketed $1,350 - $32 = $1,318 million , just with investment of $25mn capital. This shows the hallmark of Buffett’s capitalist credo.
Washington Post Co : In 1973 Katie Graham became Chairwoman of Washington Post co. She was the first woman head of a FORTUNE-500 company. Berkshire had accumulated 10% of the company’s Class-B common stock that was publicly traded. Katie could sense Buffett’s power and in order to keep him on her side she offered a seat in the Board of directors to him. In the contrary Buffett showed his trust on Katie’s leadership and promised to always side by her agenda in the board meeting. Buffett developed a very close business relationship with Katie. Pretty soon Katie recognized Buffett’s insight on business analysis. She treated him as her mentor and started following his capitalist principles. Thus Washington Post’s senior management was forced to keep a tight lid on the company’s capital expenditures. Any acquisition proposal was looked into very deeply.
Washington Post doubled its operating profit margin / share from 10% to 19% from the year 1974 to 1985. All this was just possible because management adhered to Buffett’s disciplined advice of not reinvesting new capital in the business. Instead the free cash that was generated was used to retire 7.5 million shares. So even though the total profits grew 7 times, but the profit per share grew 10 times at a compounded annual rate of 37% (including dividends). Thus Berkshire’s 10mn investment in 1974 was worth $205mn by 1985.
Wesco Financial: It was a Savings and Loan company that went public in 1950s. By 1970s it was in tough waters. Buffett was following the company since early sixties. By 1972 Wesco’s shares were trading in low teens – half its book value/share. Blue Chip stamps snapped up 8% of the stock for $2mn investment. As Wesco was temporarily in bad shape, it was planning to merge with another financial company named “financial corp of Santa Barbara”. Buffett and Munger instantly knew that Wesco was selling itself for a deep discount because its shares were undervalued as compared to the other company , whose stock was overvalued. Blue Chip increased its stake in the company to 20% so that it could influence the directors against the merger.
After failing to persuade Wesco’s President Vincenti to vote against the merger, Buffett approached Elizabeth Peters, a major shareholder of the company. She was somewhat interested in overhauling the company. Elizabeth was mesmerized by Buffett’s capitalist credo and supported his stance of going against the merger. With the help of Elizabeth’s support Berkshire was able to avert the merger and save Wesco for being sold for a discount. Blue Chip initially raised its stake in Wesco to 24.9%. But Wesco’s shares kept falling and Berkshire kept raising its stake and eventually by 1974 was a majority shareholder in the company.
SEC began inquiry in this deal and was investigating if Buffett and Munger had manipulated Wesco’s stock price so that they could get a major holding in the company. Buffett was outright honest about his explanations. SEC’s lawyers could also get a sense of Buffett’s capitalist credo and were leaning towards the opinion that he was not the man in pursuit for a fast buck. But SEC could not overlook the mirage of artifacts that were entangled and confusing. It arose because of Buffett’s parallel interests in Berkshire, Blue chip and Diversified retailing. In 1976 the case was settled. SEC formally charged Blue Chip of manipulating the stock price of Wesco. Blue chip neither agreed nor denied this and settled for $115,000. Blue Chip that time owned 80% of Wesco. Blue Chip was later merged with Diversified retailing in 1978, which in turn merged with Berkshire in 1983.
Beginning of Partnership with Charlie Munger: The merger also formalized Buffett’s relationship with Munger. Munger exchanged his holdings in Diversified retailing and Blue Chip for a 2% stake in Berkshire’s stocks. He was named Vice Chairman of Berkshire and also oversaw Wesco Financials operations as its Chairman. Berkshire recovered from its woes of mid-seventies. Its stock rose to $95/ share by 1976.