Value Investing

Buffett’s Initial Days at Berkshire 1965-1970

By Dayanand Menashi  d_menashi@yahoo.com   Safe Multiple  – learn more from Buffett- The Making of an American Capitalist – By Roger Lowenstein

Chapter I here

Stay tuned for chapter III

Berkshire Hathaway went through tough times from 1955 to 1965. It had accumulated a net loss of $10.1 million during that period. But it was seeing the light at the end of the tunnel. It had pioneered the use of synthetics and its demand was rising. Now it was up to the partnership of Buffett and Ken Chace to unlock this intrinsic value. Buffett had great respect for Chace’s technical abilities and had given him full control over the operations of the business. But he had made it clear right from day-1 that the keys to the coffer would always be in Omaha.

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Buffett’s first major step was the curtailment of stock option programs for its executives. He believed that stock options rewarded the executives when the company grew, but the recipients did not share the downward risk. This accounted for “Heads I win, Tails I don’t lose”.
Buffett knew that it was only Ken Chace who could pull the company from Doldrums. In order for getting Chace’s full support he had to keep Chace’s fortune aligned with that of the company. Thus Buffett arranged for a loan of $18,000 to Chace so that he could buy 1,000 shares of Berkshire. But Chace had some reservations towards use of credit. Buffett talked him into this deal. Thus Buffett had his cake and ate it too – He was able to impinge his principle of guardian of Shareholder’s interest by having a “NO STOCK OPTION PRINCIPLE” and at the same time kept Chace’s fortunes in line with the company’s fortune.
Buffett also laid down his golden principle of measuring the company’s progress thru “Return on capital”. He laughed at the remarks of managers who boasted about their company’s record earnings without giving the context of the kind of capital involved while generating that profit. Even a simple bank fixed deposit produces an ever growing interest every year if the principal and accumulated interests are compounded annually. This Golden principle kept the management on edge and forced them to keep a tight control over inventory and any additional capital expenditure.
The third major reform brought about by Buffett was to completely eliminate dividends to shareholders. After Buffett became Chairman in 1965, It was just once in 1967 that Berkshire declared a dividend of 10cents / share. Buffett always regretted that decision. His philosophy is that Shareholder’s best interest is by retaining the dividends and growing it , rather than paying it off and forcing the shareholder to pay tax on it.

Foray into Insurance and Berkshire’s transition years: Textiles industry in New England had made a decent comeback in late sixties. The company was keeping a tight lid on its expenses and capital expenditures. This generated abundant free cash that Buffett could invest for Berkshire. Buffett was also sensing the need to diversify, as Textiles’ future was not that bright.
In 1967 he eyed National Indemnity co. Its major shareholder was Jack Ringwalt. Jack had met Buffett before when the latter had approached him for a $50,000 investment in his partnership. Jack had viewed Buffett as still very green and did not invest with him.
Ringwalt was a pure street smart guy. He had started his business by providing insurance to Taxicabs. He had developed a niche in markets that were usually ignored by major carriers. His mantra was that there was no risk as bad or good. It all just depended on the price one is getting for it. Buffett had a close associate named Charles Heider. Charles knew how much to offer Jack to part with his company. He also knew when to approach Jack for this.
Charles arranged the meeting between Buffett and Jack at Kiewit Plaza. National Indemnity that time was selling for $33/ share. Jack demanded a steep premium of $17 / share, plus a whole lot other promises that included his employees’ job safety. Surprisingly Buffett agreed to all of Jack’s demands and thus Berkshire bought National Indemnity for $8.6 million
Wall Street was puzzled as to why a Textile company would go out of the way to buy an Insurance co. But Buffett had his work cut out. Ever since he had first analyzed GEICO in 1951, Buffett had steadily built his expertise in insurance sector and knew it like the back of his hand. He viewed insurance business as a provider of FREE cash for him to invest, provided the business didn’t make an Underwriting loss. He called this FREE cash as the FLOAT and has always possessed that as of the key growth factor for Berkshire Hathaway.
Berkshire’s first acquisitions using float: Berkshire leveraged the float to make strides in media and banking industries by acquiring Sun Newspaper and Illinois National Bank. In early thirties Illinois National Bank was in the virtue of going out of business when Eugene Abegg single handedly brought it back to life. In next 30 years Abegg chiseled the bank into a financial powerhouse of Midwest, boasting assets over $100 million. Bank was his baby and at ripe age of 71 he wanted to hand it over to a person who would maintain his business the way he had maintained for all those years. Buffett was his best choice, because even after selling the bank Eugene got to run it the way he wanted.