A Five Sigma Event – The World’s Greatest Investor

Warren Buffett was born in Omaha, Nebraska on August 30, 1930. His family ran a grocery store and as a matter of coincidence, young Charlie Munger (the current business partner of Warren Buffett) was employed at Buffett’s grandfather’s grocery store. Warren was entrepreneurial, right from his childhood. As a gift he had received a money changer. With this in hand he went door to door selling chiclets, soda, magazines, popcorns, peanuts, etc. As the great depression hit, Warren’s father, Haward Buffett lost his job at a bank. However, little did Warren know, this hardship was a set up for him becoming the greatest investors of all times. After being jobless for some time, Haward started his own brokerage firm and this introduced Warren to the world of stock markets. Apart from luck, Warren’s sheer focus also contributed to his success. He focused on reading investing books right from his childhood.

At age 13, Warren moved to Washington with his family. His interest in entrepreneurship continued and he started delivering Washington Post newspapers door to door. Soon he saved some money and bought a paintball machine for $25 and installed them at a local barber shop. If looked closely it was such a strategic location as the waiting crowd at a barber’s shop often has nothing interesting to do. His first day return was $4. He even formed a company called, “Wilson Coin-Operated Machine Company” and expanded the business to 7 machines, taking home $50 each week. He was able to save $9,000 by the time he graduated from school. 

By 1950 after graduating from college, Buffett returned to Omaha and started to develop his old interest in the stock markets. However, this time he was more inclined towards price movement and focused on technical analysis. This continued till his eyes went on “The Intelligent Investor” a book authored by Ben Graham. He was massively influenced by this book and acknowledges that he still reads it over and over again. Buffett travelled to New York University to learn investing from Ben Graham. Buffett was an outstanding student in Graham’s class and was awarded A+, which was the first time in 22 years that Graham had been awarded. At a young age of 25, Buffett started an investment partnership in Omaha, managing family and friend’s money.

The Buffett PartnerShip Ltd. began with seven limited partners. In an investment partnership, there is one General Partner who is responsible for managing the money of other limited partners. Since the very beginning, he had set the expectations for the investors right. He told them that the motto of the partnership was to reduce the loss of capital and stocks would be chosen on the basis of value (value investing) and not popularity. His target was to outperform the Dow Jones Industrial Average Index by 10%. The partnership bought undervalued stocks chosen on the basis of Graham’s teachings.  He also engaged in merger arbitrage. This is a trading strategy in which stocks of two merging companies are bought and sold simultaneously to earn a (almost) riskless profit.

For example, Company A is merging with company B in the ratio, wherein each shareholder of company A would be getting 2 shares of company B. If company A is trading at INR 250 while B is trading at INR 100, the arbitrage would work by selling 1 share of company A at INR 250 and buying 2 shares of company B @100, thereby making an INR 50 profit.

Buffett's partnership, in its first five years, was up by 251% vs Dow Jones’ 75% return over the same period.

His first major investment was in American Express. In the 1960s there was an oil company which took loans on the basis of its Salad Oil inventory. As you know, oil floats on water, and therefore, the company took fraudulent loans on adulterated inventory from some of the major banks in the U.S. Out of these banks, American Express had lent $58mn. Since it was a scam and the entire money would be written off from the bank’s balance sheet, its share price dropped by 50%. Buffet had learnt from Graham that if the share price of a strong company falls, it needs to be given special attention. Hence buffet checked the records of card transactions and traveler’s cheques issued by American Express. He found out that these were unaffected and hence he made a decision to invest a massive 25% of the total partnership’s wealth into American Express stock. In the next three years, the share price of the bank tripled.

The market valuation had become crazy by 1969. That was the time when Buffett decided to liquidate the partnership money and return money to the investors. The target of outperforming the benchmark by 10% was beaten and Buffett outperformed the market by 22% annualized for the investing period of 12 years.

This was not the end for Buffett rather the beginning. Buffett had accumulated a massive $25 mn from the partnership. He was now looking for something else. Buffett accumulated a major share in a struggling textile company called Berkshire Hathaway.

The company was unable to generate a generous return on equity (return on equity is the return generated on the owner’s capital. Generally, a company that is able to generate a return on capital upwards of 18% is considered great, 12-18% is considered good while below 12% are considered gruesome). In business, a manager should always think rationally. If the economics of the business doesn’t allow it to earn a generous return on equity, it makes no sense to infuse capital into the business. Therefore, by 1985, Buffet closed the textiles business of Berkshire Hathaway ending a century old textile unit. He however, bought an insurance company under Berkshire Hathaway, with the cash flows the company had generated over the years.