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How Warren Buffett Made His First $100,000 March 26, 2012
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Buf f ett Partnership Letter Series – December 24, 1962 Tweet
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Key Inv esting Takeaway s f rom Warren Buf f ett’s 2013 Shareholder Meeting
Someone w ho reads my articles asked me this question:
Singer Bono Presents Warren Buf f ett with a Philanthropy Lif etime Achiev ement Award
Do you know which specific investments that Buffett made in his early career gave him his biggest returns and generated his initial wealth?
Rationality Is Buf f ett's 'Secret Sauce' According to Author Hagstrom
What did he see in these companies that led him to invest in them? Geoff Gannon
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Warren Buf f ett's Letter to Kay Graham Discussing His Initial Purchases of Washington Post SharesFeedback
- Ryan MORE GURUFOCUS LINKS If you read Alice Schroeder's "The Snow ball" you can easily find the investments that generated Warren Buffett's initial w ealth. Here, I'll talk about just the first $100,000 Warren Buffett made investing in stocks.
We'll start after Warren Buffett first read “The Intelligent Investor” but before he started taking Ben Graham's class at Columbia. Buffett already ow ned Marshall Wells before he took Ben Graham's class. He still ow ned the stock w hen he w ent asked David Dodd (co-author of "Security Analysis") if he could skip Dodd's class and go to Marshall Wells's annual meeting. This is w here Buffett first met Walter Schloss.
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Let's take a look at Marshall Wells w hen Buffett ow ned the stock. GURU INTERVIEWS Marshall Wells
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So, the stock w as selling for a little over 3 times earnings. The earnings yield - "E" divided by "P" - w as about 30%. This brings me to the first point I need to make about Warren Buffett's early investing career. Warren Buffett w orshipped Ben Graham. But there's this idea that Warren Buffett started out as a Ben Graham type investor. That's false. Buffett bought some Ben Graham type stocks - like net-nets. Graham had a big influence on w hich stocks Buffett picked. But Warren Buffett never invested the w ay Ben Graham did.
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For now , the big difference w e need to discuss betw een early Warren Buffett and Ben Graham is that Warren Buffett is, w as, and alw ays w ill be a return on investment investor. He's not a value investor in the sense that he sees some static value and buys at a 50% discount to that. Buffett is obsessed w ith the idea of compounding. When Warren Buffett started taking Ben Graham's class there w as already a big difference betw een Graham and Buffett in that Graham w as thinking about earning a good return on his investment capital, protecting the safety of his principal, and beating the market over time. Warren Buffett w as thinking about compounding w ealth. He w as interested in getting rich. There's a huge difference there. Ben Graham - and later Walter Schloss - made a habit of returning a lot of their partnership's gains. So, if you had $100 invested in Graham-New man and they earned 15% on your money - the default idea w as not necessarily to take that $115 and try to turn it into $132.25 next year. The first idea in Graham's head w as: "I can earn 15% on $100 safely". So, he w as concerned w ith how much capital the partnership could operate w ith and still beat the market w hile taking less risk.
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Graham w as never concerned w ith compounding the partnership's w ealth over time. This is a huge difference from Warren Buffett. When Buffett ran a partnership, he took $1 and turned it into something like $27. That w as alw ays his goal. To grow w ealth. Not just earn a decent return safely. This is something Buffett w anted to do even before he knew anything about value investing. Buffett's obsession w ith compounding w ealth over time predates his conversion to value investing. And it w as never something he had to "learn" after his time w ith Ben Graham. He w as alw ays obsessed w ith return on investment as being the key to compounding. That doesn’t mean he w as obsessed w ith the company’s return on its ow n capital. But, from the earliest days, he thought of stocks in terms of the return they generated for him – not in terms of the discount to some fixed intrinsic value. This caused Warren Buffett to invest very differently from Ben Graham - even w hile he w as w orking for Graham. It's interesting to note that Buffett managed to invest very differently from Ben Graham even w hile he bought almost the same exact kinds of stocks Ben Graham bought. In fact, sometimes he literally bought the same stocks Graham bought. But Buffett alw ays got much better results. Why? Because he focused. Warren Buffett told Charlie Rose that "focus" w as the key to his success. He's repeated over and over again that he doesn't necessarily have more good ideas than other investors - he just has few er bad ideas. Buffett focuses on his very best ideas and puts as much money as possible into those ideas. If it sounds like I’m exaggerating w hen I say "as much money as possible" - check out the next stock: GEICO Buffett found out that Ben Graham w as the Chairman of GEICO. Graham-New man bought a huge block of GEICO stock in the past. They got the stock at a Ben Graham type price. But GEICO turned out to actually be a w onderful grow th stock. Investors w ho kept their shares of GEICO w hen Graham-New man distributed them made a lot of money over time. GEICO's headquarters w ere in Washington. So, one Saturday, Buffett took a train from New York (w here he w as going to school) dow n to Washington. You've probably heard this story before. Buffett knocked on the door. The only person there w as Lorimer Davidson. Davidson later became CEO of GEICO. He put together the Graham-New man deal.
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business because they did not use agents. Buffett w as sold on GEICO’s future prospects. Here is Buffett’s response as described in The Snow ball:
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“That Monday, less than 48 hours after he arrived back in New York, Warren dumped stocks worth three quarters of his net worth and used the cash to buy 350 shares of GEICO…GEICO was trading at $42 per share, a multiple of about 8 times its recent earnings per share… (Buffett) thought the stock would be worth between $80 and $90 per share (within 5 years).” A few points here. One, w e can do some math and see that Buffett believed he w as going to make more than 13% a year in GEICO. The low end value estimate ($80) and the longest time Buffett expected the stock to take to reach that value (5 years) w ould have resulted in about a 14% compound annual grow th rate. It’s likely that Buffett believed he w ould make at least 15% a year for as long as he held GEICO. Because he meant it w ould be w orth $80 to $90 a share w ithin 5 years. Not that it w ould actually take a full five years and that $80 to $90 w as a perfectly accurate estimate. That’s not w hat he meant. What he meant is that he thought he w as buying something that w ould most likely return at least 15% a year. GEICO w as not a Ben Graham stock at the time. It w as an insurer selling for 8 times earnings. In 1951, an insurer selling for 8 times earnings w as probably considered cheap (if it had good grow th prospects). But it w as not that close to Ben Graham territory. And insurers do sometimes trade for 8 times earnings. Maybe not an insurer w ith GEICO’s future. But that’s not the w ay Graham thought about companies. The issue here is that Buffett believed GEICO w as a grow th company. He believed its earnings per share w ould keep rising every 5 years or so. Because he thought they w ould take share from their higher cost competitors. He thought they had a better model. They didn’t use agents. Ben Graham never approved of Warren Buffett putting 75% of his net w orth into GEICO. That’s something Graham w ould never do w ith any stock. And GEICO w asn’t even a liquidation value bargain anymore. It w as just a moderately cheap insurance company w ith a long, w onderful road ahead of it. Here’s Warren Buffett from The Snow ball: “Ben would always tell me GEICO was too high. By his standards, it wasn’t the right kind of stock to buy. Still, by the end of 1951, I had three-quarters of my net worth or close to it invested in GEICO.” Buffett w orshipped Graham. But it didn’t matter. He w ent ahead and broke tw o of Graham’s rules: 1. GEICO w asn’t selling for a Ben Graham price 2. Ben Graham w ould never put 75% of his portfolio into one stock Why did Buffett do this? Because Buffett w anted to get rich. He didn’t w ant to fill his portfolio w ith 1 great idea (GEICO) and 4 good ideas and then only have 20% of his money in GEICO. If GEICO rose 50% next year w hen Buffett had 75% of his portfolio in GEICO he w ould grow his capital 37.5% just from GEICO’s contribution. If he spread his portfolio evenly over 5 stocks, then a 50% rise in GEICO’s price next year w ould only increase his capital by 10%. Buffett w asn’t interested in compounding his money at 10%. He w as interested in compounding his money at 30% or 40%. He w asn’t going to buy something in a w ay that each idea w ould contribute that little. From the very beginning of his career, Buffett alw ays felt safer in his best idea (that w ould
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money in one idea – he did try to buy as many shares as possible of his best idea at several points in his first few years investing.
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He also borrow ed money. Buffett had too many ideas and too little capital. So, he actually got his Dad to cosign a loan for him so he could put more money into his best ideas. These are things Ben Graham w ould not have done. Now , Graham did use margin early in his career – everyone did back then. And Graham w ould borrow against arbitrage positions in the fund. But that’s not w hat w e’re talking about here. Buffett took out a loan from a bank so he could add to the total investment capital he had. Why did he do this? If he had a high degree of conviction in ideas he felt w ere certain to earn at least 15% a year and might earn something crazy like 50% a year (simply because the stock price rose to meet intrinsic value quickly rather than slow ly) then w hy not borrow money? If you can get at least a 15% return on your assets, it makes sense to add to those assets by borrow ing from a bank at much less than 15%. If you borrow moderately. From the w ay the loan is described in The Snow ball it w as a little hard for me to figure out how big the loan w as in relation to Buffett’s portfolio w hen he took the loan. It w as clearly a small amount shortly thereafter – but that’s because Buffett’s capital kept grow ing really, really fast. Greif Brothers Cooperage We know Buffett ow ned this stock in 1951. It w as a barrel maker. And a net-net. For those of you w ondering if Greif Brothers Cooperage has any relation to Greif (GEF) – yes. It has every relation. It’s the same exact company. And it’s still in pretty much the same business. They used to just make barrels. Now they make all kinds of different drums, containers, etc. That’s not a very big change for a company to make over 60 years or so. Philadelphia Reading & Coal This w as Warren Buffett’s biggest position at one point. It w as a very cheap company. It actually dropped from $19 a share (w hen he bought it) to $8 a share. And he bought more after the 50% drop. Philadelphia Reading & Coal w ent on to be bought by Graham-New man as a control position. This w as a lesson in capital allocation for Warren Buffett. If you don’t understand w hy Buffett started to build an investment company on the ashes of a textile mill, you should learn more about Philadelphia Reading & Coal. Because Buffett w as at Graham-New man w hen they w ere using the capital in this business to diversify into an investment company of sorts. Philadelphia Reading & Coal bought Union Underw ear Company w hich sold underw ear under the “Fruit of the Loom” name. And then they also bought the Acme Boot Manufacturing Company. The company also stopped paying a dividend. For 4 and a half years, Philadelphia & Reading (they dropped “coal” from the name) didn’t pay any dividends. But they didn’t pour more money into the lousy coal business either. Instead, as they slipped into losses for 1954 and 1955, they actually w ent ahead and spent money on buying new businesses. This w ould be a lesson for Buffett. It also raises the issue of management and control of capital allocation. As w e’ll see, many of Warren Buffett’s early investments actually had a strong management aspect to them. Especially w here Buffett thought capital w as going to be used w isely (or returned to him). In fact, you could say that in Warren Buffett’s mind management “quality” is synonymous w ith smart capital allocation. He’s not looking for an operational genius. He’s looking for someone w ith his kinds of ideas w hen it comes to return on capital. That’s w hat he w ants in a CEO. Someone
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This one w as not a smashing success. Buffett “called it Cleveland’s Worst Mill after they cut of paying the dividend.” It w as a net-net w ith a high dividend yield. The yield didn’t last.
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Western Insurance Buffett sold his GEICO stock to buy Western Insurance. It had earnings of $21.66 in 1949 and $29.09 in 1950. In 1951, the stock’s high price for the year w as $13. The low w as $3. “It was the cheapest stock with the highest margin of safety he’d ever seen in his life. He bought as much as he could.” National Am erican Fire Insurance This company w as controlled by How ard Ahmanson. It’s a strange story. The original stock w as pretty much w orthless. It ended up being taken over as part of Ahmanson’s empire. Ahmanson w as from Omaha. Although he’s most associated w ith California. I w on’t bore you w ith the w hole story (you can find it on the w eb by searching for “Howard Ahmanson”, “H.F. Ahmanson & Co.”, “Home Savings of America”, and “National American Fire Insurance, Warren Buffett”.) Basically, Ahmanson’s father had ow ned an insurer in Omaha. Ahmanson got started very young (he w as a financial services prodigy) and got extremely rich underw riting insurance in California during the Great Depression. He then bought National American Insurance Company (in Omaha) because it w as his Dad’s old company. He w as retaking control of the family company. Through this w eird coincidence, National American Fire Insurance ended up w ith some terrific assets. The Ahmansons w ere very private. And these assets w ere controlled through different holding companies, trusts, etc. Anyw ay, here’s Warren Buffett explaining w hat he found w hen he looked into w hat NAFI really w as: “I found National American Fire Insurance…NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. This company was located right here in Omaha, right around the corner from (where) I was working as a broker. None of the brokers knew about it.” What’s w eird about this story is that on the surface the stock looked insanely cheap. It w as selling for less than 1 times earnings. And about 20% of book value. But that really understates how cheap the company w as. The deeper you delved into the story, the cheaper the stock looked. This w as a personal holding company for one of the smartest investors in the insurance business. If you look at the book value and the earnings per share in 1950, you can see the company must have had something like a 20%+ ROE. Why w ould a company w ith a 20% return on equity ever trade for one-fifth of book value? Read The Snow ball to find out. Basically, it w as a super illiquid stock that had once been w orth a lot more. The shares ended up spread thinly across a lot of different individual investors. They remembered w hen the stock w as w orth $100 a share. That’s w here a lot of them bought. And many of them didn’t w ant to sell until the stock got back to $100 and made them w hole. But, because the stock had burned them so bad, they also had no interest in buying more shares. They just clung to w hat they had. Now , w hat’s really fascinating about this story is w hat Warren Buffett did. So, the stock w as last selling for about $27 a share. At first, he tried buying around $30 a share. Then he w ent to $35. He w ent to tow ns w here he knew people ow ned the stock. He talked in person to people to try to get them to sell to him.
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But think how many of us w ould have been unw illing to go up to $100 a share. After all, if you started buying around $27 a share – doesn’t $100 a share seem like too much? How many times have w e thought: “Well, I started buying at $30 a share, do I really want to keep buying at $40 at $50 at…or should I wait for it to come back down to my price.” Famous last w ords. You w ould probably doubt yourself as you bought and bought and bought at ever higher prices. But Buffett didn’t. And that’s the difference betw een Buffett and Graham. Buffett w anted the highest return on his capital. At $100 a share, he w as still going to earn w ell over 20% a year in this stock. Remember, he w as paying less than 4 times earnings and less than 75% of book value for a company that recently earned over 20% on its equity. By either of those measures, you are clearly going to earn more than 20% a year. So, w hen you see a clear situation w here you w ill make more than 20% a year in a stock, the right answ er is to buy as much of that stock as possible. To compound your w ealth, the key is not to focus on w hether you are paying $30 or $60 a share or $100 a share. It is to get as much of your money as possible into the stock w hile it is offering a very high return. What matters is how high the return on your investment is at the price you pay. Not how much higher or low er the price you pay today is compared to the price the stock w as at w hen you started researching it. Rockw ood Buffett talks about this investment in his 1988 letter to shareholders. Rockw ood Chocolate had been shopped around to different buyers. Graham-New man w as given a chance to buy the company. But they passed because Rockw ood w anted too high a price. Jay Pritzker ended up in control of the company. And he offered 80 pounds of cocoa for each share of Rockw ood stock. The exact reasons w hy he made this offer are complicated. Cocoa prices spiked in the midst of a shortage. Rockw ood used LIFO (Last-in-first-out) inventory accounting. As a result, it carried its cocoa beans at much less than they w ere w orth during the current cocoa bean shortage (prices w ere about 12 times higher than w hen Rockw ood adopted LIFO). So Rockw ood had a big gain on its cocoa beans – but this w ould be taxable of the beans w ere sold. How ever, the transaction w ould be non-taxable if it w as used in a partial liquidation of the business. So, Rockw ood initiated a coca bean for stock sw ap. Why didn’t they just return beans to shareholders? Cocoa w as tradeable. So w hy buy back the stock? Why not just give the beans to shareholders and forget the idea of a stock buyback entirely. Graham-New man didn’t ask this question. They, like some others on Wall Street, simply participated in the arbitrage opportunity. Buffett just w ent ahead and bought Rockw ood stock so he could be on the same side of the trade as Jay Pritzker. So, instead of buying his stock, then sw apping his stock for beans and then sw apping his beans for cash – Buffett just bought Rockw ood stock and ignored the offer to sell his shares for beans. Buffett made $58 a share vs. the $2 a share the arbitrageurs made. At the time of the Rockw ood deal Buffett’s tw o biggest holdings w ere Rockw ood and Philadelphia & Reading. So he w as betting on tw o capital allocation “jockeys” here. GrahamNew man w as taking a cheap but misallocated business and turning it into a better business. And Jay Pritzker w as taking advantage of high cocoa prices to buy back stock and make remaining
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Buffett did a lot of “coat tail” riding in those days. He took a lot of other people’s good ideas. Whether it w as Ben Graham or Jay Pritzker or How ard Ahmanson.
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That’s a strange w rinkle in the early investments by Buffett. It w asn’t alw ays the case that he w as betting on superior capital allocation. At GEICO, he w as betting on a grow th stock. It just happened to be a cheap grow th stock. And at Marshall Wells it didn’t really matter w ho w as allocating the capital. What he cared about there w as that the stock w as selling for about 3 times earnings. The same thing is true – to some extent – in the last stock w e’ll look at: Union Street Railw ay. Union Street Railw ay This w as a bus company. They had some substantial hidden assets. But the most important asset they had w as cash net of all liabilities of more than $60 a share versus a stock price of $30 to $35 a share. Graham-New man had considered the stock. But did not w ant to take a huge block. Buffett did. He w asn’t interested in diversifying. The company w as also buying back stock at the same time. This w as a common feature of Buffett’s investments. Ahmanson w as slow ly buying up stock around $30 a share w hen Buffett started buying shares of NAFI. Here, the company w as buying back its ow n stock. Buffett w ent to talk to Union Street Railw ay’s CEO. The CEO told him that they w ere going to return $50 a share. Here is my best guess of w hat Buffett’s investment in Union Street Railw ay looked like: · Paid $18,700 for his shares · Got back $28,800 in cash · Stock still traded for $11,500 after the special dividend So, Buffett turned an $18,700 stock purchase into a combination of $28,800 in cash and $11,500 in stock. His return w as something like 115%. Also notice how strange the market’s attitude w as tow ard Union Street Railw ay’s cash. Before the special dividend it traded at $30 to $35 a share. After $50 a share w as paid out in cash, the stock only dropped to $20 a share. So, even though the company paid $50 in cash, the market only penalized the stock $10 to $15 a share. The market never gave Union Street Railw ay full credit for the cash w hen the company had it. So, it didn’t deduct full value from the stock w hen the cash w as paid out. From 1949 through 1954 Buffett made his first $100,000. It’s hard to know w hat his exact annual returns w ere. That’s because he saved some additional money, paid taxes, took out a loan, etc. My best guess is that Buffett compounded his money at an annual rate no less than 50% a year and no more than 60% a year. This is consistent w ith his ow n statements. Buffett told students he did make 50% a year on his ow n portfolio before starting his partnership. And he said that his returns w ere low er each decade. Buffett had annual returns on 30% a year w hen he ran his partnership. It’s clear he did better than that w ith his ow n money in the early 1950s. It’s likely Buffett earned about 50% a year on his investments in his first 5 years as an individual
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Overall, Buffett turned $10,000 into w ell over $100,000 betw een the time he first read Ben Graham’s “The Intelligent Investor” and the time he started his partnership.
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For details, read The Snow ball. It mentions plenty of other stocks Buffett bought throughout his career. I just focused on the first five years of his investments. Read Geoff’s Other Articles Ask Geoff a Question Check out the Buffett/Munger: Bargain New sletter Check out the Ben Graham : Net-Net New sletter About the author: Geoff Gannon - formerly of Gannon On Investing - likes to answer questions from you. If you have an investing question you want answered, please email him at
[email protected].
Related links: [b]Read Geof f ’s Other Articles[/b] [b]Ask Geof f a Question[/b] Warren Buf f ett [b]Check out the Buf f ett/Munger Bargain Newsletter[/b] [b]Check out the Ben Graham Net-Net Newsletter[/b] Feedback
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Comments Shortroadto -
1 year ago
Is it possible to be as successf ul as Buf f ett nowaday s? With so much inf ormation out there, it makes it much harder to f ind the "diamonds in the rough" that Buf f ett was able to f ind y ears ago.
AlbertaSunwapta Shortroadto,
1 year ago
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Personally though, I didn't hav e the guts to take hugely concentrated positions and was too slow to act (too busy at work) to buy many more stocks on sale bef ore '09's cheery spring consensus dev eloped. Now if I'd concentrated on a f ew positions I wouldn't hav e been stuck with a bunch of cash by that spring.
Josh Zachariah
-
1 year ago
You can make money the exact same way Buf f ett made it - piggy backing of f great inv estors like Buf f ett himself and Bruce Berkowitz. Its completely public the stocks these inv estors buy and y ou can easily determine the lowest price they paid. If y ou can pay less than them y ou're likely to make some serious money. In my experience that's been exactly the case.
Nicklusk -
1 year ago
I wish there was a book written about Jay pritzker's early business career. Or Gurdon Wattles. If any one knows of any please let me know
Traderatwork -
1 year ago
Bought the book months ago and sitting right on my bookshelf , now GC gav e me no more excuse to not read the book. Thanks f or the great article.
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