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The Investor's Podcast (We Study Billionaires) - The Investor’s Podcast Network
TIP682: Buffett's Early Investments by Brett Gardner w/ Clay Finck
01:15:41
Clay Finck reviews Brett Gardner’s new book, Buffett’s Early Investments.
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- [00:01]
Preston Pysh
You're listening to tip.
- [00:03]
Clay Fink
Hey everybody, welcome to the Investors Podcast. I'm your host Clay Fink. On today's episode I'm going to be chatting about a newly released book titled Buffett's Early Investments by Brett Gardner. Brett is an analyst at Disareen Group lp, a private investment partnership that invests globally based on a fundamental and long term value investing philosophy. Like us here at tip, Brett is also a huge fan of Warren Buffett. During Buffett's early partnership years from 1957 to 1969, he compounded his investors capital at 23.8% net of fees relative to the Dow Jones returning just 7.4%. We talk a lot on the show about the big bets that Buffett is making today. But I think what's more interesting is studying what he did in his first 10 or 20 years as an investor and how his investment approach evolved over time. Bret did a phenomenal job detailing 10 investments Buffett made during the 1950s and 1960s. And on today's episode I'll be outlining three of them. Philadelphia and Reading, Disney and American Express. There are certainly interesting takeaways from each of them and they also happen to be very fascinating stories. The story of Philadelphia and Reading has unusual parallels to the way Berkshire was structured years down the line. Disney was an off the beaten path investment with a visionary leader in Walt Disney, but they operated in a below average industry and had fairly unpredictable earnings. With American Express, they were weathering through the infamous Salad oil scandal where a businessman claimed to have more inventories of soybean oil than what existed in the entire country at the time. American Express found themselves in the middle of such a debacle as they warehoused and accounted for such large inventories that creditors relied on. With that, I bring you today's episode covering Buffett's early investments by Brett Gardner.
- [01:58]
Preston Pysh
Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host play.
- [02:22]
Clay Fink
Although we follow the investments that Warren Buffett's making today, what I think is far more interesting is how he invested in his early days, which is when he achieved his best investment returns. Buffett launched an investment partnership to invest capital on behalf of his friends and family in 1956. And over the 12 years that followed, he vastly outperformed the market. And during that time, Buffett implemented many of the strategies he learned from his mentor Ben Graham, who wrote the Intelligent Investor, which Buffett referred to as the best investment book ever written. To my surprise, Ben Graham did not achieve near the returns that Buffett did over his lifetime. For example, Graham's firm, Graham Newman Corp, they earned approximately a 14.7% return from 1936 to 1956, versus the market average of 12.12%. So Buffett, he really seemed to be doing something that was much different than Graham. And I feel that there's sort of this narrative that Buffett had it easy during the 50s and the 60s. He was essentially just shooting fish in a barrel with all the opportunities that were out there. And Buffett, of course, he did find stocks that were absurdly cheap. But investing is almost never as easy as just shooting fish in a barrel, especially when you look out over, say, one decade or a two decade time period. And when Buffett himself refers back to these early investments he made, he would often oversimplify the investments and the intensity of the research he did behind every single one. So Brett's book broke down 10 investments that Buffett made during the 50s and 60s. And there were a few in particular that I thought were just really fascinating and not widely discussed here on the show. So I wanted to share them with our audience here today. The first five investments he shares are from the pre partnership years, so the early 50s. And then the second five investments are from the partnership years, which is from 1957 through 69. After studying Buffett's early investments in remarkable detail, Brett concluded that Buffett's outperformance in his early career came down to just four main factors. So the first one here is his use of activism, helping him generate alpha. So he would take a significant position in a company and then influence the management teams to change corporate policy to help close the gap between price and value. The second key factor here is that he ran a highly concentrated portfolio, so he'd be willing to bet over 20% of his partnerships assets in just one stock. While his mentor, Ben Graham, he tended to be more diversified. And Buffett knew that spectacular investment opportunities were rare. So he really wanted to make those count. The third factor here to his outperformance was that he was just a tenacious and creative researcher. So he would even travel extensively to learn about companies, learn about industries, and he was just really pushing his understanding of the business much further than if he just sat in his home and was just reading all day. Buffett's well known for being an avid reader, but his willingness to reach out to others and connect with them helped give him an edge as well. And then the fourth factor here is that he developed a remarkable filter for sifting through investment ideas. He was able to filter through ideas quickly to find the best ones and concentrate his efforts on wringing out the most profit from those. Our audience is also well aware that Buffett primarily focused on stocks that were statistically cheap. And with the help of Charlie Munger and Phil Fisher, he would transition to put more focus on the quality of the business. Which is why I'm particularly excited to chat about Disney here later in the discussion. In 1951, Buffett was a student at Columbia and his professor, Ben Graham, he gave him the only A plus he had ever given in his security analysis course In Buffett, who was only 20 years old at the time, he was already having this success investing his own capital through a 5050 partnership he had with his father, Howard Buffett. After university Ben Graham, he turned down Buffett's offer to work with him for free. So he went down to Omaha. He worked for a stock brokerage firm that his father co founded. But then in 1954, Graham finally gave in and hired Buffett. So Buffett made the move back to New York and worked under Graham. So the first company I want to cover in today's episode was Buffett's purchase of Philadelphia and Reading in 1954. What I loved about this case study is how the case study, it really has lessons that Buffett would implement in the years that followed. So it helps illustrate that knowledge and experience, it really compounds in ways that we can only see looking backwards. So Brett shares a quote here from T.S. eliot at the start of the chapter, immature poets imitate, mature poets steal. So Philadelphia and Reading, it was an anthracite coal company. So I'll kick off this case study with a bit of background of the industry leading up to 1952. So throughout the 1800s and then the early 1900s, anthracite coal was vital to America's energy output, and it contributed to one fifth of the country's energy production at its peak. And around this time, anthracite coal had a near monopoly on the home heating market. Just one region in northeastern Pennsylvania, spanning 500 square miles, accounted for virtually the entire national production of this essential resource. To help transport the coal from the mines where it was produced, to the cities where it was consumed, the state of Pennsylvania issued a charter to the Philadelphia and Reading Railroad Company to build a railroad from Reading to Philadelphia in 1833. By 1871, the company became the largest anthracite coal operator in the country. After buying up a number of these coal lands. But they were in an intensely competitive industry. And just due to things like leverage, competition and economic volatility, the company ended up filing for bankruptcy three times between 1880 and 1896. And then to make matters worse, in the early 1900s, the government decided that these railroads that owned essentially all of the anthracite coal land, they were too powerful. And legislation was enacted to separate the railroads from the producers. It was in 1923 that the company was then split into two. So you had Philadelphia and Reading Coal and Iron Corporation. That was the standalone coal producer. And then you add Reading Railroad. It handled the transportation side of things. But the timing of the government's ruling really could not have been any worse for the coal producers, as the Production peaked in 1917, and there was this rise in competing energy sources like oil, gas, and other types of coal. Furthermore, anthracite coal was only getting more and more expensive to mine due to the easy to reach resources already being tapped out. The U.S. of course, experienced the Great Depression in the 1930s, and Philadelphia and Reading declared for bankruptcy in 1937 in their attempt to combat the structural decline of the industry overall. Now, Buffett, who was studying this company, it just seemed like they were in a helpless situation. Buffett was getting interested. He started buying shares in Philadelphia and reading in 1952 at 19 per share. The stock proceeded to decline to 9 per share. In Buffett, he was unfazed. He began loading up on the stock. By the end of 1954, he had invested $35,000 into the company, making it his largest personal position. Now, when looking at Philadelphia and Reading's income statement, it was just not a pretty sight to see. So from 1948 to 1953, revenues dropped by over 40%. Earnings per share dropped from $4 to practically zero over the same time period. In any investor who was interested in growth in revenue, growth in earnings, they would have passed on this stock almost immediately. So I would have been one of those people. However, the balance sheet told a totally different story. The stock sold for around 13 per share at the end of 1954, and it had a net current asset value of $9 per share. But Buffett, he would do his research on the assets the company owns. So there were these assets that were actually off the balance sheet, and he estimated those to be worth around 8 per share. So to the point earlier, Buffett was loading up at around 9 per share, and he thought the assets that the company owned were worth around 17. And then another item worth Noting was that Ben Graham, he was on Philadelphia and Reading's board of directors after purchasing the stock as well in 1952. And I believe he had a 11% position in his investment partnership. And although Graham, he hadn't taken any action as a board member By 1954, Buffett likely sensed that he would eventually make something happen to help close the gap between price and value. I'll also mention that the company's market cap, it was around $18 million at the end of 1954 in today's dollars. That would really make it a micro cap. So Philadelphia and Reading, it was run by Philadelphia businessmen. And these people, they typically owned little to no shares in the business, and they were just focusing their capital allocation strategies on the coal business, which might have been an obvious thing for them to do, since that's the business they were in. But this was actually quite foolish from a capital allocation perspective because the industry was declining. They weren't really making any money at that time from coal itself. And then in 1954, a group of Baltimore investors also accumulated around 11% of the shares. And these Baltimore investors, they approached Ben Graham seeking an alliance in November of 1954. So these two groups of investors, in addition to some other shareholders, they really wanted to see better capital allocation practices. These groups of investors owned around 30% of the stock, while Graham, he was actually quite pessimistic on the stock and the value of their current assets. Mickey Neumann, his partner, he convinced Graham to stick with it and not sell at a loss. And Mickey later stated that he could see that they could use a potential tax loss by abandoning these deep mines. And then they had actually piled up a ton of small and unusual amounts of coal. So he was seeing things on the balance sheet and things they could do potentially in the future, which we'll be getting into here. So by 1955, three of the nine board seats were held by these engaged shareholders, signaling to Buffett that change was hopefully going to come soon. And the company ended up changing its name from Philadelphia and Reading Coal and Iron Company to just Philadelphia and Reading Corporation. So they dropped the reference to coal in the name. While many investors likely felt hopeless about Philadelphia and Redding's future, Mickey took the initiative to transform the company. So his plan was to use the cash from liquidating excess inventory to go out and acquire profitable businesses whose income would be shielded from future taxes by their existing tax loss position. So I'll mention here that in 1955, the company reported a $7 million loss with $5 million of that being attributable to write offs related to the abandonment of mines. So the first company they ended up purchasing was a company called Union Underwear. And this was the country's largest manufacturer of men's and boys underwear, operating as a licensee of the Fritz Loom trademark. Jack Goldfarb was Union's previous owner looking to sell his business. And he ended up selling to Philadelphia and Reading because he deemed Mickey Newman to be a trustworthy and a likable person who would keep the business in good hands. So Goldfarb and Newman, they privately agreed to a deal in June of 1955. And when it was reported back to Philadelphia and Reading's board, the legacy board members were just absolutely furious about it. So a shareholder vote ended up taking place and wisely the shareholders ended up approving the deal. Philadelphia and Reading would purchase a union underwear for $15 million. And they were earning 3 million in pre tax profits which would partially be shielded by those tax losses. So additionally Goldfarb, he would manage the company for the next five years and he would receive a bonus of 10% of the subsidiaries profits which would of course incentivize him to continue growing the business. Brett pulls in a quote here from Berkshire's 2001 chairman's letter from Buffett. When Buffett was discussing the deal in that letter, so he stated those were the days I get goosebumps just thinking about such deals. So of the $15 million purchase, around $9 million of it was financed with a non interest bearing loan. And that would end up being paid just using Unions earnings. And then $2.5 million of Union's cash, it was used in financing the purchase as well, which really doesn't make a lot of sense to me personally, but that's what Buffett stated in the chairman's letter. So Philadelphia and Reading was just getting these extremely attractive terms in purchasing union underwear. On January 1st, Ben Graham became the chairman of the company and then Mickey Newman he was named the company's president. And the new shareholder group now had a clear board majority and they had full management control. And this really enabled them to double down on these better capital allocation practices. The next month Philadelphia and Reading acquired acme boots for $3.2 million at a valuation of just four times earnings. And like Union it was purchased with cash and a non interest bearing note that was tied to Acme's profits. And then a similar compensation arrangement was also put into place. So these two acquisitions proved to be tremendously successful for Philadelphia and reading. They earned $7 per share in 1956. And Newman, he just continued the strategy of acquiring good businesses at cheap prices in the years that followed. Another company he bought was Frito Loom, now having full control of the licensor and licensee. Brett explains here. Newman preferred to buy businesses whose management would stay in place to run their companies as subsidiaries of Philadelphia and Reading. And he preferred to use his network to source deals rather than rely on investment bankers. Jack Goldfarb introduced the Philadelphia and Reading president to Carol Rosenblum, a friend of his, who ran a handful of companies that manufacture work clothes, men's shirts, and sports clothes. Newman scooped up Rosenblum's businesses, paying with a mix of cash and Philadelphia and Reading stock. Buffett himself also Contributed. In late 1963, he found Lone Star Steel, a fully integrated producer whose biggest business was selling pipe to the oil industry. Buffett scooped up 300,000 shares around 9 and 14 in his partnership, and then reached out to Philadelphia and Reading to discuss the idea, saying it was something they thought they'd be interested in looking at. So Mickey Newman, he agreed and borrowed money to buy 73% of the company in 1965 for about $64 million, end quote. So that last purchase that I mentioned there, it ended up amounting to over 40% of the company's assets prior to the purchase, and then just led to this huge boost in earnings going into 1967. And then in 1968, Philadelphia and Reading ended up getting bought out, and it ended Mickey Newman's tenure as a control shareholder. So with regards to Buffett's investment, we don't know exactly when he sold shares, but we do know that he was buying in 1952, he was buying in 1954 when the stock drops, and he was also buying more shares in the 1960s. So presumably Buffett was betting that Mickey Neuman being active in the business was going to lead to substantial share price appreciation. So I think it's pretty safe to say that this investment had a really strong positive contribution to his overall returns. And this was an investment that really went full circle for Buffett. So as I mentioned, Philadelphia and Reading, they had purchased Fruit of the Loom in the acquisition spree. They went on and later down the line, Fruit of the Loom, it would go public in 1987 as a standalone company. And in the 2001 chairman's letter that I mentioned, Buffett discussed his investment in Philadelphia and Reading. And he had mentioned that Fruit of the Loom, it would go on to produce 200 million in annual pre tax earnings but the company got into some financial trouble and they filed for bankruptcy in 1999 in Berkshire Hathaway ended up buying it out in 2002 and it still owns the business today. And then when we look at Acme Boots, they also experienced just amazing success as a subsidiary of Philadelphia and Reading and it would become the world's largest boot maker. And then it would eventually also fall into a decline and then get purchased by Berkshire Hathaway as a subsidiary in late 2001. I'll just directly share Brett's insights here with regard to these I quote it is tempting to dismiss these two companies reentering Buffett's life decades later as an interesting coincidence. But Buffett's life is filled with such coincidences, and they perhaps point to some kind of emotional attachment he formed with the company during its formative years. To Buffett followers, the implication of these two coincidental acquisitions and his decision to discuss them in his letter should by now be obvious. Philadelphia and Reading was an important investment for Buffett largely because it served as a blueprint for Berkshire Hathaway. This blueprint came along exactly at the right time. Early in his career, Buffett was a completely passive investor in companies over which he had no influence. Later, with companies like Union Street Railway, he saw how activist shareholders could influence management teams to distribute cash and make other investor friendly moves. But with Philadelphia and Reading, Buffett saw up close the power of total control. All the many levers an intelligent investor can pull not when he influences management, but when he becomes management. Nearly all the characteristics that become famous hallmarks of berkshire Hathaway the 19th century Industrial beginnings the irreversible secular decline of the original business the initial cheap valuation the fight for full control the partial liquidation of inventory to raise cash the reallocation of capital towards new and better businesses the clever management compensation the behind the scenes tax minimization strategies the reliance on personal friendships to source deals in the fundamental integrity and trustworthiness of company leadership as the foundation of a sprawling conglomerate had some inspiration in the way Ben Graham and Mickey Newman transformed and built Philadelphia and Reading. End quote.
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Stig Brodersen
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- [23:54]
Stig Brodersen
Back to the show.
- [23:55]
Clay Fink
So I just thought it was really interesting, the observations he had here. Just so many parallels between Philadelphia and Reading and Berkshire Hathaway that Buffett would take full control of in 1965. It was a struggling textile mill that would make a similar transition, selling off these low performing assets to invest in much higher return opportunities. So next year I wanted to transition to discuss two investments from Buffett's partnership years. Disney and American Express. Around 1955, Ben Graham was ready to retire and he offered Buffett the opportunity to take over the Graham Newman investment partnership. But Buffett wanted to head back to Omaha. So Graham went ahead and closed the partnership in 1956. And then of course, Buffett went on to launch his own investment partnership. In Buffett's letter to his partners in 1961, he outlined the three types of investments that capital would be allocated to. So this would be the generals, the workouts and the controls. So the generals, these were undervalued securities where Buffett had no say in corporate policies, nor a timetable for when the stock might revert back to its intrinsic value. These investments might be correlated with the market in the short term, but over time he expected them to outperform the market over longer time periods. Now would probably characterize these as investments where he's buying a good business, he's getting a really attractive price, and these are likely to grow in value with the passage of time. So Buffett, he expected to buy five or six of these with a 5 to 10% weighting on each. So the second type of investment he'd make is workouts. These were securities whose performance depended on corporate actions such as mergers, liquidations, reorganizations and spinoffs. Buffett expected to have 10 to 15 of these in his portfolio and he thought this category would be reasonably stable as a source of earnings for the fund. So he would also be open to using some leverage to finance these investments, but they would only tend to be around 15% of the portfolio. And then finally we have controls. These were businesses where he took a significant position to change corporate policy. Buffett said that these investments might take several years to play out and would like the workouts, have minimal correlation to the Dow's gyrations. And he would occasionally allocate 25 to 35% of the partnership's capital into a single control investment. Probably Buffett's most famous control investment was Berkshire Hathaway, which he would start purchasing in 1962. It was a cheap net net, and he eventually accumulated a controlling interest in the company in the spring of 1965, after the president lied to him, Buffett fired the management and would become the company's chairman and CEO himself in 1970. And of course, he transformed this cigar but into the world's greatest conglomerate in the trillion dollar company we all know of today. So getting into the discussion here on Disney, given Graham's approach of buying statistically cheap securities, Buffett's purchase of Disney was a bit abnormal to him at the time. And we'll be getting into why that is exactly. Brett shares a very helpful background on Disney as well in the years leading up to Buffett's investment in 1966. So the motion picture industry, it has three key branches. You have the production, you had the distribution and the exhibition. Producers were in charge of creating the film. Distributors would sell, market, and deliver the film to theaters, and then the exhibitors would display the movie to viewers and collect commission fees from the theater attendees. Brett describes the distributors really as the kingpin of the industry. A select few large distributors, they've reached a large enough scale and network effect to turn a profit in the movie industry. The larger distributors, they would be totally fine if a big investment was made into a movie and to have it flop because they would be distributing a large number of movies. And odds are that a few might do really, really well. Furthermore, producers wanted their films to be shown everywhere, which meant that they would naturally want to work with the large distributors and the exhibitors. They wanted to limit the number of distributors they would work with to help simplify the process of displaying new films. So the way Brett puts it here is that the golden age of Hollywood began in the late 1920s. So there were eight major studios that dominated all aspects of the business, a number of which were vertically integrated by producing films, handling distribution, and they owned movie theaters as well. You think of names like MGM, Warner Brothers, 20th Century Fox, and Paramount. It was, of course, highly beneficial for these big majors to be vertically integrated. If they invested significant amounts of capital into a movie, they could then ensure that it was being played in the larger theaters in the big cities. That would attract a really sizable audience. The majors also utilized monopolistic tactics to their advantage, and the government ended up suing eight businesses in the industry in 1938. Now, the genius behind the Walt Disney Corporation Was, of course, Walt Disney himself. Walt established his first animation business in 1921. I think it's called Laugh O Gram Studio, something like that. In his hometown of Kansas City, he started it. The small studio had produced animated and live action cartoons, but it struggled financially as it declared bankruptcy two years after its inception. Walt then moved to Los Angeles and founded Disney Brothers Cartoon Studio with his brother Roy in 1923. This entity would later merge with two other predecessor companies to form Walt Disney Productions. Although Walt was a genius when it came to creating films, the really powerful distributors made it extremely difficult for even someone as creative as him to build a viable business. He experienced success in the beginning with cartoon films like Oswald, the Lucky Rabbit and Alice's Wonderland. But after a contract dispute with the distributor, Disney's animators were poached by them and his own film was remade. So he had given up the rights in the distribution agreement, and he had no recourse in getting his creation back. But Walt continued forward. He would create Mickey Mouse, which made its debut in 1928. Brett explains that Walt's dedication to the craft of animation helped separate Disney from its competitors. He would spend about twice as much on short cartoons than his competitors, and they initially had a monopoly on the Technicolor process that enhanced the quality of the cartoons. The quality of Walt and his team's work is really highlighted by the fact that Disney won every single Oscar for animated shorts during the 1930s. And in some ways, Walt kind of reminds me of Steve Jobs. He was someone that was just obsessed with the creative aspect of the business. And he wasn't too keen on necessarily delivering strong financial returns or behaving in a financially conservative manner. For example, Walt estimated that Snow White and the Seven Dwarves would cost around 250,000 to produce. And the actual costs were around $1.5 million, or around six times the original estimate. But the film, it also had incredible success, as it was the second highest grossing film in the 1930s. If we jump ahead to the 1940s, this was not a prosperous time for Disney, partially due to the closure of foreign markets during World War II. Box office receipts for the industry hit a Peak around 1946, and then they would enter a decline with the emergence of televisions entering the homes of essentially every single American. So in 1948, less than 1% of households owned a television. And then by 1965, that number would exceed over 90%. And over that same time period, you saw box office receipts nearly get cut in half. Since going to the movies as a Habit was in the decline phase. The producers started investing more capital to try and create these big hits. So people just felt like they had to go and see this movie in theaters. And it really wasn't as much of a recurring habit where people would go to the movies every single week. And this made investing in films a riskier endeavor, since the investment was higher and the average payoff had the potential to be lower than it was in the past. But the 1950s had two critical turning points for Disney. So first, they created their own distribution arm. So this gave them greater control over its movies. It allowed Disney to reduce its distribution cost. And then the second pivotal event was the construction of Disneyland in Anaheim, California. Walt and Roy, they had a bit of a dispute over Disneyland. So Walt decided to build the park under his own personal company, WED Enterprises. ABC Paramount would be a key partner in helping fund the cost to build the park. And then they would also own 34% of the park. Disneyland construction was estimated to be somewhere between 2 to 5 million dollars. And it ended up costing them 17 million. And then given how cost cautious Walt seemed to be, I would imagine that this would largely keep someone like Buffett away, who I think would prefer a manager who keeps a close eye on costs. And I think someone like Buffett wants to be able to predict future cash flows with a high level of certainty. But I feel like Disney was sort of an exception to this rule. So anyways, Disneyland opened its doors in 1955, and it was quickly successful. So ABC, they really didn't like how the costs, they just consistently went higher and higher than anticipated. So Walt Disney Productions, they would eventually buy out ABC share in 1960. The opening of Disneyland was really a key moment for Disney, as they weren't just a movie business. They were now like an entertainment company. They had these different and unique business segments that all just sort of complemented each other. So again, Buffett entered this investment in 66. When we look at the company's financials up to that point, you would really see three key business segments for Disney. So you had the film, you had Disneyland, and then you had their other segments. The film segment generally grew over time. It was a bit of lumpy growth just due to the unpredictability of box office hits. So they generated $60 million in film revenue. And this was a 31% increase due to the success of Mary Poppins. Disneyland produced 35 million in revenue. And then the other segment produced 13 million. So that brings total revenue to around $110 million. And then they produce net income of around 11 million. And I love how Brett pulled all of these numbers from Moody's manuals to really get a front seat view of the exact same documents that Buffett would have been reading nearly 60 years ago. Disney seemed to be a pretty high quality business considering that all three of their segments were growing at a healthy clip. And then you had a backdrop of box office receipts that was in a structural decline in Disney. They still weren't technically considered a major due to the number of films that they would release in a year. So the seven majors, they averaged around 22 films in the early 1960s, while Disney would average around six films a year. And despite not having that substantial scale advantage that the majors would have, Disney had an ebit margin of 39% in 1965, while the majors had EBIT margins of only around 10%. So if we look at MGM, to use as an example here, they generated more than double the revenue that Disney did, but they only generated a fourth of the profits. So just a quick glance at Disney's financials relative to the majors would clearly tell you that this business was really doing something much different than the majors just based on their size and their margin profile. In Disney, they had really established themselves as a family friendly brand that viewers had grown an affinity to. Families sought out Disney films, and they knew that the studio's films would be fun and they'd be appropriate for children. Occasionally, Disney would have a down year, but over time they would just consistently produce box office hits. During the Buffett and Munger family visits to Disneyland, I'm sure that Warren and Charlie spent a lot of their time analyzing the unit economics of the park. Instead of enjoying their time with family Disneyland, they generated their revenue by charging a general admission fee, and then they charge an additional amount for the ride. So in 1965, the park attracted 6.5 million attendees and it generated around $5 of revenue per attendee. And at this time, the park was generating around $4 million in income on $20 million invested into the park. And then Disney was planning to double that amount invested just in the next year, 1966. So one thing we haven't discussed yet is the governance issues related to Disney. So first off, to investors, it would really seem that the company was just so highly reliant on the brilliance of Walt Disney and his creative genius. So Key Man Risk was certainly a concern as investors, I think, but it wasn't really the only concern related to Walt Disney. I think investors should also be concerned how capital destruction might occur in someone like Walt Disney's creative pursuits. So similar to someone like Steve Jobs, he likely cared much more about the end product than producing strong financial results. And in some sense this can be really good, but if it's taken too far, then I think it can actually be really dangerous. Walt would often confess that he didn't care about profits. He had a history of producing strong financial results, but there was always the chance that he would bet big on his next big idea and then it would just fall flat on his face. And then the last point with relation to corporate governance is that Brett explains here that he really had a history of dubious self dealing with Walt and Walt Disney Productions. So this conflict arose in 1952 when Walt formed WED Enterprises to provide his family with income outside of the Disney Corporation. Walt Disney Productions consummated a contract with WED Enterprises to license Walt's name and execute a personal services contract shortly after the creation of wed. Brett writes here that the agreement was so contentious that three Disney board members resigned over it, fearful of shareholder lawsuits, which in fact did arrive. So Walt had the right to produce one movie a year outside of Walt Disney Productions, as well as the option to purchase a 25% stake in Disney's feature length live action films. And he frequently did exercise that right. Another revenue stream he had was from licensing his own name. So in 1965 he earned nearly $300,000 from this alone. If we inflation adjust this, it's around $3 million just from the licensing of his name. And then the final piece was that his entity owned a steam railroad and elevated monorail at Disneyland, which would net him around $2 million a year. So he was getting a quite substantial amount of income from these other income sources that weren't directly from the Walt Disney Corporation. So in other words, there was all this capital that was just being captured in this other entity that Walt owned. And it would generally be a huge red flag for shareholders. But Walt and his wife, they still owned 16 and a half percent of the Disney Corporation. And Buffett, he sort of saw things differently, I think, than a lot of other investors. So he ended up meeting Walt Disney and I quote him here, we sat down and he told me the whole plan for the company. He couldn't have been a nicer guy. So Buffett seemed to just trust Walton, where he was sort of taking the company. And Brett also points out that, well, he grew up in a poor household and throughout his life he had experienced others stealing his work. So he was probably pretty paranoid and didn't want to get taken advantage of. And he wanted to have these safeguards in place to ensure that things would continue, he would continue to get paid, and he bet pretty much everything on the success of Disney. So he even borrowed against his own life insurance policy and sold a he had built to help finance Disneyland, for example. I think it's still a concern for shareholders, of course, but it didn't stop Buffett from taking a sizable position. So he made it 8 1/2% of his portfolio. And Buffett actually bought 5% of the overall shares in the Walt Disney Company. So he put in $4 million. The whole business was worth 80 million. And when Buffett wrote about the investment, he had walked through some of their assets. So he said that the pirates ride that was just put in at Disneyland, that costed them 17 million. Mary Poppins, it just had huge success and it was likely to be monetized for many years ahead. He sort of compare these Disney films to an oil well where all of the oil would seep back in. And yet all of these entertainment assets they had created that had been marked down to zero. And then of course you had Walt Disney leading the helm. So Buffett stated, you didn't have to be a genius to know that The Walt Disney Company was worth more than $80 million. Buffett was especially fascinated by the enduring value of the hit films. So Disney, they'd repeatedly tap into this vault of content and continue to monetize it in some form. At the end of 1965, Disney owned hundreds of shorts, dozens of live action animated features in various other films and TV shows. Buffett thought that this library of content alone could be worth much more than 80 million, which is the entire value of the company at that time. He stated if he'd been a private company and said, I want to buy this, this is a deal, they would have bought it based on a valuation of 300 or 400 million. The very fact it was sitting there in the market worth $80 million was ridiculous. Essentially they ignored it because it was so familiar. But that happens periodically on Wall street, end quote. So when Buffett purchased the stock, it was around seven times earnings. And then the majors, they were trading at around 11 times earnings on average. And it could be argued that Disney was a much higher quality businesses than these other names. And unfortunately, Buffett ended up selling the stock a year later at a 55% gain. So the reason he sold it isn't crystal clear. But one catalyst that happened was that Walt Disney passed away in December of 1966. He was 65 years old at the time. And without the creative genius of Walt, it was a bit unclear where that business was heading exactly, and if they would be able to replicate the same number of success with the films, which, of course, they would end up doing. So in the years that followed, operating earnings just exploded. So earnings were 3.9 million in 1965, and they were 20 million just three years later. So while one could argue that selling Disney stock was a mistake, Buffett still compounded Berkshire Hathaway's capital at an extraordinary rate in the years that followed. So from 1967 to 1995, Berkshire's book value compounded at around 24%, while shares of Disney compounded at around 18%. So Buffett still did quite well without Disney. Disney was a bit of a different investment for Buffett, though, and that's what's sort of interesting about this. So he typically preferred companies with, of course, the strongest of moats. But Buffett recognized the management of Disney having the ability to buck the trend and create a moat in what was really a subpar industry movie and the entertainment industry, which really could be seen as a mediocre industry. From this perspective, Brett sees similarities in the Disney investment with other investments. So you look at Nebraska Furniture, Martin 1983, Borsche's in 1989, and Hallsberg's in 1995. Next, I wanted to cover Buffett's best investment from his partnership years, which was American Express. So American Express is just a textbook case study of being greedy when others are fearful and buying a good business when the market unfairly punishes the share price. The story of Buffett's investment in American Express starts with a fraudster named Anthony Tino DeAngelis. In 1955, Tino set his sights on dominating the soybean oil business. And he set up shop in New Jersey to accommodate ocean going steamers that could carry refined oil overseas from a high level. Tino would buy unrefined soybean oil from the Midwest, ship it to the Northeast, refine it, and then sell it overseas. His company, Allied Crude Vegetable Oil Refining, would provide more than 75% of the edible oils shipped overseas, with revenues of over $100 million annually. But the industry couldn't figure out how he was turning a profit when he was paying the highest prices for unrefined oil, and yet had these additional transportation costs compared to its Midwest competitors. Brett explained that the answer was that Tino was what he'd always been, a swindler. And this was his most ambitious swindle. Yet his salad oil refining business was simply a way to borrow as much money as possible, using his oil inventories as collateral and taking the proceeds to speculate in the commodities futures market. Not only was betting on the commodities futures market a pure gamble, much of what Tino borrowed was against collateral that didn't actually exist. Banks knew that Tino was a risky borrower given his past history, but banks were willing to lend to him as long as he had the collateral to help protect the lenders should he not be able to make payments. Now, banks aren't simply going to take Tino's word for the assets that he had, so they've required a third party, which is referred to as a field warehouser. They would control the inventory and help ensure that there was no funny business happening, and the warehouser would also collect a fee for performing that service.
- [45:30]
Stig Brodersen
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- [48:48]
Clay Fink
All right, back to the show. Brett explains that due to the success of its better known travelers checks and money order businesses, American Express's leadership thought entering the field warehousing business was a logical extension of his operations. The line of thinking was that the service would enable banks to make loans they otherwise wouldn't consider, which would improve American Express's vital relationship with said banks that sold American Express checks and money orders. So in 1944, American Express incorporated the American Express Field warehousing Corporation with $1 million of capital as its subsidiary to the parent. In 1957, Tino became a client of the warehousing business. Around this time, American Express's warehousing business was really nothing more than an afterthought or just a side project. Cumulatively, it really didn't make much money. And then late 1950s, they made pretty much all their money from two accounts out of 500, both of which were Tino's businesses. Some American Express executives even wanted to just dispose of the warehousing business altogether. One employee of the warehousing business even knew that there were underground pipes that were connected to the tanks with Tino's oil and Whatnot, and it sort of provided an opportunity for fraud or for some funny business to happen. And Brett, he outlines here a number of warning signs regarding the accounts with Tino. So In June of 1960, the President of the Field Warehousing subsidiary, Donald Miller, he received a call from an anonymous person who said that Tino's operation was a fraud. This person, who identified himself as Taylor, he had worked on that property. Miller had several conversations with Taylor, who claimed that the tanks were not filled with the valuable oil, but they were filled with useless water. Taylor pointed specifically to a tank. It was 6006, which he asserted had a metal chamber that went from the top of the tank to the bottom, while the rest was just full of water. So it's essentially this sort of real tank inside of this tank that was essentially just full of water. When the Amex inspector tested the tank, he would unwittingly drop his sampling device directly into the oil filled chamber, leading to just a sham metric. So he was pulling this measure from the tank, and he was pulling from this tiny tank that was inside of it, unknowingly. So Miller, he sent four men to investigate further, and they found water in the first five tanks they checked. No more than six inches of water should be in a tank. And anywhere from 1 foot to 8ft of water was in this huge 24 foot container. They said 10 of the 70 tanks contained what they referred to as an unusual amount of water. But this really didn't paint a clear picture because the inspection happened over a period of several days. And it was likely that the oil was being moved from tank to tank to hide the true water level from the inspectors. And Tino's employees were even allowed to provide some of the readings themselves. So upon their findings, American Express, they took no action, believing that there was enough inventory anyways to cover the firm's outstanding receipts and what they were borrowing against. So Tino also took offense to the search that American Express was doing. So he was actually threatening to take his business to another warehouser. But the reality was that Tino needed Amex much, much more than Amex needed Tino. So when Amex asked Tino for a balance sheet, he told them he couldn't show it to them because it was a competitive secret, which is just ridiculous. American expressed they didn't show much interest in uncovering the fraud. Meanwhile, Tino's inventory just ballooned higher and higher. In March of 1962, his inventory was 165 million pounds. By September, it grew to half a billion. I mean, this growth is just insane to read about. American Express's warehousing subsidiary, it guaranteed $40 million in borrowing power, which Tino used to get financing from banks. In 1963, the president of American Express, he decided that he wanted to just exit the warehousing business altogether. But Donald Miller, he persuaded him to keep the two largest clients, of course, owned by Tino, and he claimed that he had never had any issues with them. Brett states here, this was a clearly false assertion levied by an employee desperate to keep his job. End quote. Now, by this point, inventories crossed £850 million. So to put this into perspective, this was more soybean oil than the US Census Bureau said existed in the entire country. Again, it's just insane. And it was getting to the point that the potential for fraud was so large that everyone was just duped by what Tino had done. It kind of reminds me of the Netflix documentary on Bernie Madoff. All of the right things were just sort of happening at once in the house of cards. Just kept going higher and higher, and people just sort of believed that this was real. And then since the stack wasn't falling, everyone just sort of went on with the farce. By the fall of 1963, receipts crossed $87 million, $30 million, of which American Express had insurance on. So the insurance is another reason why American Express thought they'd be fine no matter what happened. And Clark, the president of American Express, he thought the risk in the business was just too high, so he wanted to fully exit. So they were set on selling the last two accounts later that year, on December 1st of 1963. And Tino knew at this point he was really in a bind because there was a couple of months where he wouldn't be getting receipts from American Express to keep that party going. So what he did was he just started forging these receipts saying that American Express said he was good to use that credit. And then meanwhile, Tino's purchases in the futures market were just exploding upward. So not long after commodity prices would drop. And the broker that Tino was using, they realized that he was doing most of the buying when the prices were going up. So they went to investigate his books to ensure that he was going to be good to pay up. And that was when Tino realized that the fraud was up. So his company declared bankruptcy on November 19 of 63. This was less than two weeks before it was going to be sold off American Express's books. So American Express thought they really had nothing to worry about. They believed there was plenty of inventory to cover the receipts. And if they were wrong, they had this $30 million insurance coverage to help cover any of the losses. And later that week, the inspectors looked at the tanks and realized there was no oil there. And it quickly became clear that Tino had forged receipts. So American Express's subsidiary, they were sued for losing what was believed to be $15 million in oil. And the salad oil scandal was now front page news. Brett writes here, tank 6006, the one that Taylor warned about, was supposed to hold $3.5 million of soybean oil. Instead, salt water poured out of it for 12 days. And sure enough, the special chamber, which did hold a few hundred pounds of soybean oil, fell to the bottom of the tank, end quote. By the end of November, shares in American Express had fallen by 26%. There ended up being a total shortage of oil of around $175 million, which American Express vouched for. A large majority of the banks and the export companies who hadn't been paid in this whole scandal, they were now looking at American Express's subsidiary to get paid. Since they were legally creditors and American Express, they had been in the business of being trusted by all these institutions, all these banks for the past a hundred plus years. Tino was indicted on December 23rd. And then on December 30th, American Express's warehouse subsidiary, they filed for bankruptcy. So $210 million in claims arose. The subsidiary had practically no assets and American Express's consolidated equity was around $78 million. So by the end of the year, American Express stock was down 40%. And the entire fate of the business was really in jeopardy in this paragraph here really caught my attention that I'm going to read. As if the situation wasn't stressful enough. American Express shareholders did not possess limited liability. Due to its history in the express business, where a lack of disclosure was a competitive advantage, the company had never incorporated. This meant that creditors could go after individual shareholders if the company couldn't pay its debts, end quote. Now talk about a reason for people to just dump this stock if they were to somehow be liable for the management's wrongdoing here. So Buffett, he was 33 at the time. He was known for buying these cheap and unloved stocks that were generally flying under the radar. He was keeping tabs on the American Express scandal. And American Express at the time, this was a extremely well known company. He wrote a letter to their president and he encouraged him to use shareholders money, which included Buffett at the time. To pay creditors harmed by the scandal. So mostly we've been talking about the American Express subsidiary here, which isn't part of the core business at the time. So I wanted to cover that a little bit as well. So American Express, this company started in 1850. It essentially acted as an intermediary between banks. So by the end of the 1850s, they covered 6,000 miles of railroad from New York to the Midwest and Canada. And then with the help of American Express, individuals were able to write checks to pay each other. And American Express would be on the back end, helping banks settle these transactions. One interesting fact that Brett shares here is that money orders, which are a type of check, were first created by the US Post office so that postal workers wouldn't try and steal the cash out of letters. American Express really created a network effect for themselves, as they had over 4,000 offices in 19 states, and they had a first mover advantage in the money order business. While the company did earn a sales charge when selling these money orders, the real money to be made was really in the float that they had. They would have this flow because someone would deposit, say, $50 for a money order, and it might take a month for that money order to get cashed. And then they also got into the traveler's checks business, which was a common way for travelers to finance their trips abroad, which, according to Brett here, was the only product that American Express ever invented themselves. This was rolled out in 1892 and led to American Express extending their relationships with banks in Europe, which would prove to be highly valuable relationships down the line. So tying this back into the float. While a money order would typically be cashed in a few days, the typical turnaround time for a traveler's check was around 45 days, and some customers even would take over a year to cash that. There was a travel boom globally post World War II that would benefit the traveler's check business tremendously. By the early 1950s, they surpassed $1 billion in travelers checks issued, and the average flow outstanding was $250 million. There was also a rise in executives who would travel for business and entertain clients at restaurants, nightclubs, and theaters. This type of consumer was typically fairly wealthy, and they typically did not want to carry a lot of cash. This led to the invention of the charge card. A company called Diners Club created the first universal restaurant charge card that was prominent in New York City restaurants. The cardholders would be charged for a meal. The restaurant would provide a 5 to 10% discount to encourage these wealthier consumers to eat at their restaurant, while also knowing that cardholders would typically spend more than someone that was using cash. And Diners Club would then pay the restaurant to provide final settlement for that transaction. Then American Express, they saw these charge cards, they were competing with their existing business and they decided that they wanted to launch their own card as well. So they launched the American Express credit card in 1958, which was five years prior to this solid oil scandal that was exposed. Just to illustrate where we're at in the timeline of the businesses history, Brad also points out here that the initial launch of the credit card was actually a charge card, since the outstanding balance was actually required to be paid in full each month and cardholders weren't allowed to carry forward the balance from month to month the way we use credit cards today. American Express up to this point and really built a strong reputation and brand for themselves and they really became somewhat of a status symbol. So these cards, they just spread like wildfire once they were launched. So due to the value of the brand they built, many restaurants and hotels wanted in on the these cards. And by opening day they had over 17,000 establishments part of their network on day one. And over a quarter million cards were issued with a huge backlog of applications that they still had to work through. Initially, the card business was really just a mess for American Express for a number of reasons. They were overwhelmed with the demand for cards. They didn't know exactly how to assess credit risk. Customers weren't used to paying their cards within a month and the establishments really wanted paid within 10 days. So they actually considered getting out of the business. But George Waters, he was hired to run that division and he really set things straight and took them towards a path to profitability. While the cards the banks issued were largely unprofitable in the 1960s, the American Express cards reached profitability in 1962 and really held a fairly dominant position with their extensive network that really just continued to grow. And although American Express had several business segments, the two segments that really mattered for investors in the 60s were the Travelers checks and then the charge cards. They had two thirds share of the traveler's check market and billings were growing at a high clip, high 20% range in 1963 as a result of both cardholder growth and then expenditure growth. As many of our listeners are likely aware, the company also tends to target a higher income clientele. So they really just dominated that cohort of consumers. So when Buffett saw the Salad Oil scandal unfold and the stock was dropping, you know, 20 to 40%, he didn't immediately buy shares. The big question was how much was American Express going to need to pay up for the scandal. Bret explained that it was in the best interest of both parties to settle the issue. So if American Express, if they refuse to pay up, they really risks the future of their traveler's check business. So they wanted to make banks happy in American Express, they generated substantial business for the banks. So they didn't want American Express to disappear overnight. So it was in both parties interest to keep American Express alive and to settle on some sort of payment in some form or fashion. So eight days after Tino declared bankruptcy, the president of Amex put out a statement. If our subsidiary should be held viable for amounts in excess of its insurance coverage and other assets, American Express Co. Feels morally bound to do everything it can, consistent with its overall responsibilities to see that such liabilities are satisfied. End quote. So In April of 1964, just a few months later, American Express, they put together a payment plan to pay back creditors, which wasn't near what the creditors had lost in the deal, but it brought to question what Amex was and wasn't liable for. So for example, should Amex be responsible for these forged receipts that these entities accepted as payment? So there was really a lot of uncertainty for investors with how much Amex was going to need to pay up. And for someone who was a balance sheet focused investor like Buffett, this likely, I would think would be like a big red flag for him. But Buffett was more intrigued by what wasn't on the balance sheet. So it was how American Express was perceived in the minds of its consumers. So in the money order business and the traveler's checks business, American Express had fundamentally changed the composition of cash. A customer would physically hand cash to an agent in exchange for a piece of paper that they would use to make payment elsewhere. And the credit card business also changed the composition of cash. American Express had really become this middleman of choice for many of these wealthier consumers to safeguard their valuable hard earned cash. When it came to the warehousing business, it really had nothing to do with their cash cow, traveler's check and card business. Most customers might not have even known this business existed anyway. So Buffett of course would want to know if the scandal would somehow impact these other businesses. Buffett and his stockbroker friend Henry Brandt, they went on to do a bunch of scuttlebutt research by visiting a lot of businesses to see how the scandal affected their view of the company. Grant would do a ton of the heavy lifting here with this regard. So he would research bank tellers, restaurants, hotels, credit card holders, and he put together this thick pile of research for Buffett to consider. All the research indicated that business was just business as usual. In fact, growth was actually accelerating for American Express. When we look at the valuation at the time, the market cap was around $180 million. And then the enterprise value to EBIT, it was around 8 at the time. So this doesn't adjust for the scandal that occurred. And at the time, the market multiple was around 19. So it was a substantial discount to the market. And even with the uncertainty of what Amex would owe in the scandal, it was fairly clear that the stock was pretty cheap if you assume just modest assumptions for growth. So they had double digit growth in revenue and earnings in the previous decade, and it was likely fairly conservative to think that that would at least continue for the next few years. From there. Buffett later stated, american Express is one of the greatest franchises in the world. Even with terrible management, it was bound to make money. American Express was last in the traveler's check market and had to compete with the two largest banks in the country. After a short time, it had over 80% of the business, and no one had been able to shake this position, end quote. So Buffett went on to buy 70,000 shares at $40 a share. It was the partnership's largest investment at the end of 1965, and the business just went on to crush it in the years that followed. So revenue more than doubled in the next five years and earnings more than tripled. From 1963 to 1967. Buffett was generally buying shares while earnings were compounding at over 30% a year. And by 1967, the company had become more fairly valued, and he was selling off some of his shares, locking in an annualized return of over 30% per year. And his exit was also well timed, as the Amex would actually end up facing significant competition in the years that followed. And similar to other investments that Buffett made, this is a stock that would actually reenter his portfolio in the future. So he bought convertible preferred shares for Berkshire Hathaway in 1991 when the company was struggling, and then he bought common shares in 1994. So, with the benefit of hindsight, Buffett was pretty wise to sell his shares, as he was able to compound his own capital faster than had he just held onto the shares, similar to what happened with Disney. So Amex. It was also another early example of Buffett sort of evolving from a quantitative investor to more qualitative. He wrote in 1967. Interestingly enough, although I consider myself to be primarily in the quantitative school, the really sensational ideas I've had over the years have been heavily weighted towards the qualitative side, where I have a high probability insight. This is what causes the cash register to really sing. However, it's an infrequent occurrence as insights usually are, and of course no insight is required on the quantitative side. The figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on the qualitative decisions. But at least in my opinion, the more sure money tends to be made on the obvious qualitative decisions. End quote. All right, so that wraps up the three case studies I wanted to touch on today. I wanted to extend a special thank you to Brett Gardner for allowing me to review this wonderful book on the show. If you enjoyed this episode, I would definitely encourage you to go out and buy his book on Amazon. We'll be sure to have that linked in the show notes below. He did such a phenomenal job on this book and I know firsthand that he put a significant amount of research into this. So this episode certainly wouldn't have been possible without his great work. And since this is one of my last episodes of 2024, we're in December now, I just wanted to recap some of the highlights from our Tip Mastermind community from the year. Our Tip Mastermind Community is our vetted community of entrepreneurs, private investors and high net worth individuals to talk stocks, share ideas and network with high quality and like minded people. During the year, Stig, Kyle and I hosted a number of live in person events in Omaha, New York City, London and Copenhagen. We also hosted more than 70 live Zoom discussions that were recorded for our members and we continue to onboard dozens of amazing people into our group as we approach our limit of 150 members in December. Here we have a number of great calls booked for our members. We have a presentation on Brookfield by one of our members, a member Spotlight with a quality oriented fund manager, a Q and A with podcast guests Roger Fan and Lawrence Cunningham, and social hours to give members the chance to meet others in the group. We'll also be hosting a few great dinners and socials in Omaha and May and we're looking to onboard five new members this month. So if this sounds of interest to you, please sign up for our waitlist@theinvestorspodcast.com mastermind that's theinvestorspodcast.com mastermind or simply click the link in the Show Notes below. You can also shoot me an email if you have questions or concerns or whatnot. That's Clay theinvestorspodcast.com and I can get you pushed forward on that waitlist. So with that, thanks so much for tuning in and I hope to see you all again next week.
- [71:00]
Preston Pysh
Thank you for listening to tip. Make sure to follow we study billionaires on your favorite podcast app and never miss out on episodes. To access our Show Notes, transcripts or courses, go to theinvestorspodcast.com this show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.