“The highest rates of return I’ve ever achieved were in the 1950’s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” – Warren Buffett, 1999
Most Buffett fans have seen that quote. I recently had a few questions and comments that I’ve been meaning to address regarding Buffett’s early strategy. In fact, my own thoughts on how Buffett really generated those 50-60% annual returns in the 50’s have changed as I’ve really researched his past holdings. In my opinion, there are two things regarding Buffett’s early investment style that most people don’t fully weight:
- Buffett understood the power of compounding at an early age, and cared about the quality of a business and its long term earning power, even in the early days
- Buffett’s portfolio management strategy, and specifically the level of concentration he put on the compounders
There is a perception out there that Buffett made his huge returns in the early years by buying a bunch of cheap Graham style cigar butts and flipping them for profits. At the annual meeting a few years ago, he mentioned that the majority of his returns—even in the early years—were due to just a select few decisions. The rest were largely average results. I think he mentioned he owned over 400 securities during the time of his partnership (not at once—400 over the entire time period of 13 years).
It’s hard to say exactly how he made these 50% returns in his pre-partnership years, but we do know about a few of the investments he made. From studying his early letters and the two main biographies, I believe that he made his returns largely through the higher quality businesses that could compound value (in some cases good businesses with profitable histories that were also ridiculously cheap), and not the cigar butts that everyone talks about. In fact, you can piece together a few of his early investments from reading Snowball and a few other biographies.
Some Early Buffett Investments
Buffett made 75% in 1951, mostly because of a large position in GEICO, that proceeded to double in the first 18 months he owned it. He sold it too soon (it would rise 100x over the coming decades), but he replaced it with another insurer in 1953 that was a profitable business trading at around 1 time earnings and a fraction of book value. Most are familiar with a column Buffett wrote called “The Security I Like Best”, which was an excellent writeup on GEICO. Fewer people know about the next insurance stock he invested in called Western Insurance. Buffett referenced Western Insurance at a talk at Columbia in 1993, using it as an example of stocks he found by flipping through Moody’s manuals:
“I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual was $12 to $20. Earnings were $16 per share.”
Buffett also wrote up a column on this stock, demonstrating how remarkably cheap the stock was. The interesting thing about looking at the old Moody’s manuals is that the company was profitable, and had a stable operating history with rising premium volume and consistent earnings. As a side note, this stock actually traded as a low as $1 in 1949, and appreciated up to $95 in 1955, a 95-bagger for those fortunate souls who bought the stock six years earlier!
Buffett was buying Western in 1952 and 1953, and although I’m not sure where he sold, it’s likely he at least doubled his money on this stock as well. He said he was buying between $12 and $20, and wrote his analysis write-up in early 1953 when the stock was at $40–later that year it traded to $65 and then to as high as $95 two years later.
We know how good of a company GEICO was, but Western Insurance–despite being incredibly cheap–was also a quality business. Of course, the attraction was not just that it was a good business, but it was cheap: When Buffett wrote the column, it was trading at $40, and had made $24 per share of earnings the previous year in 1952, a year Buffett called a poor year for auto insurers. Buffett felt the company had “normal earning power” of $30 per share, which gave this stock a P/E of around 1.3 at that price.
But back to the issue of the firm’s quality: it’s interesting to note how Buffett was thinking, even in the early days of the early 1950’s, when he was supposedly a Graham style cigar butt investor. Notice how Buffett ends his write-up on Western Insurance:
“Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40”.
Buffett seemed enthusiastic about the earnings power and the profitability, and of course the valuation. But the article doesn’t seem to emphasize valuation as much as you’d think (considering the stock had a 1 P/E)! He clearly is excited about the profitability, the growth, and the stable operating history. It’s also interesting to note that he is recommending a stock that has gone up 40 fold in the last 4 years!
Graham’s Influence on Buffett
Many people think he made 50% by buying a bunch of Graham and Dodd cheap stuff and constantly flipping them. It is certainly true that he bought a lot of cigar butts, but I think even at age 21, he was a much different investor than his mentor Ben Graham. Buffett understood that a quality business can be very valuable as it compounds for you. He was much more interested in GEICO than I think even Graham was (who was more interested in it because of the margin of safety–they could have liquidated it if it didn’t work out). Graham wouldn’t have likely bought GEICO as an outside minority common stockholder. He bought it as a partner and became chairman of the board. Buffett saw GEICO as a compounding machine and put 65% of his assets into it.
One thing I would agree with is that his turnover was much higher in the early years—partly because his conveyor belt of ideas was moving at a much faster speed and he was continually finding ideas that were much more undervalued than the ideas in his portfolio that appreciated, so there was a consistent cycling of ideas.
There are also examples of more of the classic Graham style investments that everyone thinks of… and looking back at some of his early investments, many of them were special situations (the Jay Pritzker cocoa bean investment skyrocketed about 5 fold or so very quickly–that’s one example of a special situation investment he made).
But if you look at his returns and past holdings, I think he was interested in the compounders at an early age… and although he bought net-nets and cigar butts like Cleveland Worsted Mills and Marshall Wells, most of the money he made–even early on–was due to a few big winners that were, for the most part, superior quality businesses. And later in his partnership days–much of the same. He owned a lot more stocks, but even he admits that the big money came from just a few ideas.
An Early Partnership Investment
Everyone knows about the hugely successful American Express and Disney investments in the partnerships, but even in the 50’s, one of his first investments was Commonwealth Bank. And if you read that early partnership letter, you’ll see that Buffett wasn’t interested in it only because it was cheap. He thought that the bank was a high quality bank that was growing intrinsic value over time. Here is how he summarized his thoughts on this particular stock in 1959, which he felt had a current intrinsic value of $125 per share:
“So here we had a very well-managed bank with substantial earning power selling at a large discount to intrinsic value… we had a combination of 1) Very strong defensive characteristics; 2) Good solid value building up at a satisfactory pace, and; 3) Evidence to the effect that eventually this value would be unlocked although it might be one year or ten years. If the latter were true, the value would presumably have been built up to a considerably larger figure, say, $250 per share.”
He mentions management, earning power, and his estimation that the business will likely continue growing intrinsic value over time. I don’t think he was excited about net-nets that were not compounding intrinsic value as much as he liked the quality businesses. Everyone talks about Munger having this influence on him, and that’s true, but I think Buffett understood this early… even back to his gumball machine days in the barber shops: Cash flow is important. Better yet, cash flow from gumball machines that can be reinvested into more gumball machines is even better.
To Sum It Up
It’s interesting to study Buffett’s past results for obvious reasons. I think many investors are always trying to compartmentalize Buffett’s career and categorize the various phases of his career. There have certainly been phases and evolutions, but I think his ideas on investing in the early 1950’s were much more advanced than even Buffett himself lets on.
And one quick comment on Graham: I believe there are similar misinterpretations on his strategy as well. He is often labeled as a “net-net” investor, and he did employ that strategy in his early hedge fund, but it was one of five or six separate strategies he employed, and it only represented a small portion of his funds. In fact, in some of his writings Graham was much more interested in quality and earnings power than most people realize (see this post on a lesser known book by Graham).
So in terms of mentors, Buffett was most influenced by Graham–there is no question about it. But Buffett was an investing genius, and I think he took influences from Graham, Fisher, and Munger and molded them with his own investment thoughts.
Next week, I’ll finish up my discussion on the importance of Return on Invested Capital. At some point in the near future, I’ll post some comments on some small banks (an area that I have one investment in and will likely have a couple other investments in soon), and a brief summary of one of Buffett’s first bank investments.
Have a great week!