Case StudiesSuperinvestorsWarren Buffett

Buffett’s Investment in Dempster Mill–A Cigar Butt

I came across a case study that discusses Dempster Mill recently. I thought I’d post a brief summary of some notes I jotted down while reading it. Dempster Mill is a company that Buffett bought in the early 1960’s when operating his partnership.

The company manufactured farm equipment, specifically windmills and water irrigation systems. It was a difficult business because the farm equipment it made was not much different than its competitors’ products, and because of these commodity-like economics, the business produced low returns on capital, and in fact struggled to break even. But despite its poor earning power, Buffett bought the stock because of the discount to its net tangible assets–a classic cigar butt.

Here is Buffett’s introduction of Dempster Mill from his 1961 letter to partners:

“Dempster is a manufacturer of farm implements and water systems with sales in 1961 of about $9 million. Operations have produced only nominal profits in relation to invested capital during recent years. This reflected a poor management situation, along with a fairly tough industry situation. Presently, consolidated net worth (book value) is about $4.5 million, or $75 per share, consolidated working capital about $50 per share, and at yearend we valued our interest at $35 per share…”

Buffett bought this originally as a generally undervalued stock—one that he bought because it was cheap and expected to sell out at a profit at some future date. Indeed it was cheap: Buffett paid around $28 for a stock with $50 of working capital and $75 of book value. However, the stock remained cheap as the business struggled, and Buffett began buying more of it—eventually owning 70% of the company. The position represented 21% of his portfolio.

What’s interesting is that Buffett took control of the company, and expected two possible ways to profit from this investment: the company could improve its operations and achieve a higher valuation in the market, or the value of the assets could be monetized (through liquidation or asset-sales).

“Certainly, if even moderate earning power can be restored, a high valuation will be justified, and even if it cannot, Dempster should work out at a high figure.”

Buffett and Charlie Munger worked together on this investment—and they brought in their own manager in hopes of restoring the company to profitability.

The case study provides the complete story of this investment, or just read the 1961-1963 partnership letters for complete details. Snowball and The Making of An American Capitalist provide more commentary from Buffett and Munger as well.

Dempster Mill Summary

Here are some notes I jotted down as I read the case study and reread the old partnership letter:

  • Buffett bought the stock of Dempster Mill extremely cheap (as low as 25% of book value)
  • He was very patient, buying it in dribs and drabs over 5 years—from 1956 until 1961
  • At first he was content to buy a cheap stock, but as he bought a larger stake in the company, he began taking more control of the operations
  • Management paid lip service to fixing operations and cutting bloated costs
  • Eventually, Buffett owned 70% of this business with low earning power and bleak prospects. He needed to turn it around in order to either sell the company or improve earnings.
  • Charlie Munger, who wasn’t particularly fond of poor businesses like Dempster, recommended hiring Harry Bottle.
  • Bottle was surprisingly able to turn the company around. He cut costs and liquidated assets. Bottle sold down excess inventory so Buffett could use the proceeds to invest in stocks for Dempster’s account. Bottle laid off workers, closed unprofitable branch locations. He even was able to improve business operations which led to modest sales growth, and thanks to his focus on keeping costs under control, profitability improved.
  • Bottle helped Dempster gain profitability and use up its tax losses, which eventually led Buffett to want to either fold Dempster’s business into BPL partnership (to avoid the corporate double taxation) or to sell the company outright.
  • The company ended up getting sold around book value for $80 per share, a nice increase from the $15-$30 per share where Buffett was buying his shares at years earlier.

My Own Comments on the Dempster Mill Investment

The investment was a big success for Buffett’s partnerships (BPL). I think the key though was not the bargain price that Buffett paid for the shares, but the fact that Harry Bottle was able to turn the company around by stabilizing sales, cutting unnecessary costs, and improving profitability. If Bottle didn’t come along, the company’s management likely would have continued down the same path, which would have led to mediocre or poor operating results, which likely wouldn’t have resulted in anywhere near the success that BPL had on this investment.

When it was all said and done, BPL had over 20% of the partnership invested in Dempster, and the stock went up nearly 3-fold from the original purchase price.

But if it weren’t for the shrewd strategies of Harry Bottle, this could have been a mediocre investment at best, and at worst, in Buffett’s postmortem words:

“If Dempster had gone down, my life and fortunes would have been a lot different from that time forward.”

The moral of the story is that Buffett invested in a cigar butt that went nowhere for years until he was able to gain control and install his own manager—who had a focus on essentially liquidating the company. If it weren’t for Bottle, the company would have almost certainly continued to destroy value.

Unlike BPL’s purchase of American Express or Disney whose intrinsic values were increasing as time went on, (and whose stock prices responded accordingly—the  former went up 3x for BPL and the latter gained about 50% the year after Buffett bought it), Dempster was eroding its intrinsic value each year that it continued to exist. The best result is a quick sale or liquidation for these types of investments.


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com

18 thoughts on “Buffett’s Investment in Dempster Mill–A Cigar Butt

  1. I’ve always loved the Dempster Mill story…

    I wonder though. Let’s say he had put the money into AXP or DIS? How would it have worked out? Would he have compounded money faster or slower?

    Cigar butts can sometimes be more trouble than they’re worth.

    1. I would say usually, that is probably true. But in this case he was able to nearly triple his money (his average cost in Dempster was around $28 and he sold it for $80). He owned the stock for a long time, so it’s possible that some other opportunities would have been better (probably GEICO). But the investment ended up working out. That said, I would bet that Buffett would separate the good result from the decision to buy it. I think he probably views it as a mistake, and if it weren’t for Harry Bottle, the investment almost certainly would have turned out much worse.

      1. Indeed, it was an excellent result from a very poor company. At 25% of book value, he was probably calculating a return closer to 100% (liquidating assets at half price), rather than a triple.

        Do we know how many years he owned the Dempster Mill shares for? It isn’t immediately apparent.

        1. He bought his first shares in 1956 for $16 I believe. It was one of the first investments he made in his partnership. He steadily bought more shares between $16 and $30 between the years 1956 and 1961, until he had about 20% of his assets in Dempster and had owned 70% of Dempster’s shares (I think Buffett had around $7 million assets under management at this time, so this gives you an idea of how tiny Dempster was–using these numbers I get a market cap of around $2 million, which in today’s money would be a market cap of around $12 million, so a true microcap). I think he bought these shares over 5 or 6 years (even bought shares from Walter Schloss, who also owned the stock), and had an average cost of about $28 per share. Still a very solid IRR over the course of that 7 year period, especially since the majority of his stake was purchased just a couple years before the final sale of the company.

  2. This deal worked out better than WB expected but I think in normal case he still got a modest return for quite sure. He seem to satisfy with that with some portion of the porfolio.
    If you have a chance like this right now and you have no Harry, would you do it?

    1. Tung, I personally wouldn’t be interested in something like this without a Harry Bottle (the manager that turned things around). I think the company would have destroyed value for Buffett if it weren’t for the impressive (and difficult) cost cuts that Bottle instituted. People sometimes forget how difficult this type of turnaround is, not just logistically, but emotionally. The whole town hated Buffett because of the layoffs that Bottle was doing. Buffett himself fired the previous CEO to bring on Bottle, which was difficult. But the whole town was against the liquidation and fought it tooth and nail. That’s why the path of least resistance was always to just leave the status quo. But the status quo was a mediocre windmill company that was not making any money and steadily destroying value, so Buffett understood what he had to do.

      But short of being in a control position, I wouldn’t have any interest in investing in this type of stock. Not that people can’t make money from such cigar butts, but I prefer businesses that are growing value over time.

      1. Thanks. You remind me of the real world instead of just focusing on financial.
        But sometime liquidation is not that bad for employees. In our market(Vietnam), one company(https://www.vcsc.com.vn/tin-chi-tiet/kls-delisting-of-kls/54634) is liquidating and the employees got big bonus(6 months salary plus other) and it’s not that difficult to find another job. The stock also raised to liquidation value so shareholder is happy too. 🙂

        1. I missed one important point: KLS is a stock broker and is not labor intensive(at least compared to its total asset ). For labor intensive companies, problem may be much harder.
          (I participated in a liquidation of a manufacturer company but cannot feel the pain of these employees because the company was far away)

  3. This story firms up my belief that small investors should stay away from such stocks. People like us can never place their own manager and turnaround businesses.

    1. I agree. I think in any investment, the management is absolutely crucial to the outcome of the investment. I’m not sure I buy the idea that “prefer a company that any idiot can run, because one day, one will”. I get why people say that, but I think even great businesses can be compromised by poor management (it almost happened to Coke in the early 1980’s). But yes, especially with a business like Dempster, unless you have a heroic manager, you have no shot (and even then I’d say it’s a long shot).

      I once read an article about Tom Brady that discussed all the luck that was involved for him to win 4 super bowls (the fumble that was ruled an incomplete pass (tuck rule), the two snowy field goals that tied and then won that game, Seattle throwing the pic on the 1 yard line, etc…). There were about 20 different examples cited in this article, and the point was not that Brady won those rings solely because of luck (obviously, that’s not the case), but that every champion needs some luck in order to win. LeBron James needed some missed free throws down the stretch in Game 6 by the usually certain Spurs in order to win in 2013. Sometimes, the best get lucky. Dempster was probably the equivalent of that 45 yard snowy field goal in 2001.

      I happen to disagree with Buffett that if Dempster went down, things would have been much worse going forward. Things would have been different for sure, but Buffett still would have done very well subsequently. Just like if Brady didn’t win in 2001, he probably would still be a champion today (although maybe not to the same extent).

  4. I love the story of Dempster Mill, especially because it was a company out of Beatrice, Nebraska near my home town. I recently read about it in Buffett’s Ground Rules (a great book by the way). With regard to your comment to Yogesh, I too would think Buffett would still do well subsequent to a failure of Dempster. But perhaps Buffett’s comment is implying that the risk of loss of capital was greater than he would have wanted or expected (thank god for Harry Bottle).

    When I read stories about Buffett’s past investing, it makes me want to see him in action today with a smaller pool of capital to see what types of investments he would dabble in. Understandably, his investment philosophy has changed over time to (still undervalued) long-term, high return on capital businesses. But maybe he would end up buying a few cigar-butts if they were cheap enough!

    Thanks for the post, I enjoyed the write-up.

  5. Investing in a cigar butt comes with a caveat: you wanna take the last puff as soon as you can.

    So most importantly, you need a lighter. The risk of investing in cigar butts is that you may never find your lighter, or it comes only after a long period of time.

    Warren got his lighter on Dempster Mill by owning 70% of the company. He managed to light up his cigar butt 2 years after becoming the largest shareholder (or 7 years after he initiated the position) and took the last puff with 186% gain.

    For retail investors like us, if you insist to invest in cigar butts (presumably someone pointing a gun to your head), you need to diversify and hope that some lighters appear as soon as possible while waiting for the remaining to come. You may still outperform the market but be very sure that you won’t get 186% gain in 2 years.

  6. Great analysis of the Dempster Mill case. Thanks for writing this post.

    Could you Please post some more investment cases from buffet’s past investments, analyzing them in your style, the same way as you have done it here. When you explain all the bits and pieces of an investment it gives us clear understanding of what was the biggest contributor to success/failure or a particular investments.

  7. Hi John,

    Have you read “Buffett’s Ground Rules”? Great new book analyzing Warren’s early partnership years and the letters. It also covers the Dempster case and others extensively.

    I think you would enjoy it.

    Cheers

    1. Thanks for the recommendation. I need to get a copy of that book. Haven’t read it yet, but looking forward to it.

  8. Hey John

    I’m a young starting investor (20 years old) overwhelmed by the amount of successful strategies many investors have sucessfully employed during the last decades and still trying to find the one that fits me the best.

    One approach I really liked was Greenblatt’s Magic Formula for simplifying the concept of buying good and cheap, which has always made the most sense to me. However, although the earnings yield metric he uses is one of the best one could use from a valuation standpoint, I find the ROC metric to be pretty much useless the way he uses it. A good company can’t be determined just by looking at single year profitability figures and many of the companies that end up listed by the formula have a volatile and inconstant profitability.

    Now, my views are similar to yours on the value/quality duo (value matters most in the short term, but consistent profitability is what dictates returns in the long term), hence my asking of your opinion: I think a major improvement over the original Magic Formula would be to use a 10 year geometric average ROC instead of the ROC measure he uses. 10 years because it covers more than the common business cycle and geometric average because we’re talking about returns, which compound and can’t be averaged through the common arithmetic average.

    Ranking companies by this metric would position the companies with the highest, most consistent and less volatile ROC over those 10 years and, therefore, the most consistently profitable companies (more than likely to possess a moat) first, something the single year ROC Joel uses definitely cannot do.

    This way we could effectively buy the best businesses that are simultaneously undervalued the way Greenblatt would want to do it but that I think fails because of the wrong application of ROC.

    So, I just wanted to ask you what you think of this. I don’t have the means to test it, but I’m guessing it would yield superior risk-adjusted returns than the original Magic Formula.

    Thanks,

    Miguel

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