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Book Review: The Snowball, Part Three

Friday, December 21st, 2012


If you have to make it simple, Warren Buffett is in the compounding business. That is what he has done since he was a young boy. He started with selling gum. He moved on to working inside the family firm.

Once his father moved onto DC as an idealistic Congressman, Buffett had a paper route, and as his assets began to grow, he bought a farm and other assets.  He was always trying to grow his net worth.  That is a constant with Buffett – he has always tried to grow his net worth.

By the time he linked up with Ben Graham, there were still a lot of “cigar butts” to pick up and puff.  In that era compounding was easy because the post-depression competition was so low in stock-picking.

But by the late 1960s almost all of the ‘cigar butts” had been picked up and smoked.  Easy pickings were gone, and Buffett was saddled with an unproductive textile company – Berkshire Hathaway, and a mediocre-to-bad department store in Baltimore.

He decreased the activities of the textile company, and reinvested the free cash flows predominantly into insurance, including buying half of GEICO.

(As an aside, Buffett was not a great manager of insurance companies at the beginning, and even the middle.  His early companies had their issues.  Jack Byrne did well running GEICO, followed by Tony Nicely.  Buying Gen Re was a mistake, at least initially – he bought something so complex, and he assumed that all would be fine, setting himself up for losses in the derivative book, and also in the casualty book, where they were reinsuring losses to avoid accounting issues.)

Then came the era of investing permanent capital, where he bought the “sainted seven,” and they produced profits for him.  He made more money off his public equity investments in the era of the 80s & 90s, but in short order thereafter it shifted.  Berkshire Hathaway was no longer an investment company akin to a closed end fund or a business development company – it was a full-fledged conglomerate.  That’s how we should think of it today.  Berkshire Hathaway is a conglomerate that gets a lot of its funding from insurance premiums.

He occupies a unique niche in business.  He will acquire entire firms that are attractive to him, does not change their underlying culture, and rarely if ever sells them.  This appeals to entrepreneurs who built a unique culture, and love their employees.  They will sell to Buffett, because alternative acquirers very likely would destroy the employees and culture for the sake of short-term gain.  Buffett is focused on the long run, and is willing to let a subsidiary underperform for a while, before he sends in additional management to sort things out.

On Buffett’s Wisdom

Buffett has a tremendous memory. He knows all manner of statistics regarding industry, which informs him in his investment decisions.  That is one reason why he makes so many wise decisions.

But another area of Buffett’s wisdom was against the Efficient Markets Hypothesis.  Whether in his debate against Michael Jensen in 1984, which helped to produce the article, “The Superinvestors of Graham and Doddsville [PDF, 13 pages],” or in his annual shareholder letters, that risk is not volatility – risk is the permanent impairment of capital.

If you work with a margin of safety, and buy companies that will produce free cash flow, and can grow free cash flow, you will be safer than most investors, and probably more successful as well.

I’ll finish up this review tomorrow.


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.

Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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