Buffett

by Roger Lowenstein

  For Buffett, this was a dangerous game. An investor operating two pools of capital is working for competing, and potentially conflicting, masters. Oddly, given Buffett’s concern for his reputation, this did not occur to him. He and his friend were having too good a time buying cheap stocks together. When Buffett was in California, which was not infrequently, they would laugh about the pickings, making it sound so easy.2

  One example was Source Capital, a closed-end mutual fund, also in Los Angeles. Source had been started by Fred Carr, the Go-Go manager, in 1968. In the early seventies, after Carr quit, its stock crashed. Indeed, it fell, as many stocks did, by too much. Though Source had $18 a share in asset value, the price slumped to 9. Blue Chip scooped up 20 percent of the fund. Thus, Buffett and Munger finally came around to Go-Go, but only when everyone else had left the party.

  Munger, representing Blue Chip, went on Source’s board and took a sledgehammer to anything he didn’t like. One time, looking over the bond portfolio, he noticed that Source owned some less-than-safe names. He bluntly told the portfolio manager, “This is a perfectly respectable Baa list. For Source Capital I don’t want anything but A1.”3 Buffett could not have asked for a better proxy—especially since he was ill suited to playing the tough cop and tried to avoid unpleasantness.

  In 1971, Buffett and Munger got what was potentially the opportunity of a lifetime—a “good business” of the sort that Munger preferred, as distinct from the cheap Ben Graham type. Robert Flaherty, an investment adviser to Blue Chip, learned that See’s Candy Shops, a premier chocolate chain in California, was for sale. William Ramsey, a Blue Chip executive, was hot to buy it. He went over to Flaherty’s office, and they put in a call to Buffett, who was at his home in Omaha.

  “Gee, Bob,” Buffett said. “The candy business. I don’t think we want to be in the candy business.” Then the phone went dead.

  Ramsey, who had heard this on the speaker phone, began to pace the floor frantically while they tried to get Buffett back. It seemed like an eternity. The secretary mistakenly dialed Buffett’s office, where no one answered.

  After three or four minutes, they got hold of him. Before they could say a word, Buffett said, “I was taking a look at the numbers. Yeah, I’d be willing to buy See’s at a price.”

  What the “numbers” told Buffett was that California chocoholics were willing to pay a premium price for the See’s well-regarded brand. But the price for the company was $30 million. Buffett and Munger were dissuaded by the paltry level of the See’s book value, and would go no higher than $25 million.4 There the talks ended. In this case, Buffett had made a common mistake.

  Investors often assume that book value approximates, or at least is suggestive of, what a company is “worth.” In fact, the two express quite different concepts. Book value is equal to the capital that has gone into a business, plus whatever profits have been retained. An investor is concerned with how much can be taken out in the future; that is what determines a company’s “worth” (or its “intrinsic value,” as Buffett would say).

  Suppose, for a moment, that a new company invested in candy-making equipment, stores, and inventory identical to those of See’s. Its book value would be the same, but the name on its candy box would be unknown. And this upstart, having far less earning power, would be worth far less. Since book value is blind to intangibles such as brand name, for a company such as See’s it is meaningless as an indicator of value.

  But Buffett and Munger got lucky. See’s rang back and took the $25 million—Buffett’s biggest investment by far. With seeming suddenness, his empire now included candy, textiles, retail, insurance, banking, publishing, and trading stamps.

  Buffett’s trick was to compartmentalize these holdings as though each were an only child. Wearing his See’s hat, he did a cram course on sugar futures. His letter to Chuck Huggins, president of See’s, shows Buffett delving into surprising detail.

  My reluctant inclination … is to take prices up on Sunday, December 29. My present thinking is 20¢ to 30¢ per pound.… If sugar futures keep falling as they have the last few days, I would be inclined to hold off on purchases until we get some reaction in the market for refined sugar.5

  Buffett also pestered Huggins about enhancing the See’s brand name. Ironically, Buffett’s inadequacy as an epicure enlightened him as to what the company was really “selling.”

  Maybe grapes from a little eight-acre vineyard in France are really the best in the whole world, but I have always had a suspicion that about 99% of it is in the telling and about 1% is in the drinking.6

  Then Buffett would tunnel his attention onto trading stamps. Discount supermarkets had been taking business from stamp-dispensing stores, which were increasingly seen as a bad deal for shoppers. Buffett bombarded Blue Chip with ideas on how to counter this perception, but he conceded, in a revealing bit of self-analysis, that marketing was out of his range:

  The problem I have is that I think like an accountant or an actuary. My reaction is to explain all the facts and do all the mathematics for the consumer, to show her just how much better off she is by getting our stamps. I think I could convince a group of mathematicians, actuaries, security analysts or accountants … but [not] the housewife.7

  Buffett also put $45 million of the “float” from Blue Chip into bank stocks, mimicking his capital reallocation at Berkshire.8

  But now his dangerous game was well along. He was investing on behalf of three companies, Berkshire, Blue Chip, and Diversified, that had separate groups of shareholders, and he was obliged to each to get the best deals. Into which pocket would he put the Washington Post and which the See’s Candy? Understand that Buffett was scrupulously fair about it. Even so, the conflict of interest was inherent and inescapable. The arrangement was complex beyond call, and for Buffett quite out of character. And where matters are complex, the securities cops rightfully pay attention.

  In the midst of this merry game, a broker offered Buffett a block of Wesco Financial, a Pasadena, California, company that owned a savings and loan. Buffett knew Wesco in his sleep. He had read its annual report—as he did those of hundreds of savings and loans—every year since the mid-sixties.9 Wesco was trading in the low teens, less than half its book value.* Buffett checked with Munger, who agreed that it was cheap, and Blue Chip snapped up 8 percent of the shares.10 At the time—the summer of 1972—Wesco was a minor, $2 million investment. But in January 1973, Wesco announced a plan to merge with another California savings and loan, Financial Corp. of Santa Barbara.

  Buffett and Munger instantly reached the same conclusion: Wesco was giving away the store. Under the merger terms, holders of Wesco would exchange their undervalued stock for shares in Santa Barbara—which seemed highly overvalued. Quoting Buffett:

  I read these terms, and I didn’t believe them. And I told [Munger] the terms as announced and he couldn’t believe it as I couldn’t believe it. But it was there in black and white on the Dow Jones tape.11

  Munger wanted to buy more stock in Wesco, in the hope of defeating the merger, which would be subject to a vote of shareholders. Buffett, who was stoic about taking an occasional loss, did not. He said, “To hell with it; we made a mistake.”12 But Munger persevered. For the next six weeks, Blue Chip bought every Wesco share in sight, accumulating 20 percent of the stock.

  However, they still could not stop the merger. And now Blue Chip was in deep. As Munger said, they were like the rat in the trap who decides it no longer wants the cheese.

  In February, Munger paid a call on Louis R. Vincenti, Wesco’s president. Using an odd choice of words, Munger said that Blue Chip had been buying stock “in the hope of creating a climate” in which Vincenti and the other Wesco directors would not feel any “moral obligation” to carry out the merger.

  Vincenti stuck to the script. He observed that Blue Chip was free to vote no, and to solicit other shareholders to do the same. To Munger, such a populist course reeked of vulgarity. He had come as a man of honor, confident th
at between two such men no problem was irresolvable. He declared that he liked Wesco’s management, and that Vincenti, in particular, was Buffett’s and Munger’s sort of fellow. In fact, Munger declared several times that if Vincenti personally asked him, man to man, so to speak, Blue Chip would stop buying shares.13

  Vincenti thought it most odd. He did not understand Munger’s appeal to morality in the midst of a routine business transaction. Yet it went to the core of what distinguished Munger, which was an adherence to old-school ethics. He never tired of quoting Benjamin Franklin, whose aphorisms he judged more useful than most of what was taught in business school.

  In and out of business, Munger subscribed to the gentleman’s code. He was headstrong about getting his way, but indifferent to assessing blame or credit for the results. When a doctor botched a cataract operation, ruining his eyesight, he uncomplainingly observed that it happened in a tiny percentage of such cases and took to studying ophthalmology.14

  In private life, Munger was enormously active. Following the Belous abortion case, he was a driving force for instituting abortion clinics in Los Angeles.15 As a volunteer chairman of Good Samaritan Hospital, he totally revamped the hospital’s mission and menu of specialties. Yet he bullied the doctors, as he did his fellow trustees at the local Planned Parenthood. Where Buffett had a common touch, the Republican Munger reeked of noblesse oblige. He would lope into a boardroom, thinking out loud and telling stories that he found uproarious, a half-blind philosopher-king with a hugely magnifying and terrifying lens.16

  “Charlie is very funny, and also very pompous,” said a member of Buffett’s circle. “He believes in the aristocratic point of view, that there is a select group of accomplished, talented people in the world, and that he is one of them.”

  Munger was wont to joke about establishing a Munger “dynasty.” When he divorced his wife, “the first duchess,” he read obituaries in the hope of finding a widow with the desired attributes for his intended offspring. He and the “second duchess” raised eight little Munger lords and ladies.

  Unlike his Omaha partner, he led a big life, fishing in the rivers and wilds of various continents for trout, bonefish, and Atlantic salmon, holding court at the California Club, and dominating a party, especially after a glass of wine. Ira Marshall recalled a soirée in Bel-Air: Munger was talking his way through a rambling, sonorous monologue—something about a thousand-year orgasm—which Munger found quite funny, when the host asked Marshall, “Can you get Charlie to shut up? No one can say a word.”

  Otis Booth, a close friend, would awake in the middle of the night on a fishing trip and Munger would be sitting up poring over a book, likely quite arcane. On an expedition with Booth and Marshall to the Australian rain forest, all the while as their jeep went bounding through the jungle Munger was reading an obscure work of paleontology. Then, at night, Munger lectured the group from his reading, “telling us out of the clear blue sky how the dinosaurs evolved into birds,” Marshall recalled.

  People, including many of Buffett’s friends, were intimidated by Munger’s weighty discourses on black holes and Einstein, not to mention his contemptuous manner. Buffett’s friend Roxanne Brandt once remarked that the only hospital she knew of in Los Angeles was Cedar Sinai Medical Center. Munger shot back, “That’s because you’re Jewish.”

  Yet Munger was a formidable armchair psychologist and, in particular, a student of behavior. He saw the devil in such phenomena as the inability of people to change their minds, or what he termed “first-conclusion bias”:

  “This is why organizations solicit public pledges. Hell, it’s the reason for the marriage ceremony.”17

  Buffett was deeply influenced by such precepts of Munger’s. Yet it was Buffett, not Munger, who had the more natural touch when it came to applying them. Indeed, Buffett was a master at overcoming a person’s “first-conclusion bias.”

  In the Wesco matter, after Munger had failed with Vincenti, Buffett began to court the one director with the power to abort the merger. Elizabeth Peters, a San Francisco heiress, was Wesco’s largest shareholder.18 Peters’s parents had founded the savings and loan and taken it public in the late 1950s. Her brothers being unsuited to the task, it had been left to Peters, an English major, to learn the business and protect the family interest. She found, first, that she was good at it, and second, that Wesco provided an agreeable contrast to her other pursuits, which included tending to a Napa Valley vineyard that produced a fine cabernet and reading Chaucer.

  By the early seventies, Wesco had gone a bit flat. Peters was anxious to give it a kick, but the other directors had little interest, financial or otherwise. When Santa Barbara made its offer, Peters knew that the terms were sorry, but she reckoned that a merger might stir the pot.

  Buffett sent Donald Koeppel, Blue Chip’s president, to talk to Peters, but she remained adamantly in support of the merger. A short time after Koeppel left, Buffett called. He pleasantly introduced himself, and suggested a tête-à-tête.

  A couple of days later, Buffett and Peters sat down in a lounge at the San Francisco airport. Buffett told her that in his opinion, Wesco stock would in time be worth far more than what Santa Barbara was offering. This was the refrain that Peters had heard from Koeppel, but from Buffett it sounded more persuasive. For one thing, Buffett spoke to her as a fellow owner. His capital was on the line with hers.

  When Peters insisted that something had to be done to reinvigorate Wesco, Buffett said he’d like to try it himself. He talked some about his relationship with other companies, which he described as being one of partnership. He talked some about himself. He was calmly reassuring, pushing the right buttons.

  Peters felt that she wouldn’t mind being this guy’s partner, either. She liked Buffett—liked him a lot.19 And he was a ray of hope.

  Peters had just one question. “Mr. Buffett, if I buy you, what happens if you get hit by a truck at the intersection?” Who would save Wesco then?

  Buffett replied that he had a partner whose ability he considered equal to his own. He had arranged for this fellow to be in charge of Berkshire, and of Buffett’s family interests, in the event of a “truck,” and he felt that either of them could be trusted with Wesco.20

  When Buffett finished, Peters had made up her mind. The merger was dead.

  Buffett and Munger now felt an obligation to her, and decided to raise their stake in Wesco. They could have bought stock on the cheap, as, ordinarily, when a merger blows apart the stock will tank. But to chisel investors who were bailing out because of the deal’s failure—a failure for which Buffett and Munger were directly responsible—would seem less than classy. Therefore, they told their brokers to be liberal about the price.

  Blue Chip bid for Wesco at 17—the price that had prevailed before the deal had fallen through. Though this was highly unusual, according to Munger, “We decided in some quixotic moment that it was the right way to behave.”

  Blue Chip raised its stake to 24.9 percent. Subsequently, Wesco’s shares fell, along with the general market, and Blue Chip made several tender offers. By the middle of 1974, Blue Chip owned a majority of the stock (Peters continued as a big minority holder). There matters seemed to rest. But unbeknownst to Buffett and Munger, their trail had been picked up by the Securities and Exchange Commission.

  The first hint of trouble came in the fall of 1974. It arose, in part, from Buffett and Munger’s intricate, but still informal, partnership. Buffett and Munger, separately, owned stock in both Blue Chip and Diversified Retailing. However, Munger was not involved in Berkshire. Thus, when Buffett spent money from his Blue Chip pocket, it was collaborative; when he reached into Berkshire—his front pocket—he was on his own. The interlocking ownership made for a confusing, conflicted mess.21

  As a first step toward untangling these spaghetti strands, Buffett and Munger announced a plan to merge Diversified into Berkshire. But the SEC had questions. Lots of questions.

  Munger, at first, presumed that the SEC was dela
ying them because Buffett and he were such “interesting” characters. He had a quaint image of a regulator scrutinizing Blue Chip as though it were an unusual bug that had crawled across its microscope. But as the months dragged on, Munger got testy. Writing to Charles Rickershauser, his and Buffett’s lawyer at Munger’s law firm, Munger had an aggrieved air, as though dealing with a plodding functionary at the bureau of motor vehicles:

  I hope the foregoing will satisfy everyone at the SEC and that, if not, you can arrange that I receive the promptest possible response, preferably by direct telephone calls to me, so that we can clear up any problems and get our merger consummated.22

  Alas, Munger had not read Kafka. Rickershauser sent a toned-down version of his letter to the SEC. In December, Munger got his prompt response—though not the one he expected. The SEC opened a formal investigation of the Prince of Omaha: In the Matter of Blue Chip Stamps, Berkshire Hathaway Inc., Warren Buffet [sic], HO-784. Buffett was now the target of a full-scale probe.

  Blue Chip, Berkshire, Buffet [sic], singly or in concert with others … may have engaged in acts which may have, directly or indirectly operated as a device, scheme, or artifice to defraud; or included an untrue statement of a material fact or omitted …23

  The inquiry focused on whether Blue Chip had “manipulated” the price of Wesco’s stock, a vague charge that can be difficult to resolve either way. Within the SEC’s enforcement division, it was considered a big case, and it quickly broadened into a general investigation of everything Buffett had touched.

  Under subpoena, Buffett shipped three cartons of files to Washington. His stock-transfer records, his letters to Blue Chip, his every memo to the textile mill and See’s Candy and to Buffett’s bankers—all of it was sucked into the SEC vacuum. In the opinion of Verne McKenzie, Berkshire’s treasurer, “They had discovered a rich guy and decided he had to be a crook.”