Buffett

by Roger Lowenstein

  Buffett found it “extraordinary” that academics studied such things. They studied what was measurable, rather than what was meaningful. “As a friend [Charlie Munger] said, to a man with a hammer, everything looks like a nail.”

  Buffett seemed especially resentful about the theory’s hold on his alma mater. He was willing to give a lecture at Columbia, and did so every year or two, but refused to donate money to it. John C. Burton, the business school dean, said, “He told me very frankly he didn’t think education was enhanced by money and secondly that he didn’t think business schools were teaching the things he wanted to support. He was very hostile to the idea of efficient market research.”

  Burton, who owned a few shares of Berkshire, thought Buffett’s reason was genuine, but incredibly myopic. Buffett often cited his personal debt to Graham, yet when Burton pressed him to give something back—to endow, perchance, future Grahams and future Buffetts—the billionaire would turn him down.

  Columbia’s program was less one-sided than most. It hired Wall Street pros as part-time lecturers, some of whom used a Graham-and-Dodd approach. But the finance program was, as Buffett maintained, dominated by Efficient Market Theory. A stroll through the business section of the university bookstore suggested that a student could get an M.B.A. at Columbia without ever hearing the names Graham and Dodd, and without even a faint exposure to value investing. Eventually, Columbia established a Graham-and-Dodd chair, but oddly assigned it to Bruce Greenwald. Greenwald, an MIT-trained economist, had married into money, made a million or two in bond futures, lost a similar sum in oils, and quit at the insistence of his in-laws. “At investing I’m a complete idiot,” he noted, rather affably, adding that it was speculating that turned him on. He invited Buffett to give a guest lecture but did not think him imitable. “I’m sympathetic to the Graham-and-Dodd point of view,” Greenwald said, “but I’m not really a Graham-and-Dodder.”34

  On Wall Street, meanwhile, the theory made remarkable inroads. There was a trend toward making security analysis “precise.” Brokerages emphasized groups of stocks, rather than selecting individual winners. In a remarkable comment, circa 1979, the chief strategist at Drexel Burnham said his aim was to make the analyst less like an independent entrepreneur who worked alone judging stocks.35 Less, that is, like a Warren Buffett.

  The introduction, in the 1980s, of stock-index futures marked the theory’s coming-of-age. Academics had preached that investors could not pick stocks. Now they needn’t try; they could heave a single dart at the entire market. Buffett urged Rep. John Dingell, chairman of the House Subcommittee on Oversight and Investigations, in 1982, not to permit such futures. “We do not need more people gambling in nonessential instruments identified with the stock market,” Buffett wrote.36 In a prophetic aside, he warned that futures could lead to speculative excesses and sour the public on stocks altogether.

  It is easy to lose sight of the distinction between “futures” and stocks—after all, are they not both investments? This is arguable. Futures are zero-sum bets on the market direction. They do not raise capital for business, which is the essential purpose of the stock market. They do not represent a stake in a business—merely a stake in a wager.

  In the eighties, money poured into futures as well as into “index funds” designed to mimic the market averages (by owning every stock or a reasonable proxy). Money managers were giving up investing for trading the market whole—thus abandoning the job assigned them by markets, which is to keep prices “right” by searching out bargains and winnowing out the overpriced. By 1986, well over $100 billion was managed “passively,” meaning it was not managed at all. It was chained to the Ouija board of various market indices.

  In the summer of 1986, there were, finally, cries that the trend had gone too far. The occasion was a then-shocking 62-point drop in the Dow. Perhaps too many people had been looking at Ouija boards? Burton Malkiel, writing in the Wall Street Journal, demurred. If markets were efficient, automaton investing was a cause for celebration.

  … I am proud to have been at least partly responsible [for] a growing faith in the efficiency of stock markets and a trend toward passive portfolio management.37

  Buffett countered in the Washington Post, arguing that new-age trading was fulfilling Keynes’s dark prophecy of the market as a casino. Speculation had so overwhelmed markets that their proper, value-discovering role was being swamped by hyperactive trading. The new, esoteric instruments were not “investments”; they served no social agenda; they did the work not of the Invisible Hand but of “an invisible foot kicking society in the shins.” Now Buffett trotted out a rather savage satire; he fantasized that a boat of twenty-five brokers were shipwrecked and forced to live out their days on an uninhabited island.

  Faced with developing an economy that would maximize their consumption and pleasure, would they, I wonder, assign 20 of their number to produce food, clothing, shelter, etc., while setting five to endlessly trading options on the future output of the 20?38

  As a remedy for the “casino society,” Buffett proposed what Jonathan Swift would have called “a modest tax”: 100 percent of the profits on stocks and futures held for less than a year. This idea disappeared without a trace. But fears about hyperactive trading did not. In 1987, with markets restless, worries of a meltdown escalated. Malkiel, writing in the New York Times, again defended push-button trading as fostering “liquidity.” Alluding to the market’s jumpiness, he added, “but the market only seems more volatile because of a scale effect.”39 His timing was off; three weeks later, the market crashed. The Brady report on Black Monday uncovered a truism that Malkiel had missed: when everyone lined up on the same side of a trade, the liquidity provided by futures was an “illusion.”40

  Malkiel had praised professional investors for using futures to “shift and control risk and to respond to market movements.” In Buffett’s vision, true risk—the risk, say, that sales of carpets or of World Book would hit a slump—could not be “shifted.” Such risk was inherent to owning Berkshire. Nor did market movements call for a “response.” He blamed the crash on the very people Malkiel had praised:

  We have “professional” investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead.41

  The market survived the crash, but the theory was badly wounded. How could prices have been rational both before and after? No new information had surfaced to account for such a drop. There had been no sudden change in expected future profits. Indeed, for the people who sold stocks on October 19, corporate profits were not a remote consideration. According to Robert J. Shiller, a Yale economist who surveyed nearly one thousand investors soon after Black Monday, the only news that investors had been aware of that day was news of the crash itself. In place of the cold, “unromantic” investor of Brealey and Myers, Shiller’s respondents reported sweaty palms, rapid pulse rates, and hypertension. On average, they had checked prices thirty-five times. The survey presented a microcosm of crowd psychology in action, with 40 percent of the institutional investors experiencing “a contagion of fear from other investors.”42

  In another blow, Eugene Fama demonstrated that the beta of a stock had no relation to its actual return.43 Nobel prizes had been awarded for treatises on beta; now, it developed, beta was useless. But analysts and academics continued to use it. Definitions were rejiggled here and there, but the structure was left intact. Indeed, as the Economist reported, the theory itself lived on, despite the “awkward” facts.

  As Charles Goodhart, of the London School of Economics, points out, no one has thought up a better theory. Instead, academics have tried to reinterpret the awkward evidence in less-threatening ways.44

  The post-crash edition of Brealey and Myers was unreformed. It conceded, in a brief passage, that Black Monday posed some problems. But on the same page, the aut
hors again advised, “… you can trust prices.” But which prices—of the morning of October 19, or of six hours later? Never mind; the theory was “remarkably well-supported by the facts.”45

  In a broader sense, the theory retained its hold on the investing culture. Wall Street pros continued to flock to esoteric new instruments, and advisers continued to counsel extreme “diversification.” Berkshire shareholders, in particular, were continually being advised that they should “diversify”—that is, should sell. J. P. Morgan was trustee for one woman who had virtually all of her money in Berkshire. As her portfolio soared into the millions, her man at Morgan repeatedly (but vainly) urged her to lighten up. It did not occur to him that one investment might be better than another. He affixed a note to her statement to cover himself: “Co-trustee/beneficiary refuses to sell Berkshire Hathaway.…”

  In a narrow sense, the persistence of the theory was a boon to Buffett’s career. Thousands of his potential competitors were taught that studying securities was a waste of time. “From a selfish point of view,” Buffett wrote after the crash, “Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.”46 But Buffett would have preferred that schools perpetuate the teaching of Buffett. In academia, he was still an “anomaly,” a “red herring,” a “three-sigma” irrelevancy. “No one,” he wrote of the theory’s proponents,

  has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools.47

  And Buffett was not. But in the aftermath of Black Monday, Buffett was to give his most convincing lesson ever.

  Chapter 18

  SECRETS OF THE TEMPLE

  In the fall of 1988, Coca-Cola noticed that somebody was buying its stock. Roberto C. Goizueta, the chairman, and Donald Keough, the president, were more than mildly curious about who it was. The stock had fallen 25 percent from its pre-crash high, and the mysterious investor was gulping down shares by the caseload. When Keough saw that a broker in the Midwest was doing the buying, he suddenly thought of his former neighbor. “You know,” he told Goizueta with a start, “it could be Warren Buffett.” Goizueta urged Keough to call him.

  “Well, Warren, what’s going on?” Keough began. “You don’t happen to be buying any shares of Coca-Cola?”

  “It so happens that I am,” Buffett replied.1

  Buffett asked Keough to stay mum until he was required to disclose his stake. In the meantime, he continued to accumulate the stock. By the next spring, Berkshire had acquired $1.02 billion worth, or 7 percent of the Coca-Cola Co., at an average price of $10.96 a share. When the news broke, Buffett passed it off on his Cherry Coke dependency, quipping that the investment was “the ultimate case of putting your money where your mouth is.”2 Otherwise, he was delphic:

  It’s like when you marry a girl. Is it her eyes? Her personality? It’s a whole bunch of things you can’t separate.3

  A Wall Street analyst termed it a “very expensive stock.”4 But in a mere three years, Buffett’s stake in Coca-Cola would soar to an astounding $3.75 billion—roughly the value of all of Berkshire when it had begun investing in Coca-Cola.

  What happened to Coca-Cola in those three years? Income per share rose 64 percent—a heady gain, but hardly enough to justify the near quadrupling of its stock. What did the trick, more nearly, was a sea change in Wall Street’s perception of the business. It suddenly dawned on investors that as popular as Coke was, it had barely scratched the surface in the planet’s most populous regions. The average American was guzzling 296 Cokes a year, compared to only thirty-nine drinks for the typical foreigner. And Coca-Cola was rushing to close the gap, aggressively expanding in markets such as Eastern Europe, France, China, and the entire Pacific Rim. It was already earning more in Japan than it was at home.5 In places such as Indonesia, where the per capita intake was only four Cokes a year, the potential was vast. Keough crowed, “When I think of Indonesia—a country on the equator with 180 million people, a median age of eighteen, and a Moslem ban on alcohol—I feel I know what heaven looks like.”6 By 1991, judging from its stock, Wall Street did, too.

  But what had inspired Buffett to become the biggest single owner of Coca-Cola just before its surge? What had inspired him to invest more—much, much more—in Coca-Cola than in any previous stock? Was it just a lucky dart? Or was it, as Buffett maintained, as close to a sure thing as he had ever seen?7

  Many of his previous investments had hinged on specific events, or on values that could be tabulated from a balance sheet. The Washington Post had been selling for a mere fraction of its liquidation value, while GEICO, acquired for next to nothing, had been an absolute steal if one was convinced that the then troubled company would survive. Coca-Cola was different. Buffett couldn’t derive its value from the balance sheet. He couldn’t compute the value. But he could see it.

  He was often asked, how did he determine the “value” of a stock? Conceptually, Buffett likened it to that of a bond. A bond’s value was equal to the cash flow from future interest payments, discounted back to the present. A stock’s value was figured the same way; it equaled the anticipated cash flow per share,* except that the investor had to fill in a crucial detail:

  If you buy a bond, you know exactly what’s going to happen, assuming it’s a good bond, a U.S. Government bond. If it says 9 percent, you know what the coupons are going to be for maybe thirty years.… Now, when you buy a business, you’re buying something with coupons on it, too, except, the only problem is, they don’t print in the amount. And it’s my job to print in [to figure out] the amount on the coupon.9

  With this notion of value in mind, Buffett tried to find stocks whose “value” was greater—significantly greater—than their price. Buffett’s guides to finding such a stock could be summarized quickly:

  • Pay no attention to macroeconomic trends or forecasts, or to people’s predictions about the future course of stock prices. Focus on long-term business value—on the size of the coupons down the road.

  • Stick to stocks within one’s “circle of competence.” For Buffett, that was often a company with a consumer franchise. But the general rule was true for all: if you didn’t understand the business—be it a newspaper or a software firm—you couldn’t value the stock.

  • Look for managers who treated the shareholders’ capital with ownerlike care and thoughtfulness.

  • Study prospects—and their competitors—in great detail. Look at raw data, not analysts’ summaries. Trust your own eyes, Buffett said. But one needn’t value a business too precisely. A basketball coach doesn’t check to see if a prospect is six foot one or six foot two; he looks for seven-footers.

  • The vast majority of stocks would not be compelling either way—so ignore them. Merrill Lynch had an opinion on every stock; Buffett did not. But when an investor had conviction about a stock, he or she should also show courage—and buy a ton of it.

  Buffett did that. After the Cap Cities deal, in 1985, he sat for three long years without buying a single common stock.† And then, when Coca-Cola fell to attractive levels, he staked a fourth or so of Berkshire’s market value on that one stock.

  The question was: why then? Coca-Cola’s stock, after all, had been cheaper years before, and the global reach of its drink was hardly new. Robert Winship Woodruff, the Georgia tycoon who became Coca-Cola’s president in 1923, had been determined to make Coke available everywhere on earth. In 1928, it was bottled in China. During World War II, the company persuaded the U.S. government to ferry fifty-nine bottling plants overseas, theoretically to boost troop morale and not incidentally to spread the soda.10 In 1949, nine Buddhist priests presided over the opening of a plant in Bangkok. Such was Coke’s universality that in 1956, an enterprising Coke publicist set forth to find an innocent to whom he could introduce the drink. He trekked 150 miles into the Peruvian back country, encountered an Indian woman in the jungle, and, through an
interpreter, explained his mission. The woman reached into a sack and pulled out a bottle of Coke.11

  Buffett was exposed to this wondrous beverage in about 1935. “Of a certainty,” he wrote to shareholders,

  it was in 1936 that I started buying Cokes at the rate of six for 25¢ from Buffett & Son, the family grocery store, to sell around the neighborhood for 5¢ each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product. I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses … and the like.12

  Coca-Cola was the sort of “simple” business—one with pricing power and a protective “moat”—that Buffett came to crave, particularly in the 1970s, as his taste began to shift from “anthracite” to franchise companies such as See’s. Coca-Cola’s main business was not selling Coke; it was providing concentrate and syrup to bottlers and soda fountains. Such a business (unlike bottling) required little capital. What’s more, its name recognition was unique, especially overseas, where Coke outsold Pepsi four-to-one.13 In Buffett’s terms, the brand name was a sort of a universal toll bridge.

  However, by the seventies, though the drink had blanketed the world, the company was adrift. Sales overseas had been left to the individual bottlers, not all of whom were up to the job. Also, certain cultural proclivities slowed Coke’s acceptance (in France, opponents of Americanization made common cause with vineyards).14 Even worse, J. Paul Austin, the chief executive, did not know what to do with Coca-Cola’s surplus cash. By mid-decade, that was a $300 million problem. Austin, a handsome, red-haired Olympic rower from Harvard, by then secretly ailing from Alzheimer’s and Parkinson’s,15 invested in a string of un-cola diversifications: water purification, wine, shrimp farming, plastics, whey-based nutritional drinks, and fruits and vegetables. Buffett thought such moves were squandering precious capital.16 And, indeed, the average annual return on Coca-Cola’s stock during the seventies was a miserable 1 percent.