WARREN BUFFETT

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PART ONE

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The First Partnership

Following the my last ten part series on the life and career of Charlie Munger, Vice-Chairman of Berkshire Hathaway
Corporation and Warren Buffett’s right hand man, in this series I’m taking a look at Warren Buffett’s early career.

Before Warren Buffett became well-known, and before he acquired Berkshire Hathaway Inc. (NYSE:BRK.A)
(NYSE:BRK.B), he ran a number of partnerships, investing the money of family, friends and outside investors. It’s
these partnerships that helped build his reputation and provided the funds for him to ultimately acquire Berkshire
Hathaway.

This is the story of Warren Buffett’s early career, the years that laid the foundations for him to become the world’s
greatest investor.

Warren Buffett -- Part one: The First Partnership

In 1952, Warren Buffett went to work with the godfather of value investing, Benjamin Graham at the Graham-
Newman partnership. Here, Warren Buffett put his education from the Columbia University to work and learnt his
trade as a value investor.

Unfortunately, Graham-Newman partnership closed its doors during 1956 so Buffett, took his savings (around
$174,000) and started the first Buffett Partnership Ltd in Omaha.

When he first set out to invest money for others, Warren Buffett knew that he wouldn’t be able to stand criticism from
his partners if stocks he selected started to fall. As Buffett was going to be the sole manager of the partnerships run
by Buffett Partnership Ltd., there was nowhere to hide if he failed. With this being the case, Buffett only invited family
and friends to invest in his first partnership -- Buffett Associates, Ltd.

In total, six other partners, plus Warren Buffett invested in Buffett Associates, Ltd. raising $105,100 in capital.
Two more partnerships were set up in the months after Buffett Associates, Ltd. started trading bringing the total
number of partnerships controlled by Buffett to three by the end of 1956.

• On September 1st, 1956, he raised $120,000 from Homer Dodge, a physics professor who had attended Har
vard University. With it, Buffett setup Buffett Fund, Ltd.

• Then, on October 1, 1956, Warren founded another partnership for a friend of his, John Cleary, who was
his father’s secretary in Congress. (Buffett’s father served in the House of Representatives.) It had $55,000
in capital.
These partnerships immediately made money for investors in their first full year of trading. As Warren Buffett wrote
in his second annual letter to limited partners at the end of 1957:
“In 1957 the three partnerships which we formed in 1956 did substantially better than the
general market. At the beginning of the year, the Dow-Jones Industrials stood at 499 and at
the end of the year it was at 435 for a loss of 64 points. If one had owned the Averages, he
would have received 22 points in dividends reducing the overall loss to 42 points or 8.470%...

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All three of the 1956 partnerships showed a gain during the year amounting to about
6.2%, 7.8% and 25% on year end 1956 net worth. Naturally a question is created as to
the vastly superior performance of the last partnership, particularly in the mind of the
partners of the first two. This performance emphasizes the importance of luck in the
short run, particularly in regard to when funds are received. The third partnership was
started [in late] 1956 when the market was at a lower level and when several securities
were particularly attractive. Because of the availability of funds, large positions were
taken in these issues. Whereas the two partnerships formed earlier were already sub-
stantially invested so that they could only take relatively small positions in these issues.”
-- Warren Buffett annual letter to partners
All three partnerships held the same securities with similar weightings. I’ll cover the stocks Warren was buying later
in the series.

Three types of trade

It’s here that I should introduce Warren Buffett’s early trading strategies.

Buffett had three main strategies: Firstly, Buffett has his “generals”, which were usually undervalued securities where
he had nothing to say about corporate policies. Typical value plays in other words. Generals made up the bulk of Buf-
fett’s portfolio.

Then there were the “work-outs”, undervalued securities where corporate action was required for the market imbal-
ance to correct itself. And finally the “control” situations where Buffett aimed to influence policies of the company
in order to unlock value. In a number of cases, Buffett’s generals and work-outs quickly turned into control situations
when Buffett either ran out of patience or decided that management had to go.

“At the end of 1956, we had a ratio of about 70-30 between general issues and work-
outs. Now it is about 85-15. During the past year we have taken positions in two situ-
ations which have reached a size where we may expect to take some part in corporate
decisions. One of these positions accounts for between 10% and 20% of the portfolio
of the various partnerships and the other accounts for about 5%. Both of these will
probably take in the neighborhood of three to five years of work but they presently
appear to have potential for a high average annual rate of return with a minimum of

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risk. While not in the classification of work-outs, they have very little dependence on
the general action of the stock market. Should the general market have a substantial
rise, of course, I would expect this section of our portfolio to lag behind the action
of the market.” -- Warren Buffett 1957 annual letter to partners.

The compensation structure for Warren Buffett’s partnerships was fairly simple. Investors received 6% interest on
their money from the partnership and 75% of profits above this threshold. If there were a loss, Buffett took 25% of
it himself. That means that even if Buffet broke even; he lost money.

What’s more, Buffett’s obligation to pay back losses was not limited to his capital; it was unlimited.

Buffett also had a little partnership with his father, called Buffett & Buffett. Warren charged no fee for the manage-
ment of this partnership.

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PART TWO

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Expanding

Warren Buffett’s first three partnerships, set up during, 1956 outperformed the market significantly during their early
years and attracted plenty of attention. As a result, more potential investors began to approach Warren and ask him
to manage their money.

So, to meet demand during June of 1957, Buffett started another partnership calledUnderwood, with one of the
original partners of Buffett Associates, Ltd., Elizabeth Peters, with $85,000. Then, on August 5, 1957, Warren Buffett
started his fifth partnership, which was called Dacee. Eddie Davis and his wife Dorothy Davis had Buffett manage
$100,000 for themselves and their three children. The year after, on May 5, 1958, Dan Monen and his wife, Mary El-
len, formed the basis of Warren’s next partnership, called Mo-Buff. They put in $70,000.

The five partnerships that were in operation during 1958 posted returns of 36.7% to 46.2%. As Buffett wrote in his
annual letter to partners at the end of 1958:

“The latter sentence describes the type of year we had in 1958 and my forecast
worked out. The Dow-Jones Industrial average advanced from 435 to 583 which,
after adding back dividends of about 20 points, gave an overall gain of 38.5% from
the Dow-Jones unit. The five partnerships that operated throughout the entire year
obtained results averaging slightly better than this 38.5%. Based on market values at
the end of both years, their gains ranged from 36.7% to 46.2%. Considering the fact
that a substantial portion of assets has been and still is invested in securities, which
benefit very little from a fast-rising market, I believe these results are reasonably
good. I will continue to forecast that our results will be above average in a declining or
level market, but it will be all we can do to keep pace with a rising market.” -- Warren
Buffett 1958 annual letter to partners.

Warren Buffett

However, with the market rising, Warren Buffett was struggling to find opportunities, and it’s at this point that his
investing methods started to take on an activist style.

“THE CURRENT SITUATION

The higher the level of the market, the fewer the undervalued securities and I am
finding some difficulty in securing an adequate number of attractive investments. I
would prefer to increase the percentage of our assets in work-outs, but these are very
difficult to find on the right terms.

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To the extent possible, therefore, I am attempting to create my own work-outs by

acquiring large positions in several undervalued securities…” -- Warren Buffett 1958
annual letter to partners.

The seventh Buffett partnership was called Glenoff and consisted of $50,000 contributed by a local businessman and
two sons in one of Omaha’s most prominent families. It was established in February of 1959.

Based on the compensation structure, as covered within the first part of this series, by 1959, Buffett, who had only
contributed $100 to each partnership, had earned fees, counting reinvested earnings, of $83,085 and owned approxi-
mately 9.5% of the combined partnerships due to his performance.

Compounding growth
From the outset, Warren Buffett knew and understood that his focus should be to outperform the leading indexes on
a long-term time horizon.

“My continual objective in managing partnership funds is to achieve a long-term per-

formance record superior to that of the Industrial Average. I believe this Average, over
a period of years, will more or less parallel the results of leading investment companies.
Unless we do achieve this superior performance there is no reason for existence of the
partnerships.” -- Warren Buffett 1960 letter to partners.

How was Buffett going to achieve this goal? By not losing money. Here’s an extremely valuable piece of advice from
the Sage of Omaha, to any investors just starting out. (This was written to inform several new Buffett partners what
they should expect when investing in the partnerships.)

“...I have pointed out that any superior record which we might accomplish should
not be expected to be evidenced by a relatively constant advantage in performance
compared to the Average. Rather it is likely that if such an advantage is achieved, it
will be through better-than-average performance in stable or declining markets and
average, or perhaps even poorer- than-average performance in rising markets. I would
consider a year in which we declined 15% and the Average 30% to be much superior
to a year when both we and the Average advanced 20%. Over a period of time there
are going to be good and bad years; there is nothing to be gained by getting enthused
or depressed about the sequence in which they occur. The important thing is to be
beating par; a four on a par three hole is not as good as a five on a par five hole and
it is unrealistic to assume we are not going to have our share of both par three’s and
par five’s. The above dose of philosophy is being dispensed since we have a number
of new partners this year and I want to make sure they understand my objectives, my
measure of attainment of these objectives, and some of my known limitations…”
-- Warren Buffett 1960 letter to partners.

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PART THREE

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GEICO
As more investors flocked to Warren Buffett’s partnerships during the late 50s and early 60s, his investing prowess re-
ally started to show through. By 1960, Buffett had seven partnerships operating and had produced a cumulative return
for partners of 141% over three years from 1957 to 1960.

These returns were generated by using a combination of deep value, and activist investing. In his trademark style, Buf-
fett would buy a large percentage of his target company, with a large portion of partnership assets, isolating his good
ideas and reaping the rewards as their valuations returned to normal levels.

Warren Buffett details some of his biggest investments at the time in his letters to partners of the Buffett Partner-
ships, from 1956 onwards. But he was also recommending investments as early as 1951.

Early recommendation
At only 20 years of age, the then unknown Warren Buffett penned an article that was published in the Commercial
and Financial Chronicle. The article was titled “The Security I Like Best” and was published on Thursday, December
6, 1951. Buffett was pitching the Government Employees Insurance Company, or GEICO that had gone public three
years before.

Buffett recognized the fact that, at only eight times earnings, GEICO’s valuation did not reflect: “the tremendous
growth potential of the company.”

“The term “growth company” has been applied with abandon during the past few
years to companies whose sales increases represented little more than inflation of
price and general easing of business competition. GEICO qualifies as a legitimate
growth company…”

“Probably the biggest attraction of GEICO is the profit margin advantage it enjoys.
The ratio of underwriting profit to premiums earned in 1949 was 27.5% for GEICO
as compared to 6.7% [for the sector average]...During the first half of 1951, practi-
cally all insurers operated in the red on casualty lines...Whereas GEICO’s profit mar-
gin was cut to slightly above 9%...”

“Earnings in 1950 amounted to $3.92 as contrasted to $4.71 on the smaller amount

of business in 1949. These figures include no allowance for the increase in the un-
earned premium reserve which was substantial in both years. Earnings in 1951 will
be lower than 1950, but the wave of rate increases during the past summer should
evidence themselves in 1952 earnings. Investment income quadrupled between 1947
and 1950, reflecting the growth of the company’s assets.”

“At the present price of about eight times the earnings of 1950, a poor year for the
industry, it appears that no price is being paid for the tremendous growth potential
of the company.”

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You can find the whole article here.

This article gives an invaluable insight into Warren Buffett’s investment process. Even though he was only 20 at the
time, he was still able to sniff out a bargain in the market and conduct the rigorous, but simplistic analysis that he has
become so well known for over his career.

Warren Buffett pumped around 65% of his own personal wealth (around $13,000) into GEICO stock and he later
wrote that with GEICO he was able to “develop a depth of conviction which I have felt few times since about any
security”.

No mention
At only 20 years of age, the then unknown Warren Buffett penned an article that was published in the Commercial
and Financial Chronicle. The article was titled “The Security I Like Best” and was published on Thursday, December
6, 1951. Buffett was pitching the Government Employees Insurance Company, or GEICO that had gone public three
years before.

Buffett recognized the fact that, at only eight times earnings, GEICO’s valuation did not reflect: “the tremendous
growth potential of the company.”

This was the first time that Buffett wrote about GEICO, but it certainly wasn’t the last. Within a year-and-a-half of
Buffett’s initial purchase, GEICO’s share price doubled as growth continued.

However, though Buffett owned GEICO in his personal accounts as early as 1951, he didn’t start buying the stock for
his partnerships or Berkshire, until several decades after. There’s no mention of GEICO in Buffett’s letters to partners
from 1956 to 1970.

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Buffett makes his move

Warren Buffett didn’t make his move on GEICO until it was teetering on the edge of bankruptcy. A combination
of overexpansion, inflation, federal price controls, bad risks and questionable accounting had floored GEICO, and
during 1975; the company reported its first loss in 36 years. At was at this time that Shelby Davis, another renowned
value investor, specializing in insurance stocks, started buying.

GEICO undertook a hefty restructuring in the years after 1975; David Byrne was poached from GEICO’s fellow
insurer, Travelers Insurance, where he was executive vice president to initiate a turnaround. 3,000 of GEICO’s 7,000
employees were laid off. The company withdrew from markets with overbearing regulatory regimes, hiked rates by as
much as 40% in some regions and tightened its insurance criteria.

Unfortunately, even these drastic actions failed to shore up GEICO’s balance sheet, and David Byrne has to take dras-
tic action. He persuaded 27 competing insurance companies to contribute capital to help avert a GEICO bankruptcy,
and along with the help of Warren Buffett, issued $75 million in convertible preferred stock.

It was at this point that Warren Buffett started buying GEICO common at $2 per share, investing an initial sum of
$4.1 million. Five years later, GEICO stock hit $15; Buffett kept buying. Finally, in 1995 Berkshire purchased the rest
of GEICO for a total of $70 a share.

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PART FOUR

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Unlocking Value
“So that you may better understand our method of operation, I think it would be
well to review a specific activity of 1958. Last year I referred to our largest holding
which comprised 10% to 20% of the assets of the various partnerships.” Warren
Buffett letter to partners 1958

There’s a stark contrast between Warren Buffett’s early investments and those of later years. It was in 1972 that Warren
Buffett’s strategy really started to change, from a deep value activist approach to that of long-term quality and value.
This change was inspired by the $25 million purchase of See’s Candies. A deal Buffett was pushed into by Charlie
Munger, as the two investors started to become friends and build a strong working relationship.

Still, it’s Warren Buffett’s early investments that are really interesting. Indeed, many view Warren Buffett as a passive
deep value investor, who’s incredible skill (and possibly some luck) at picking investments helped him to get to where
he is today.

But that is not the case. Many of Buffett’s early successes were driven by activist tactics. Buffett would devote most of
his partners’ assets to one company, buy a controlling stake and then push for change. Granted, most of the compa-
nies he targeted were trading below their net asset value and were deep value opportunities anyway. But Buffett wasn’t
prepared to wait for the market to correct the valuation gap.

Commonwealth Bank

One of the first investments Warren Buffett wrote about wasn’t an activist situation. This situation was Common-
wealth Bank, which Buffett started buying during 1958. At $50 per share, Commonwealth was trading at a measly
five times earnings and had had an intrinsic value $125 per share computed on a conservative basis.

Over time, approximately ten years, Buffett computed that the bank’s intrinsic value could rise to $250 per share. So,
this was both a deep value and growth play.

Over a period of 12 months, Buffett acquired around 12% of the bank at a price of $51 per share, which made
Buffett and his partners the bank’s second largest shareholder. The bank only had around 300 shareholders in total,
the shares traded only around two times per month.

However, during the latter half of 1958, Warren Buffett sold his entire commonwealth holding.

“Late in the year we were successful in finding a special situation where we could
become the largest holder at an attractive price, so we sold our block of Com-
monwealth obtaining $80 per share although the quoted market was about 20%
lower at the time.

It is obvious that we could still be sitting with $50 stock patiently buying in dribs
and drabs, and I would be quite happy with such a program although our perfor-
mance relative to the market last year would have looked poor. The year when a
situation such at Commonwealth results in a realized profit is, to a great extent,

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fortuitous. Thus, our performance for any single year has serious limita-
tions as a basis for estimating long term results. However, I believe that a
program of investing in such undervalued well protected securities offers
the surest means of long term profits in securities.”

In other words, Buffett took his near 60% return -- in under a year -- and started to gobble up the stock of another
deep value opportunity.

Clearly, Buffett’s involvement in Commonwealth did have some impact on the bank’s stock price. It’s here that it starts
to become clear that Buffett’s success has not been wholly down to his stock selection strategies. The five Buffett
partnerships that were operating throughout the year gained between 36.7% to 46.2%, outperforming the Dow-Jones
Industrial Average, which returned 38.5%. Buffett was paying close attention to the index at the time. He wanted to
outperform, the reason he took his gains in Commonwealth and snapped up another opportunity.

Sanborn Map

The other opportunity was a company called Sanborn Map and at the end of 1959, Warren Buffett had ploughed a
total of 35% of partnership assets into Sanborn stock.

Warren Buffett’s Sanborn trade (I consider Sanborn to be a short-term trade rather than the long-term investments
Buffett has become known for) is well documented. Buffett hoped the situation would work out within a few years,
and during 1960 he was proved right.

As I said above, the trade is well documented so I won’t go into too much detail here. Sanborn was a mapping com-
pany that had, over the years, built a sizeable equity and bond portfolio with excess cash. At the time Warren Buffett
started buying Sanborn stock, during 1958, the map business was evaluated at a minus $20 with the stock portfolio
trading at only $0.70 on the dollar. Sanborn had a sales volume of about $2 million per year and owned about $7
million worth of marketable securities.

Warren Buffett managed to get his hands on a large chunk of 15,000 Sanborn shares from the widow of a deceased
president of the company. Her son had tried and failed, to instigate change at the company. Through open market
purchases, Buffett increased his holding to 24,000 shares and pushed for change. To avoid a proxy fight, manage-
ment caved, and Buffett got his way. The company was separated, and value was unlocked.

“About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged
for portfolio securities at fair value. The map business was left with over $l,25 million in
government and municipal bonds as a reserve fund, and a potential corporate capital gains
tax of over $1 million was eliminated. The remaining stockholders were left with a slightly
improved asset value, substantially higher earnings per share, and an increased dividend
rate.”
A great example of Warren Buffett’s early activist activities.

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PART FIVE

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A Lollapalooza
“Buffett’s decision to limit his activities to a few kinds and to maximize his atten-
tion to them, and to keep doing so for 50 years, was a lollapalooza. Buffett suc-
ceeded for the same reason Roger Federer became good at tennis. Buffett was, in
effect, using the winning method of the famous basketball coach, John Wooden,
who won most regularly after he had learned to assign virtually all playing time to
his seven best players.” -- Charlie Munger

Warren Buffett adopted the same mentality from an early age. I don’t really have enough space to explore the topic in
full here but if you’re looking for further research on the topic, Michael J. Mauboussin has written an interesting paper
on position sizing. He writes that:

“Position size is extremely important in determining equity portfolio returns. Two

portfolio managers with the same list and number of stocks can generate mean-
ingfully different results based on how they allocate the capital among the stocks.
Great investors don’t stop with finding attractive investment opportunities; they
know how to take maximum advantage of the opportunities. As Charlie Munger
says, good investing combines patience and aggressive opportunism.”

Warren Buffett’s success over the years has been driven, in part, by his asset allocation strategy. This is extremely ap-
parent in his early partnership letters.

Position sizing
Indeed, throughout the late 50s and 60s, Warren Buffett ploughed most of the assets of his partnerships into several
key investments; Commonwealth Bank, Sanborn Map,Dempster Mill and Berkshire Hathaway. These investments
could account for as much as a third (or more) of total partnership assets at any one time.

As the quote from Warren Buffett’s right-hand man, Charlie Munger, at the top of this article indicates, it was this
asset allocation strategy, coupled with Buffett’s conviction in his ideas that helped turbocharge returns over the years.

It’s here that I’m going to deviate slightly from Warren Buffett’s history and look at the topic of asset allocation and
position sizing in general.

Activist investor
If Warren Buffett had used a traditional asset allocation model, as advocated by his mentor, Benjamin Graham would
he have been able to achieve the same returns over his career? It is unlikely. That being said, it’s unlikely that Buffett
would have taken these large positions if it were not for the fact that he was trying to gain control of each company.

Indeed, in every case where more than a fifth of partnership assets were pumped into one stock, Buffett sought to
take control of the company to unlock value -- somethingI’ll explore in part six of this series.

This investing philosophy has more in common with activist investors, the likes ofCarl Icahn and Bill Ackman, rather
than Graham alumni and Superinvestors of Graham-and-Doddsville. In fact, it could be said that Buffett was, from

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the very start of his career, an activist investor.

And to understand Warren Buffett’s position sizing strategy you have to understand his perception of risk.

Warren Buffett on risk

John Maynard Keynes wrote in 1942 that:

“To suppose that safety-first consists in having a small gamble in a large number
of different [companies] where I have no information to reach a good judgment,
as compared with a substantial stake in a company where one’s information is ad-
equate, strikes me as a travesty of investment policy.”

What about Warren Buffett’s altered perception of risk? Well, here’s a quote from Berkshire Hathaway’s 2007 annual
meeting:
“The measurement of volatility: it’s nice, it’s mathematical, and wrong. Volatility is
not risk. Those who have written about risk don’t know how to measure risk. Past
volatility does not measure risk. When farm prices crashed, [farm price] volatility
went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn’t
riskier because it’s more volatile. [Measures like] beta let people who teach finance
use the math they’ve learned. That’s nonsense. Risk comes from not knowing what
you’re doing. Dexter Shoes was a terrible mistake-I was wrong about the business,
but not because shoe prices were volatile. If you understand the business you own,
you’re not taking risk. Volatility is useful for people who want a career in teaching.
I cannot recall a case where we lost a lot of money due to volatility. The whole
concept of volatility as a measure of risk has developed in my lifetime and isn’t
any use to us.” -- Warren Buffett

To put it simply, if you really know and understand the company you’re taking a position in, the size of the position
as a percentage of overall assets shouldn’t matter.

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PART SIX

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Method Of Operation
By 1961, Warren Buffett had achieved a compounded gain of 181.6% for his partners over the space of four years.
To celebrate this fact, and point out how rare such outperformance was, Warren Buffett presented the following
chart in his annual 1961 letter to partners.

This chart shows the performance of Buffett’s limited partnerships compared to the Dow, the two largest common
stock open-end investment companies at the time and the two largest closed-end investment companies.

When Warren Buffett presented this data, the Massachusetts Investors Trust has net assets of about $1.8 billion; In-
vestors Stock Fund about $1 billion; Tri -Continental Corporation about $ .5 billion; and Lehman Corporation about
$350 million; or a total of over $3.5 billion. At the beginning of 1962 net assets belonging to the Buffett partnership
group amounted to $7,178,500.00.

Method of operation

Warren Buffett notes that his method of operation is very different to that of mutual funds and he then goes on to
break down the various categories of trades that he undertook for partners -- I touched on this briefly in part four.
Buffett also uses this section of the letter to lay out his position sizing strategy.
“The first section consists of generally undervalued securities (hereinafter called
“generals”) where we have nothing to say about corporate policies and no timeta-
ble as to when the undervaluation may correct itself. Over the years, this has been
our largest category of investment, and more money has been made here than in
either of the other categories. We usually have fairly large positions (5% to 10%
of our total assets) in each of five or six generals, with smaller positions in another
ten or fifteen.”

Buffett notes that the generals tended to behave very much in sympathy with the Dow. Nevertheless, the generals as
a group put in the best performance over the long-term.
“Our second category consists of “work-outs.” These are securities whose finan-
cial results depend on corporate action rather than supply and demand factors
created by buyers and sellers of securities. In other words, they are securities with
a timetable where we can predict, within reasonable error limits, when we will get
how much and what might upset the applecart. Corporate events such as merg-
ers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important

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source in recent years has been sell-outs by oil producers to major integrated oil
companies.”

Work-outs, Buffett goes on to note, tend to move irrespective of the Dow. In a year where the Dow falls by a large
percentage, the work-outs tended to help improve Buffett outperform. Further, Buffett notes that these work-outs
were the one situation where it was permissible to use borrowed money to improve results:

“Over the years, work-outs have provided our second largest category. At any
given time, we may be in ten to fifteen of these; some just beginning and others in
the late stage of their development. I believe in using borrowed money to offset
a portion of our work-out portfolio since there is a high degree of safety in this
category in terms of both eventual results and intermediate market behavior...My
self-imposed limit regarding borrowing is 25% of partnership net worth. Often-
times we owe no money and when we do borrow, it is only as an offset against
work-outs.”

And Warren Buffett’s final category of investments at the time was “control” situations. These situations saw Buffett
take a large, controlling stake in the target company and attempt to influence corporate policies.

These positions tended to be the biggest single positions in Buffett’s portfolio. His activist approach to control situ-
ations allowed Buffett to take huge bets on these opportunities as the chances of the trade turning against him were
almost non-existent.

Dempster Mill

In some cases, Buffett’s general’s turned into control situations and Dempster Mill Manufacturing Company was one
such investment.

Dempster Mill is an interesting case study of Buffett’s style. The position was first purchased in the mid-50s, and Buf-
fett brought his way onto the board in late 1961. As Buffett explains in his 1962 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.
While I claim no oracular vision in a matter such as this, I feel this is a fair valua-
tion to both new and old partners. Certainly, if even moderate earning power can
be restored, a higher valuation will be justified, and even if it cannot, Dempster
should work out at a higher figure. Our controlling interest was acquired at an
average price of about $28, and this holding currently represents 21% of partner-
ship net assets based on the $35 value.”

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After several months of pushing for change at Dempster, Warren Buffett grew tired of management’s lack of action.
So, on April 17, 1962, Buffett met with turnaround guru Harry Bottle, and by April 23rd Harry was sitting in Demp-
ster’s president’s chair.

Harry Bottle got straight to work, sold Dempster’s unproductive assets and freed up capital. The change in Demp-
ster’s asset value in just 12 months is highly impressive, as the two tables below show.

Dempster Mill balance sheet 1962 (pre-Harry)

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PART SEVEN

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Work-Outs
As covered in the last part of this series, Warren Buffett had three different types of investments when he was manag-
ing his partnerships. These three categories were: generals, workouts and control situations.
Workouts, or special situations (corporate events such as mergers, liquidations, reorganizations, spin-offs,) are by far
the most interesting of this group.
Due to their nature, Buffett was able to predict what kind of a return he would generate from each workout, over a
specified period of time, and to some extent, this reduced risk.

“The gross profits in many workouts appear quite small. A friend refers to this as
getting the last nickel after the other fellow has made the first ninety-five cents.
However, the predictability coupled with a short holding period produces quite
decent annual rates of return. This category produces more steady absolute prof-
its from year to year than generals do.”

Warren Buffett considered some of his workouts to be so low risk -- Warren Buffett used the term “high degree of
safety” -- that he often borrowed money to increase returns.

In his 1962 letter to investors, Warren Buffett gave a detailed explanation of his workout plays undertaken during
the year. And at the time, Buffett was finding deals in the oil sector. Specifically, sell-outs by oil producers to major
integrated oil companies.

Warren Buffett: Borrowing to increase returns

At any one time, Buffett was involved in five to ten workouts. Some just beginning and others in the late stage of their
development.

During 1962, Buffett’s partnerships borrowed a total of $1,500,000 to fund workout situations. Partnership assets
stood at $9.4 million at the end of 1963. Buffett’s self-imposed borrowing limit was 25% of partnership funds. In
addition to using leverage, Buffett also made use of short selling during 1962 to hedge against market volatility while
he was waiting for a workout to play out:

One run-of-the-mill workout opportunity that Warren Buffett took was Texas National Petroleum, a workout that
arose from Buffett’s number one source of workouts, sellouts of oil and gas producing companies.

Early in 1962, Warren Buffett notes, there were rumors that TNP was discussing a deal with Union Oil of California,
although he failed to act on the opportunity. (Buffett makes it quite clear that he never acts on rumors). Unfortunately,
this cost him a “substantial” amount of money. Nonetheless in early April 1962 a deal was announced.

TNP had three types of securities:

1. 6 ½% debentures. Of the $6.5 million of these outstanding, Buffett purchased $264,000

2. 3.7 million shares of common. 40% of which were owned by directors. Buffett purchases 64,035
3. 650,000 warrants to purchase common stock at $3.50 per share. Buffett purchased 13% of this issue.

The risk of stockholder disapproval was nil. The deal was negotiated by the controlling stockholders. There were no
antitrust problems. The only problem was the obtaining of the necessary tax ruling. This delayed the deal but did not

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threaten it. Warren Buffett describes the whole deal in his letter to partners:
“When we talked with the company on April 23rd and 24th, their estimate was
that the closing would take place in August or September. The proxy material was
mailed May 9th and stated the sale “will be consummated during the summer of
1962 and that within a few months thereafter the greater part of the proceeds will
be distributed to stockholders in liquidation.” As mentioned earlier, the estimate
was $7.42 per share. Bill Scott attended the stockholders meeting in Houston on
May 29th where it was stated they still expected to close on September 1st.

The following are excerpts from some of the telephone conversations we had
with company officials in ensuing months:

On June 18th the secretary stated “Union has been told a favorable IRS ruling has
been formulated but must be passed on by additional IRS people. Still hoping for
ruling in July.”

On July 24th the president said that he expected the IRS ruling “early next week.”
On August 13th the treasurer informed us that the TNP, Union Oil, and USC
people were all in Washington attempting to thrash out a ruling.

On September 18th the treasurer informed us “No news, although the IRS says
the ruling could be ready by next week.”

The ruling was received in late September, and the sale closed October 31st…
The financial results of TNP were as follows:

(1) On the bonds we invested $260,773 and had an average holding period of
slightly under five months. We received 6 ½% interest on our money and realized
a capital gain of $14,446. This works out to an overall rate of return of approxi-
mately 20% per annum.

(2) On the stock and warrants we have realized a capital gain of $89,304, and we
have stubs presently valued at $2,946. From an investment or $146,000 in April,
our holdings ran to $731,000 in October. Based on the time the money was em-
ployed, the rate or return was about 22% per annum.”

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PART EIGHT

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Shaking Up Berkshire Hathaway

On May 11, 1965 an article appeared in the The New York Times Company (NYSE:NYT) titled: TEXTILE CON-
CERN CHANGES CONTROL; Berkshire Hathaway Policy Row Spurs Resignations. The article cited a curious case
at a small, 76-year old textile company called Berkshire Hathaway. Two top officers of the company had tendered their
resignations, following, “a policy disagreement with certain outside interests who have purchased sufficient stock to
control the company.”

Seabury Stanton, president, a director and chairman of the executive committee, along with his son, John K. Stanton,
vice president, treasurer and director were the officers handing in their notices. The article in the New York Times
continues:
“Although he did not state who had bought control of the company, Malcolm G.
Chace Jr., chairman, said yesterday that a large interest had been purchased by Buf-
fett Partnership Ltd., an Omaha investment company.”

Although this article was published the first half of 1965, Warren Buffett himself did not mention Berkshire Hatha-
way by name in his letters to partners until November 1, 1965.

“The partnership owns a controlling interest in Berkshire Hathaway Inc., a public-

ly-traded security...asset values and earning power are the dominant factors affect-
ing the valuation of a controlling interest in a business…”

Stealth position
Buffett first mentioned Berkshire by name to his partners at the end of 1965. However, the Buffett Partnerships
had owned the stock, as one of Buffett’s “generals” since 1962. In true early-Buffett style, Buffett had become
bored of Berkshire Hathaway’s management, buying up a controlling stake in the company to help enforce change.
Warren Buffett gave a full run-down of the Berkshire situation within his January1966 letter to partners:

“Our purchases of Berkshire started at a price of $7.60 per share in 1962. This
price partially reflected large losses incurred by the prior management in closing
some of the mills made obsolete by changing conditions within the textile busi-
ness (which the old management had been quite slow to recognize). In the postwar
period the company had slid downhill a considerable distance, having hit a peak in
1948 when about $29 1/2 million was earned before tax and about 11,000 work-
ers were employed. This reflected output from 11 mills. At the time we acquired
control in spring of 1965, Berkshire was down to two mills and about 2,300 em-
ployees. It was a very pleasant surprise to find that the remaining units had excel-
lent management personnel, and we have not had to bring a single man from the
outside into the operation. In relation to our beginning acquisition cost of $7.60
per share (the average cost, however, was $14.86 per share, reflecting very heavy
purchases in early 1965), the company on December 31, 1965, had net working
capital alone (before placing any value on the plants and equipment) of about $19
per share. Berkshire is a delight to own.”

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But this wasn’t the whole story. The New York Times article, mentioned above sheds some more light on the situa-
tion:
“In discussing the resignations of the two Stantons. Mr. Buffett said that Seabury
Stanton ‘was planning to resign at the end of the year; it’s possible that his son
might have hoped to succeed him.’”

“It was learned, however, from Wall Street sources that Seabury Stanton and the
Buffett group might have been at odds over the speed with which unprofitable
mills should be closed. In addition, Mr. Buffett and Mr. Cowin were said to be
anxious to have younger men at the company to take over a bigger role in its man-
agement. Berkshire Hathaway, a major northern mill, turned a profit in the latest
fiscal year, ended Sept. 30, 1964 for the first time in four years. The company’s
sales however, have slipped in each year but one since fiscal 1959.”

Trouble ahead
After Seabury Stanton left, Berkshire experienced two good years; 1965 and 1966. But by July 1967 performance
had deteriorated once again. Buffett wrote in his July 1967 letter to partners:

“B-H is experiencing and faces real difficulties in the textile business, while I don’t
presently foresee any loss in underlying values. I similarly see no prospect of a
good return on the assets employed in the textile business. Therefore, this segment
of our portfolio will be a substantial drag on our relative performance (as it has
been during the first half)...”
Of course, if Warren Buffett had been working with Charlie Munger at the time, (Charlie Munger didn’t join forces
with Buffett on a full-time basis until 1978 when he closed his own investment partnerships) he would have been
able to see the dire situation that Berkshire was in.

“[The] textile business in New England… was totally doomed because textiles are
congealed electricity and the power rates were way higher in New England than
they were down in TVA country in Georgia. A totally doomed, certain-to-fail busi-
ness,” -- Source

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PART NINE

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Berkshire Hathaway Starts To Grow

After shaking up Berkshire Hathaway in the mid 60’s, by mid-1967, after two years of good performance the textile
business was beginning to deteriorate once again. As covered in part eight of this series, within his July 1967 letter to
partners Buffett wrote that:

“B-H is experiencing and faces real difficulties in the textile business while I don’t
presently foresee any loss in underlying values. I similarly see no prospect of a
good return on the assets employed in the textile business. Therefore, this segment
of our portfolio will be a substantial drag on our relative performance (as it has
been during the first half)...”

But by this point Berkshire Hathaway was evolving. At the time, Buffett controlled around 70% of Berkshire, so his
partnerships effectively owned the business. During March 1967, Berkshire acquired National Indemnity and its sister
company, National Fire & Marine, for $8.6 million.

Through another entity, Diversified Retailing, which Buffett and his partners owned 80% of, Buffett purchased As-
sociated Cotton Shops. There was also Hochschild Kohn as mentioned earlier in this series.

National Indemnity
The National Indemnity acquisitions turned out to be two of Buffett’s greatest acquisitions ever. Today, based on
GAAP principles, these businesses are worth $111 billion, a value which exceeds that of any other insurer in the world.

Further, as Buffett made a note of in Berkshire’s 50th-anniversary letter to shareholders National Indemnity provided
Buffett with more than just an insurance business:

“One reason we were attracted to the property-casualty business was its financial
characteristics: P/C insurers receive premiums upfront and pay claims later. In ex-
treme cases, such as those arising from certain workers’ compensation accidents,
payments can stretch over many decades. This collect-now, pay-later model leaves
P/C companies holding large sums – money we call “float” – that will eventually
go to others. Meanwhile, insurers get to invest this float for their benefit. Though
individual policies and claims come and go, the amount of float an insurer holds
usually remains fairly stable in relation to premium volume...”-- Warren Buffett-
Berkshire 2014 letter.

Changing strategy
At the end of 1967, Warren Buffett wrote to his partners informing them that the market was changing.
Investing had become a popular past time, and more money was flowing into the market, chasing a shrinking number
of opportunities. What’s more, to meet the rising demand for brokerages services, the number of analysts on Wall
Street was exploding. The number of low-risk, high-return deep value opportunities available was shrinking.

So Buffett started to invest differently.

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National Indemnity and Diversified Retailing were acquired as part of this changing strategy. Both companies achieved
high returns on capital and generated plenty of excess cash for Buffett to grow his expanding Berkshire with. In Buf-
fett’s Jan 1969 letter to partners he wrote:

“Particularly outstanding performances were turned in by Associated Cotton

Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Com-
pany, a subsidiary of B-H run by Jack Ringwalt. Both of these companies earned
about 20% on capital employed in their businesses. Among Fortune’s “500” (the
largest manufacturing entities in the country, starting with General Motors Com-
pany (NYSE:GM)), only 37 companies achieved this figure in 1967, and our boys
outshone such mildly better-known (but not better appreciated) companies as
International Business Machines Corp. (NYSE:IBM), General Electric Company
(NYSE:GE), General Motors, Procter & Gamble, DuPont, Control Data, Hewl-
ett-Packard, etc…”

“I still sometimes get comments from partners like: “Say, Berkshire is up four
points - that’s great!” or “What’s happening to us, Berkshire was down three last
week?” Market price is irrelevant to us in the valuation of our controlling interests.
We valued B-H at 25 at yearend 1967 when the market was about 20 and 31 at
yearend 1968 when the market was about 37. We would have done the same thing
if the markets had been 15 and 50 respectively. (“Price is what you pay. value is
what you get”). We will prosper or suffer in controlled investments in relation to
the operating performances of our businesses - we will not attempt to profit by
playing various games in the securities markets.”

If anything, this confirms Buffett’s switch from activist hedge fund manager to businessman. And during 1969, Berk-
shire Hathaway really started to grow. By the end of the year, the company had three main operating businesses:

“...the textile operation, the insurance operation (conducted by National Indem-

nity Company and National Fire & Marine Insurance Company, which will be col-
lectively called the insurance company) and the Illinois National Bank and Trust
Company of Rockford, Illinois. It also owns Sun Newspapers Inc, Blacker Print-
ing Company and 70% of Gateway Underwriters…”

Winding down
By the end of 1969, Buffett had commenced the wind-down of his partnerships and the Berkshire Hathaway we
know today was starting to take shape...stay tuned for the final part of this series.

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PART TEN

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Warren Buffett Abandons Deep Value

On October 9 1967, Warren Buffett wrote to the partners of his Buffett Partnership group announcing that he was
changing his strategy. Up to this date, Buffett had sought out deep-value plays, with a self-imposed performance
hurdle of 10% above the Dow’s annual return. This was becoming increasingly difficult to achieve for the following
reasons, as laid out in Buffett’s letter:

“The following conditions now make a change in yardstick appropriate:

1. The market environment has changed progressively over the past decade, resulting in a sharp
diminution in the number of obvious quantitatively based investment bargains available;

2. Mushrooming interest in investment performance...has created a hyper-reactive pattern of market

behavior against which my analytical techniques have limited value;

3. The enlargement of our capital base to about $65 million when applied against a diminishing trickle of
good investment ideas has continued to present...problems…

4. My own personal interests dictate a less compulsive approach to superior investment results than when
I was younger and leaner.”

The first point was Buffett’s main concern. The numbers deep value opportunities in the market had dwindled by
1969; it was becoming increasingly difficult for Buffett to make calculated, low-risk bets with a high percentage of
partners’ capital.

Buffett identified two key reasons for this decline in bargain issues. Firstly, the number of takeovers was increasing
-- takeovers often focused on bargain issues. Secondly, “the exploding ranks of security analysts” that have helped
investors identify opportunities with ease, eliminating the need to do the legwork themselves. At the end of 1968,
Buffett wrote that he was unable to find any potential ideas for his 1969 watch list.

A hyper-reactive pattern of market behavior was another driving force behind Buffett’s decision to move away from
the deep-value side of investing. He wrote:

“I have always cautioned partners that I considered three years a minimum in

determining whether we were “performing”. Naturally, as the investing public has
taken the bit in its teeth the time span of expectations has been consistently re-
duced to the point where investment performance...is being measured yearly, quar-
terly, monthly, and perhaps sometimes even more frequently.”

“In my opinion what is resulting is speculation on an increasing scale.”

“...I do believe certain conditions that now exist are likely to make activity in mar-
kets more difficult for us [in] the intermediate future.”

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A retreat
So, an increasing number of investors chasing a dwindling number of securities, coupled with increasing short-
termism, a rising value of asset under management and request for more personal time were the key reasons behind
Buffett’s decision to retreat from the deep-value game. At the same time, Buffett reduced his yardstick performance
water mark.

“...I am likely to limit myself to things which are reasonably easy, safe, profitable
and pleasant...The long-term downside risk will not be less; the upside potential will
merely be less.”

“...out longer term goal will be to achieve the lesser of 9% per annum or a five per-
centage point advantage over the Dow. Thus, if the Dow averages -2% over the next
five years, I would hope to average +3% but if the Dow averages +12%, I will hope
of achieve an average of only +9%.”

Deteriorating
On May 29 1969, Buffett followed up his first letter, issued at the beginning of October 1967. Buffett noted that the
situation in the markets had deteriorated further:

“...opportunities for investment...have virtually disappeared, after rather steadily dry-

ing up over the past twenty years...our $100 million of assets further eliminates a
large portion of this seemingly barren investment world, since commitments of
less than about $3 million cannot have a real impact on our overall performance...
this virtually rules out companies with less than about $100 million common stock
at market value…”

Along with these factors, Buffett noted once again that the markets were becoming increasingly short-term focused,
and he was struggling to devote 100% of his time to the running of the Partnership interests. With these problems
laid out, Buffett revealed to his partners that he intended to announce formally his resignation before the end of 1969.

This was the end of the Buffett Partnerships and the beginning of Berkshire Hathaway as we know today.

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PART ELEVEN

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The End Of An Era

“About eighteen months ago I wrote to you regarding changed environmental
and personal factors causing me to modify our future performance objectives.

The investing environment I discussed at that time (and on which I have com-
mented in various other letters has generally become more negative and frustrat-
ing as time has passed…”

“The October 9th, 1967 letter stated that personal considerations were the most
important factor among those causing me to modify our objectives...publishing
a regular record and assuming responsibility for management of what amounts
to virtually 100% of the net worth of many partners, I will never be able to put
sustained effort into any non-BPL activity.”

“Therefore, before yearend. I intend to give all limited partners the required for-
mal notice of my intention to retire...” -- Warren Buffett May 29th, 1969 letter to
partners.

During November of 1969, Warren Buffett formally announced his intention to wind up his investment partnerships.
He made this decision for several reasons. Firstly, as mentioned above, undervalued securities were becoming harder
to find. Secondly, the size of the partnership was becoming a problem.

At the time he announced his retirement, the partnerships were managing over $100 million in assets, with gains of
over $40 million during 1968 alone. And thirdly, managing Berkshire alone with its subsidiaries as well as partnership
assets, become too much for Buffett.

But for those that wanted to keep their money in the market, Buffett offered a replacement; Bill Ruane. Bill Ruane’s
managed his own set of partnerships and in the years to the handover achieved returns of 40% on average per annum
for shareholders. If you want to find out more about Bill Ruane, his investment process and returns for partners, head
over the ValueWalk Bill Ruane resource page.

Outsized returns
There has always been plenty of talk about Warren Buffett’s ability to compound shareholder equity at Berkshire,
although it’s the returns that he achieved during his years running the partnerships that are really impressive.

Over ten years, Buffett turned less than $1 million into more than $100 million, achieving a compound annual return
of 31.6% during the period.

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This record eclipses Berkshire’s growth.

Buffett summed up the performance of the Buffett Partnerships in one of his final letters to partners.

“Buffett Associates, Ltd., the initial predecessor partnership, was formed May 5,
1956 with seven limited partners (four family, three close friends), contributing
$105,000, and the General Partner putting his money where his mouth was by in-
vesting $100. Two additional single-family limited partnerships were formed dur-
ing 1956, so that on January 1, 1957 combined net assets were $303,726. During
1957, we had a gain of $31,615.97, leading to the 10.4% figure shown on page
one. During 1968 I would guess that the New York Stock Exchange 127 was open
around 1,200 hours, giving us a gain of about $33,000 per hour (sort of makes
you wish they had stayed with the 5-1/2 hour, 5 day week, doesn’t it), or roughly
the same as the full year gain in 1957. On January 1, 1962 we consolidated the
predecessor limited partnerships moved out of the bedroom and hired our first

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full-time employees. Net assets at that time were $7,178,500. From that point to
our present net assets of $104,429,431 we have added one person to the pay-
roll. Since 1963 (Assets $9,405,400) rent has gone from $3,947 to $5,823 (Ben
Rosner would never have forgiven me if I had signed a percentage lease) travel
from $3,206 to $3,603, and dues and subscriptions from $900 to $994. If one of
Parkinson’s Laws is operating, at least the situation hasn’t gotten completely out
of control.”

Buffett takes the helm at Berkshire

As the Buffett Partnerships controlled the majority of Berkshire Hathaway, it wasn’t until the partnerships were dis-
solved that Buffett began to manage Berkshire himself.

Berkshire’s 1970 letter to shareholders was written and signed by Kenneth V. Chace, President. Berkshire’s 1971 letter
to investors was signed by Warren E. Buffett Chairman of the Board.

Even though Buffett had wound down his partnerships citing the lack of opportunities and scope for return in the
market, he was immediately able to achieve an outsized return at Berkshire.

Berkshire’s 1971 operating earnings, excluding capital gains amounted to more than 14% of shareholders equity. Con-
siderably above the average of American industry. Below are Warren Buffett’s first three letters to Berkshire stocks
holders as the company’s Chairman.
• To the Stockholders of Berkshire Hathaway Inc. 1971
• To the Stockholders of Berkshire Hathaway Inc.1972
• To the Stockholders of Berkshire Hathaway Inc.1973
That’s the end of this series on Warren Buffett’s early years. Stay tuned for the next exclusive ValueWalk famous inves-
tor series.

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