Book notes and lessons learnt: “Snowball” by Alice Schroeder

Although innovation might lift the world out of poverty, people who invest in innovation historically have not been glad afterward

“Well, that’s the way people feel with stocks. It’s very easy to believe that there’s some truth to that rumor after all.”

Compounding married the present to the future. If a dollar today was going to be worth ten some years from now, then in his mind the two were the same.

One Thousand Ways to Make $1,000, it was called. A million dollars, in other words! Inside the cover, in a photograph, a tiny man gazed up at an enormous pile of coins. “Opportunity Knocks,” read the first page of the text. “Never in the history of the United States has the time been so favorable for a man with small capital to start his own business as it is today.” What a message! “We have all heard a great deal about the opportunities of bygone years….Why, the opportunities of yesterday are as nothing compared with the opportunities that await the courageous, resourceful man of today! There are fortunes to be made that will make those of Astor and Rockefeller seem picayune.” These words rose like sweet visions of heaven to Warren Buffett’s eyes. He turned the pages faster. “But,” the book cautioned, “you cannot possibly succeed until you start.

Carnegie advocated avoiding confrontation. “People don’t want criticism. They want honest and sincere appreciation.” I am not talking about flattery, Carnegie said. Flattery is insincere and selfish. Appreciation is sincere and comes from the heart. The deepest urge in human nature is “the desire to be important.”

“Graham’s book” was The Intelligent Investor, published in 1949.6 This book of “practical counsel” for all types of investors — the cautious (or “defensive”) and speculative (or “enterprising”) — blew apart the conventions of Wall Street, overturning what had heretofore been largely uninformed speculation in stocks. It explained for the first time in a way that ordinary people could understand that the stock market does not operate through black magic. Through examples of real stocks such as the Northern Pacific Railway and the American-Hawaiian Steamship Company, Graham illustrated a rational, mathematical approach to valuing stocks. Investing, he said, should be systematic.

How do companies make money? A company was much like a person. It had to go out and find a way to keep a roof over its employees’ and shareholders’ heads.

Thus, Graham’s investing method was not simply about buying stocks cheap. As much as anything it was rooted in an understanding of psychology, enabling its followers to keep their emotions from influencing their decision-making. From Graham’s class, Warren took away three main principles:

• A stock is the right to own a little piece of a business. A stock is worth a certain fraction of what you would be willing to pay for the whole business.
• Use a margin of safety. Investing is built on estimates and uncertainty. A wide margin of safety ensures that the effects of good decisions are not wiped out by errors. The way to advance, above all, is by not retreating.
• Mr. Market is your servant, not your master. Graham postulated a moody character called Mr. Market, who offers to buy and sell stocks every day, often at prices that don’t make sense. Mr. Market’s moods should not influence your view of price. However, from time to time he does offer the chance to buy low and sell high. Of these points, the margin of safety was most important. A stock might be the right to own a piece of a business, and the intrinsic value of the stock was something you could estimate, but with a margin of safety, you could sleep at night.

“I would get these papers from 1929. I couldn’t get enough of it. I read everything — not just the business and stock-market stories. History is interesting, and there is something about history in a newspaper, just seeing a place, the stories, even the ads, everything. It takes you into a different world, told by somebody who was an eyewitness, and you are really living in that time.”

Warren, who had such confidence in his own judgment, saw no reason to hedge his bets this way and inwardly rolled his eyes at diversification.

Every decision had an opportunity cost — he had to compare each investing opportunity with the next best one. As much as he liked GEICO, he had made the wrenching decision to sell it after finding another stock that he coveted even more, called Western Insurance. This company was earning $29 a share, and its stock was selling for as little as three bucks.

What Warren was learning about by keeping his ears open was the art of capital allocation — placing money where it would earn the highest return. In this case, Graham-Newman was using money from one business to buy a more profitable business. Over time, it could mean the difference between bankruptcy and success.

To him, stock-picking was an intellectual exercise. “One time, we were waiting for an elevator. We were going to eat in the cafeteria down at the bottom of the Chanin Building at Forty-second and Lex. And Ben said to me, ‘Remember one thing, Warren: Money isn’t making that much difference in how you and I live. We’re both going down to the cafeteria for lunch and working every day and having a good time. So don’t worry too much about money, because it won’t make much difference in how you live.’ ”

His only constraints were the money, energy, and time he had available. It was lumberjack labor, but he loved doing it. This was nothing like the way most people invested: sitting in an office and reading reports that described research performed by other people. Warren was a detective, and he naturally did his own research, just as he had collected bottle caps and thought about fingerprinting nuns.

The market shot up, and once again comparisons were made to 1929. Warren had never ridden out a speculative market, yet he remained unruffled. It was as if he had been waiting for this moment. Instead of pulling back, as Graham might have done, he did something remarkable. He went into overdrive raising money for the partnerships.

By 1960 it took at least $8,000 to get in the door. And he no longer asked people to invest with him. They had to bring it up. It had to be their idea. People not only would have no inkling what he was doing, they had to put themselves in this position.* It converted them into enthusiasts for Buffett, and reduced the odds of their complaining about anything he did. Instead of asking a favor, he was granting one; people felt indebted to him for taking their money. Making people ask put him psychologically in charge. He would come to use this technique often, in many contexts, for the rest of his life. Along with getting him what he wanted, it seemed to soothe his persisting fears of being responsible for other people’s fates.

He often paraphrased Graham, saying: “Be fearful when others are greedy, and greedy when others are fearful.” This was the time to be greedy.

The differences in their philosophies made for long conversations. Buffett would forgo the chance of profits any day to avoid too much risk, and viewed preserving his capital as an almost holy imperative. Munger had the attitude that if you weren’t already rich, you could afford to take some risk — if the odds were right — to get rich. His audacity put him in a different category from all the others who cultivated Buffett, for his deference to Buffett was limited by his high opinion of himself.

As his record of outstanding results lengthened, his letters also began to display a preoccupation with measuring success and failure. As readers began to recognize this pattern, some assumed he was manipulating them, while others accused him of false modesty. Hardly anybody knew how deep his sense of insecurity ran.

Warren had strong views about specialization; he defined his special skills as thinking and making money.

“The tide continues to be far more important than the swimmers” was the bottom line, as Buffett saw it.

one compromise he would never make was to give up his margin of safety. This particular quality — to pass up possible riches if he couldn’t limit his risk — was what made him Warren Buffett.

Buffett posed the Desert Island Challenge. If you were stranded on a desert island for ten years, he asked, in what stock would you invest? The trick was to find the company least subject to the corroding forces of competition and time: Munger’s idea of the great business. Buffett delivered his own choice: Dow Jones, owner of theWall Street Journal. His interest in newspapers was growing and would only become more intense, yet curiously he did not actually own this stock.

“Retail is a very tough business,” says Charlie Munger. “Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix.” Their experience had given them a deep wariness of retailing — one that would only grow, not lessen, over time.

Time is the friend of the wonderful business, the enemy of the mediocre….It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements. That leads right into a related lesson: Good jockeys will do well on good horses but not on broken-down nags.

Even apparently casual conversations were less casual than they seemed. They always seemed to have a purpose, however obscure, which sometimes involved his testing people. Buffett vibrated with an inner tension that belied his outwardly casual style.

Forbes captured Buffett’s attitude in an interview that November, which opened with a juicy quote: Asked how he felt about the market, “Like an oversexed man in a harem,” Buffett replied. “This is the time to start investing.”13 He went on to say, “This is the first time I can remember that you could buy Phil Fisher [growth] stocks at Ben Graham [cigar butt] prices.” He felt this was the most significant statement that he could make, but Forbes didn’t include it; a general audience wouldn’t understand the references to Fisher and Graham.

Berkshire annual reports — carefully crafted, enlightening, eye-opening letters — had grown more personal and entertaining by the year; they amounted to a crash course in business, written in clear language that ranged from biblical quotations to references to Alice in Wonderland and princesses kissing toads.

Buffett and Munger defined risk as not losing money. To them, risk was “inextricably bound up in your time horizon for holding an asset.” Someone who can hold an asset for years can afford to ignore its volatility. Someone who is leveraged does not have that luxury — the investor may not be able to wait out a volatile market. She is burdened by the “carry” (that is, the cost) and she depends on the lender’s goodwill.

“Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless.” Those words have since been parsed and dissected in classrooms and case studies as the model of corporate nobility. Buffett’s unflinching display of principle summed up much about the man. In this statement, many of his personal proclivities — rectitude, the urge to preach, his love of simple rules of behavior — had merged. Openness, integrity, extreme honesty, all the things that he meant to stand for: Buffett meant for Salomon to stand for them too.

“Then at dinner, Bill Gates Sr. posed the question to the table: What factor did people feel was the most important in getting to where they’d gotten in life? And I said, ‘Focus.’ And Bill said the same thing.” It is unclear how many people at the table understood “focus” as Buffett lived that word. This kind of innate focus couldn’t be emulated. It meant the intensity that is the price of excellence. It meant the discipline and passionate perfectionism that made Thomas Edison the quintessential American inventor, Walt Disney the king of family entertainment, and James Brown the Godfather of Soul. It meant single-minded obsession with an ideal.

Munger often attributed much of Buffett’s success to the fact that he was a “learning machine.” Their common intellect, interests, and way of thinking gave them considerable common ground. They shared the same intensity. Buffett taught Gates about investing and acted as the sounding board for Gates’s ruminations about his business. It was the way Buffett had learned to think in models that impressed Gates most. Buffett was as eager to share his thoughts about what makes a great business with Gates as Gates was eager to hear them.

It is hard to overstate the significance of a central-bank-led rescue of a private money manager. If a hedge fund, however large, was too big to fail, then what large financial institution would ever be allowed to collapse? The government risked becoming the margin of safety. No serious consequences had followed the derivatives near-meltdown. The market afterward seemed to behave as if no serious consequences ever could.

He told Howie that it was his decision whether to stay at ADM. He gave only one piece of advice: to decide within the next twenty-four hours. If you stay in longer than that, he said, you’ll become one of them. No matter what happens, it will be too late to get out.

Buffett avoided technology stocks partly because these fast-moving businesses could never be run by a ham sandwich. He wanted to get Berkshire Hathaway to the point that it could be run by a ham sandwich too — though not until after he was gone.

“I don’t want to speculate about high-tech,” Buffett said. “Anytime there have been real bursts of speculation, it eventually gets corrected.”

Yet Buffett showed them a graph indicating that the value of the market was still one-third larger than the economy. That was far higher than the level at which Buffett said he would buy stocks. It was considerably higher than the market had ever stood in modern history — higher, even, than the peak of the Great Bubble of 1929. In fact, the graph suggested that the economy would have to nearly double, or the value of the market would have to fall by nearly half, before he would get really excited about it.

“The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine,” Buffett said. “So if you had your choice, if you could put a hundred million dollars into a business that earns twenty percent on that capital — twenty million — ideally, it would be able to earn twenty percent on a hundred twenty million the following year and on a hundred forty-four million the following year and so on. You could keep redeploying capital at [those] same returns over time. But there are very, very, very few businesses like that…we can move that money around from those businesses to buy more businesses.”15 This was about as clear a lesson on business and investing as he would ever give. It explained why Berkshire was structured as it was.

Buffett could at times be brutally rational about the way vast sums of money made a person more attractive, funny, and intelligent. Still, his wonderment had never quite ceased that celebrities of any rank sought him out.

People who were looking down from the top at everybody else had to keep things in perspective. So what if they got knocked down a few pegs or lost some of their money? Those who still had their family, their health, and a chance to do something useful for the world should try to count their blessings, not their curses. “If you go from the first floor to the hundredth floor of a building and then go back to the ninety-eighth, you’ll feel worse than if you’ve just gone from the first to the second, you know. But you’ve got to fight that feeling, because you’re still on the ninety-eighth floor.”

Americans were buying huge amounts of products from other countries and didn’t have the income to pay for them, because we weren’t selling as much to other countries as they were selling to us. To make up the difference, we were borrowing money. Those who were lending it to us might be less willing to do so in the future. Now, Buffett said, we were spending more than two percent of all our income just to pay the interest on our national debt, and that meant the situation would be hard to turn around. Most likely, he thought, at some point foreign investors would decide they liked our real estate and businesses and other “real assets” better than our paper bonds. We would start selling off pieces of America, like office buildings and companies. “We think that over time the U.S. dollar is likely to decline in value against some of the major currencies,” he said. Therefore, the economy — which had been pretty wonderful over the past twenty years, with both low interest rates and low inflation — could at some point reverse. Interest rates probably would be higher, as would inflation, which would be an unhappy situation. As always when he made predictions, he couldn’t say when. In the meantime, however, he had bought $12 billion of foreign currency to hedge Berkshire’s dollar risks.

Munger sat through it patiently, but he was getting tired and sometimes talked with bemusement of this circus that Warren had created. He, too, enjoyed being worshipped, but never would have gone to the trouble to stage-manage and encourage it, the way his partner did.

Half of the companies have names that sound like a porno movie. They make basic products, like steel and cement and flour and electricity, which people will still be buying in ten years. They have a big market share in Korea, which isn’t going to change, and some of these companies are exporting to China and Japan too. Yet for some reason, they haven’t been noticed.

his investing was tightly focused on simple businesses that were as close to immortal as possible. Newspapers — in fact, any sort of media — no longer qualified. Candy, on the other hand, was an immortal business, and the economics of the candy business remained predictable.