Tuesday, October 28, 2008

The Warren Buffett Way: Chp 1: Five-Sigma Event

Warren Buffett's investment track record is phenomenal. It is so impressive, that Efficient Market theoreticians claim that efficient market theory is not flawed, rather, that Buffett's track record is so rare that it's a five-sigma statistical event (a 5 sigma event has a 1 in 3,488,555 chance of occuring).

From a young age, Warren was fascinated with numbers, probabilities, entrepreneurial activities and the stock market. As a boy, he read stock books, ran paper routes, reconditioned and rented out pinball machines and even bought and rented out a 1934 Rolls Royce. Warren kept pursuing his interests and in 1954 he joined the Newman-Graham corporation, an investment capital partnership (along with Walter Schloss, Tom Knapp and Bill Ruane).

After Graham retired in 1956, Warren, at the age of 25, started a partnership with seven limited partners. The limited partners received 6% annually on their investments and 75% of the profits above the 6% threshold. At the time of formation of the partnership, Warren had contributed $100 and the limited partners had contributed a total of $105,000. For the next thirteen years, Warren compounded the partnership's money at a rate of 29.5% per year.

In 1969, Warren disbanded the partnership due to a lack of value oppportunities available in the speculative stock market at the time. During this period, it was common to find stocks trading at 50-100 times earnings. Rather than abandon the principles he understood and believed in he disbanded the partnership.

In 1965, Buffett and some partners bought a controlling interest in Berkshire Hathaway, a textile and manufacturing firm. After working many years with management to turn the company around, finally he closed the textile operations in 1985. In the early years, Berkshire Hathaway provided excess cash which Warren used to make other investments.

One investment that Buffett made shortly after the Berkshire purchase, was in the Diversified Retailing holding company. The retailing stores that Diversified owned proved to be facing difficult times with declining economics and eventually caused Buffett to sell it in 1987. However, Buffett capitalized on this investment by leveraging the assets of Blue Chip Stamp, which was owned by Diversified Retailing. The Blue Chip Stamp company provided retailers with a collectible stamp program for customers and this program had a float of $60 million dollars in unredeemed stamps. Warren used the $60 million in cash to purchase See's Candy Shop and Buffalo News. Both of those investments made a tremendous amount of cash for Berkshire Hathaway over the years.

In 1967, Berskshire Hathaway also purchased controlling interests in two insurance companies, the National Indemnity Company and National Fire & Marine Company. Warren's sense of probabilities played an important part in how those companies issue insurance policies. Unlike many of his insurance competitors, Warren refused to have his insurance companies write policies that were likely to lose money.

The insurance business is difficult, but the cash collected from policy holders provides a renewable source of cash for Warren to invest. Today, Berkshire Hathaway owns many diversified public and private businesses, due in large part to the excess cash generated by its insurance activities.

When Warren took control of Berkshire Hathaway, the corporation's net worth was $22million. In 29 years, the value of the corporation grew to $10.4 billion. The annual compounded per share book value growth has been 23.3% between 1965 to 1993.

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