Becoming Berkshire: Issue 3-Cigar Butts 1962
Buffett Partnership, Limited
In 1962, when our Berkshire Hathaway Journey began, Buffett became a full-fledged money manager. He started the partnership, Buffett Limited Partners, in 1957 when assets totaled $303,726, an account that had grown to $7,178,500 by 1962.
During these years of the partnership, Buffett never deviated from the principles of Ben Graham. “Everything he bought was extraordinarily cheap, cigar butts all, soggy stogies containing one free puff.”1 Graham called these investments cigar butts because they were cheap and unloved stocks that had been cast aside like the sticky, mashed stub of a stogie one might find on the sidewalk.2
However, Buffett was also starting to develop his investment style as he questioned what it meant to be a “conservative” investor.
“Conscious, perhaps overly conscious, of inflation, many people now feel that they are behaving in a conservative manner by buying blue-chip securities almost regardless of price-earnings ratios, dividend yields, etc. Without the benefit of hindsight as in the bond example, I feel this course of action is fraught with danger. There is nothing at all conservative, in my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.”3
I believe these formative years taught him the importance of taking a concentrated, outsized position that would have been considered too risky for the risk-averse Graham, who grew up during the Depression.
“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”4
Dempster Mill, the Once-Dumpster Fire
At this point, Buffett had already taken a controlled position (73%) in Dempster Mill, a formula he would use for Berkshire in the future. Dempster was primarily in farm implements (mostly items retailing for $1,000 or under), water systems, water well supplies, and jobbed plumbing lines. The partnership obtained control in 1961 at an average price of about $28 per share, having bought some stock as low as $16 in earlier years and the vast majority in an offer of $30.25 in August of 61. Buffett valued Dempster Mill at $35.25 on a book value per share basis in 1961
Initially, he worked with the old management toward more effective utilization of capital, better operating margins, reduction of overhead, etc. These efforts were completely fruitless, and that’s when Buffett hired Harry Bottle to come in and be the manager of Dempster.
“Harry has accomplished one thing after another that has been labeled as impossible and has always taken the tough things first. Our breakeven point has been cut virtually in half, slow moving or dead merchandise has been sold or written off, marketing procedures have been revamped, and unprofitable facilities have been sold.”5
After the subsequent changes by Harry and Warren, the book value per outstanding share was valued at $51.2 in 1962.
Three facts stood out Buffett:
(1) Although net worth has been reduced somewhat by the housecleaning and writedowns ($550,000 was written out of inventory; fixed assets overall brought more than book value), Buffett had converted assets to cash at a rate far superior to that implied in our year-earlier valuation.
(2) Buffet had converted the assets from the manufacturing business (which has been a poor business) to a business that Buffett believed to be a better business, securities.
(3) By buying assets at a bargain price, Buffett didn’t need to pull any rabbits out of a hat to get extremely good percentage gains. This was the cornerstone of his investment philosophy:
“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”
Berkshire Hathaway
Don Cowin, a Grahamite from Buffett’s network, had brought Buffet, a textile maker from New Bedford, Massachusetts. Dan was hoping to purchase the Company and liquidate it, to sell it off piecemeal and shut it down.
New Bedford, the town that was its headquarters, once shone as the diamond in New England’s crown. The ships that would sail from its harbor to hunt sperm whales made New Bedford North America’s richest city.
The Company, a product of a merger between Berkshire Fine Spinning and Hathaway Manufacturing, supplied the market with plain fine combined cotton goods, colored box loom fabrics, rayon, nylon, Dacron, and other synthetic fabrics.
Seabury Stanton, President of Berkshire Hathway and the second Stanton to run the Company, had shuttered more than a dozen mills over the last decade. Staton had taken over in 1934 with the vision of modernizing the plant and saving the mills.
On December 12th, 1962, the Buffett partnership began purchasing shares in an unprofitable textile company from New Bedford, Massachusetts, for $7.50 per share. Seabury had also been purchasing Berkshire Stock, making a tender offer for outstanding shares every few years. Buffett believed he could tender his shares to Seasbury at a modest profit. The Company had a book value of $22.51 per share, three times the current price of $7.50 per share. Being the protégée of Mr. Graham, Buffett must have purchased this company strictly from the quantitative aspect of it trading below its net working capital. However, as Buffett would later learn, this “cigar butt,” which had suffered from 10 previous years of losses, would be one of the biggest mistakes in his investing career.
“The partnership owns a controlling interest in Berkshire Hathaway Inc., a publicly traded security. As mentioned in my midyear letter, asset values, and earning power are the dominant factors affecting the valuation of a controlling interest in a business. Market price, which governs valuation of minority interest positions, is of little or no importance in valuing a controlling interest. We will value our position in Berkshire Hathaway at yearend at a price halfway between net current asset value and book value. Because of the nature of our receivables and inventory this, in effect, amounts to valuation of our current assets at 100 cents on the dollar and our fixed assets at 50 cents on the dollar. Such a value in my opinion is fair to both adding and withdrawing partners. It may be either of lower than market value at the time.”
Berkshire Hathaway had $53 million and a net loss of $2.2 million. 1962 was a terrible year for cotton, and Berkshire was one of the largest producers due to overproduction and a price decrease. At the time, Seabury Staton, Berkshire CEO, was intent on reducing the production of cotton goods by closing several mills and looking to produce other types of fabrics.
The question that comes to mind is why Buffett waited until December to establish the position. From December 1961 to June 1962, the Dow Jones dropped 28% in what many call the Flash Crash of 1962, or others call the Kennedy Slide, primarily due to valuations getting out of hand. The Dow ended the year at 652.10, a 10% decrease from the year prior. Indeed, he could have made this Investment during the summer. Whichever reason it may be, this Investment in Berkshire would change Buffett’s life and is the moment in which our journey begins.
1 Schroeder, Alice. The Snowball: Warren Buffett and the Business of Life, 2008, Page 196.
2 Id.
3 1962 Buffett Limited Partnership Letter
4 Id.
5 Id.
