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Berkshire Hathaway
The Education of Warren Buffett

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By wabuffo100
April 12, 2006

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I think it would be an interesting project to look at Warren Buffett's investing career and pick out the key events that shaped his thinking about investing. By that I mean the major inflection points where he consciously shifted gears and changed his approach due to some on-the-job learning or insight. I think Warren's career has got many interesting aspects to it but this point has always fascinated me so I thought I would take a stab at it by picking the five most important inflection points in Buffett's career. I'm sure there are others that I may have missed but I really tried to boil it down to the top five.

If I were to make up a list off the top of my head it would look something like this:

1) First exposure to Benjamin Graham's ideas in the late 40s � particularly chapter 8 ("Mr. Market is there to serve you") and 20 ("Margin of Safety") of the Intelligent Investor. This one is obvious as Buffett has said that he followed charts and did technical analysis, as a teenager following stocks. You get the sense that Buffett was desperately searching for a model and a mentor until he read Graham's works.

2) Running into the Institutional Imperative at the Buffett Partnership in the early 60s. In other words, Buffett was using Graham's cigar butt methods by looking at Net Working Capital Turnarounds � Sanborn Map/Dempster Mill Manufacturing/Berkshire Hathaway. Its here that I believe he ran into the concept of the institutional imperative. As he describes each of these situations in the partnership letters, you can feel a young Buffett struggling against agency costs and the allocation of capital by managers who are committed to their business but not to Buffett's hunger for return on capital. Buffett realizes that he can't do turnarounds and brings in Harry Bottle at Dempster Mill. In fact, Buffett himself falls prey to the imperative by continuing to keep Berkshire textile mills operating well past the point of economic rationality. He finally closes the last of the mills in the 80s.

3) Discovering Float via National Indemnity Insurance acquisition in the late 60s � how float can be used to leverage investment results. I think it led to Buffett's closing of the Buffett Partnership because he had found a new source of other-people's-money (OPM). It leads Buffett into float-based businesses (gets into reinsurance, buys more insurance companies, buys Blue Chip Stamps (trading stamp float, etc)). It gives Buffett a structural advantage in his investing results because float amplifies his investment gains at zero cost. Without float, Buffett would not have achieved the results he did. He would have had great results, but not the stellar record. At the 2001 Annual General Meeting, someone specifically asked Buffett what portion of Berkshire's out-performance over the years vs. the S&P was due to the leveraging action of growing insurance float. Buffett thought about it for a moment and said about 2/3rds of the out-performance.

The important thing about leverage is that even when it has zero cost it will magnify your losses � so it doesn't remove the importance of avoiding losses. I think these two parameters are the essence of Buffett's advantage -- his float (OPM) has had at least a zero cost on average, and he has avoided capital losses, especially during falling markets.

4) Buying See's Candy in the early 70s � Buffett, with a push from Munger, discovers the joys of paying up for quality businesses and the final move away from Graham's cigar butts forever. Buffett realizes that there is a margin of safety in businesses with franchises. Pricing power becomes all-important to him in the inflationary times of the 1970s. Buffett realizes that asset-intensive businesses of the type that Graham's statistical methods ferret out actually suffer more in an inflationary environment due to inadequate depreciation relative to replacement cost.

5) Restructuring for the end game mid to late 90s -- Issuing B-shares, buying remainder of GEICO, and buying Gen Re all via BRK stock issuance: Buffett is confronted with an overvalued stock market and overvalued BRK stock during the mid-to-late-90s. Buffett can't sell his biggest investments in his equity portfolio. Also, due to BRK's growing capital base, the pool of available stocks Buffett can buy shrinks. He sells by issuing BRK stock in exchange for cash and float. In a few swift moves, he positions BRK to become more of an operating company (i.e. conglomerate owner of hundreds of wholly-owned businesses) and less of an investment portfolio of marketable securities. This also helps with succession issue as BRK will ultimately become a conglomerate of businesses generating cash and paying out dividends from its ample free cash flow and not rely on investing results to the same degree for business performance.

Like I said this is my list and I'm sure there are many other examples of major turning points where Buffett changed his approach. But these are the top five in my humble opinion.

wabuffo


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