It may seem hard to believe now, but before Warren Buffett was Warren Buffett, he was just a shabbily dressed kid from Omaha with thick glasses and a penchant for carbonated beverages. He didn't shoot hoops with basketball stars, he didn't advise heads of state on economic policy, he didn't move markets with New York Times editorials, and he certainly didn't invest the way he does today.
Rather than buy best-of-breed blue chips like AT&T (NYSE: T), du Pont (NYSE: DD), or General Electric (NYSE: GE), like the investors around him, young Buffett searched for special situations -- arbitrage, liquidations, and dirt cheap, downtrodden companies.
He bought big stakes in doomed companies like Sanborn Map and Dempster Mill Manufacturing. He even spent $25,000 on discontinued four-cent stamps, and attempted to buy a Maryland "town" that the Federal Housing Authority was selling "for peanuts."
And all these unconventional investments paid off handsomely. Between the years of 1957 and 1969, Buffett's investment partnership posted 31.6% gross and 25.3% net annualized returns, respectively, in comparison with an annual gain of just 9.1% for the Dow. It was among the best 13-year stretches in Buffett's illustrious investing career.
Learning from the master
While we likely won't get the chance to purchase four-cent stamps anytime soon, we can still apply the lessons from Buffett's early career to evaluate modern-day special situations. Here are three consistent themes from young Buffett's purchases that we can use to make money investing in special situations today:
1. Begin with the balance sheet
It was clear that Sanborn Map was headed south. This company published detailed maps of power lines, water mains, driveways, and emergency stairwells for insurers, but its revenue was shrinking as the industry consolidated. However, Buffett determined that the company's investment portfolio was worth $65 per share. With the company's stock selling for $45 in late 1958, this one was a no-brainer.
Such glaring inefficiencies are rarer today, but they still pop up occasionally if you know where to look. Value investing legend Seth Klarman advises investors to search for hidden assets like overfunded pension plans, undervalued real estate, or under-appreciated subsidiaries. For example, in 2003, not only were investors able to purchase McDonald's (NYSE: MCD) at a discount to the company's real estate value, but they also snagged a stake in the company's high-growth Chipotle Mexican Grill (NYSE: CMG) subsidiary for free.
2. Management matters
If the same folks who ran the company into the ground are presiding over the turnaround, it's probably a safe bet that the company won't actually turn around. Dempster Mill continued to bleed cash until Buffett fired the incumbent general manager and replaced him with a handpicked successor. Having learned from this experience, Buffett refused to buy shares of GEICO until he had the chance to size up new CEO Jack Byrne.
Fast-food chain Steak 'n Shake was floundering for years under management's misguided expansion agenda. Fortunately for shareholders, activist investor Sardar Biglari stepped in, shored up the balance sheet, and cut costs. In 2008, Steak 'n Shake shares traded for less than the value of the company's real estate. They have since tripled.
3. Keep your emotions in check
When Buffett bought his stake in American Express (NYSE: AXP) in 1963, the company's shares had been halved in the aftermath of the salad oil scandal. After a little due diligence, Buffett determined that the company's brand had not been permanently tarnished, and the $60 million settlement the company faced would be as inconsequential in the long run as a dividend check that got "lost in the mail." He happily plunged one-third of his investment partnership's assets into this unjustly beaten-down blue chip.
Will safety concerns about the diabetes drug Avandia be GlaxoSmithKline's (NYSE: GSK) salad oil scandal? Although negative news about Avandia has dominated the headlines, this drug accounted for just $1.2 billion in sales in 2009 -- a drop in the bucket for this pharmaceutical giant. Meanwhile, Glaxo has a diverse drug portfolio and a consumer products division with many strong brands, the company generates tons of free cash flow, and it pays a hefty 5% dividend.
But is it special enough?
Will investors' fears about Avandia make Glaxo a special situation investment story? Is there another Steak 'n Shake in the making?
Tom Jacobs and his team will be following the young Warren's lead as they look for opportunities the market doesn't understand. If you'd like to learn more about Tom's approach to special situations investing and what ideas he has right now, just enter your email address in the box below.
