On March 15, 1991, Warren Buffett, chairman of Berkshire Hathaway (NYSE:BRK-A), purchased $40 million of convertible bonds from M&T Bank (NYSE:MTB), then called First Empire State Corporation. The bonds were convertible into M&T stock at a split-adjusted $7.89 per share, about a 15% premium to the prevailing stock price. Fifteen years later, M&T's stock is trading at $119 per share, a 15-fold increase in value.
If we conservatively assume that Buffett directly invested in M&T stock at the $7.89 conversion price and ignore dividends and interest income from the convertibles, I calculate that Buffett's M&T investment has earned at least 20% annually. By reading the 1989 and 1990 M&T annual reports, we can, with the benefit of 20-20 hindsight, attempt to reverse-engineer Buffett's thought process and indirectly learn from the greatest investor in modern history. I thought some of the key takeaways were as follows.
1. You win with great management.
Buffett has often said that investors should look for great businesses that even a fool could run, because sooner or later, one will. Nevertheless, Buffett's track record indicates that he thinks management is one of the critical ingredients in a company's competitive advantages. Some current and former managers of Berkshire's core long-term holdings and subsidiaries are Tom Burke at Capital Cities, Harvey Golub at American Express (NYSE:AXP), Robert Goizueta and Don Keough at Coca-Cola (NYSE:KO), Katharine and Donald Graham at Washington Post (NYSE:WPO), Lou Simpson and Tony Nicely at GEICO, and Dick Kovacevich at Wells Fargo (NYSE:WFC). These are management hall-of-famers, and it's no coincidence that their companies eventually found their way into Buffett's portfolio.
So what should investors look for in management? A good manager should have the qualities you'd look for in your son or daughter's suitors: integrity, modesty, competence, and responsibility. When Buffett read about M&T management's track record, he must have been extremely pleased by what he saw. When current CEO Robert Wilmers took over the company in 1983, he immediately cleaned up the balance sheet by writing off shaky debt and tightened the guidelines for classifying operating expenses and capital expenditures. Both of these contributed to an immediate 55% drop in net income, but the short-term pain increased the company's discipline and accounting integrity.
Over the years, M&T's management proved its mettle. In 1989, M&T could have reported its highest net income ever, but again went the conservative route. When regulators decided that companies would have to start accruing for pension costs, companies had the option of amortizing the expense over a number of years. M&T conservatively decided to book the whole expense at once, which resulted in a 19% hit to net income.
2. Buy when there's blood in the (Wall) Street.
M&T management's conservative attitude eventually paid off in spades. In its 1990 annual report, M&T noted the Federal Deposit Insurance Corporation (FDIC)'s prediction that because of the real-estate crash, an estimated 300 to 400 banks with $95 billion-$160 billion in assets would fail in the coming years. The problem, in a nutshell, was that banks were making stupid loans, especially in the real-estate sector, because management could book accounting earnings up front, which resulted in hefty bonuses. Those loans turned out to be bad. M&T, however, didn't get caught up in these lax practices - in 1990, no industry concentration exceeded 5% of M&T's book, the company had no exposure to lesser-developed countries, and highly leveraged transactions accounted for less than 2% of loans outstanding. Thus, it's no surprise that in 1990, when other banks were going under, M&T actually increased its net income.
As any value investor knows, the point of maximum pessimism is the point of greatest opportunity. By picking the survivors, Buffett gets a cheaper price as bank investors throw the babies out with the bathwater. Furthermore, the survivors will find themselves in a less crowded field as competitors go out of business.
3. Buy at a low valuation and margin of safety.
Buffett never invests without a margin of safety. On the day of his investment, M&T's stock was at roughly $69 per share (pre-split) and had 6.822 million shares outstanding, giving the company a $470 million market cap. As of the end of 1990, M&T also had $437 million in tangible book value and $54 million in net income. By paying about 1 times book value, Buffett could take comfort that he was paying around M&T's liquidation value (which was probably rock-solid, given M&T's conservative accounting practices). He was also paying about 8.7 times trailing net income -- a good price for a well-run bank. Today, M&T's stock trades at 16.5 times trailing net income. Furthermore, because Buffett invested in convertible bonds - which take priority over equity holders in the event of liquidation -- he added an extra layer of downside protection.
4. Invest in companies with untapped pricing power.
This is probably the most overlooked yet most important Buffett principle. In fact, this principle led Buffett and partner Charlie Munger to invest in their first big score, See's Candy. See's was pricing its candy under the market. After buying the company, Buffett and Munger simply instructed their manager to raise prices and instantly received a boost in profitability.
As for M&T, it had untapped earnings power for a myriad of reasons. First and foremost were M&T's conservative accounting practices, which understated economic earnings. Because of the banking recession, bank earnings were likely at a trough rather than a peak. Even the most disciplined banks suffer during a credit crunch. In 1990, M&T's provision for loan loss expenses nearly doubled, to $27 million from $15 million. As the economy recovered, M&T's credit losses would likely subside, boosting income. M&T, with a healthy balance sheet, was also well-poised to benefit from its competitors' missteps.
In 1989 and 1990, M&T absorbed from two failed banks roughly $1.75 billion in deposit liabilities and $900 million in assets. As part of the deal, the FDIC paid M&T about $900 million in cash to make up for the difference between absorbed assets and liabilities. These developments were extremely positive, because deposits have a low cost of funds. M&T also used the cash from the FDIC to pay down more expensive money market funds, further strengthening M&T's funding base. However, none of this showed up in short-term results. Instead, the cost of integrating the absorbed assets and branches resulted in a $2.5 million hit to net income. Buffett knew that the market was likely overlooking this boost to long-term earnings power. Indeed, six years later, M&T's net income had tripled to $150 million, a 20% annual increase.
In conclusionIsaac Newton said, "If I have seen further, it is by standing on the shoulders of giants." By paying homage to the great value investors, we can learn from their methods and hope to improve our own investing results. It's clear that M&T was a textbook example of a Berkshire investment, with the key ingredients being great management, great timing (low valuation), margin of safety, and untapped earnings power.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.
