“Life can only be understood backwards, but it must be lived forwards.” Soren Kierkegaard
I like using this quote, mainly because I hope it justifies my undergraduate degree in philosophy.
Luckily, with Buffett’s partnership and Berkshire letters, we can read his letters both forwards and backwards to understand his investment decisions.
Although this post is about the 1978 Berkshire letter, I want to jump around in time a little.
Let’s go back to 1967 when Buffett bought the retailer Hochschild, Kohn.
“During the first half we, and two 10% partners, purchased all of the stock of Hochschild, Kohn & Co., a privately owned Baltimore department store. Naturally we wouldn’t have purchased HK unless we felt the price was quite attractive.”
Fast forward 25 years, from his 1989 letter, Buffett discusses his first 25 years of mistakes. Second on the list, after his biggest mistake (which was purchasing Berkshire), is his purchase of Hochschild Kohn, described as follows:
“Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras – unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o – three years later I was lucky to sell the business for about what I had paid.”
In short, he got a great price on a business run by great people, but still made no money. Having not yet endured the three years of Hochschild ownership, Buffett bought another retailer in 1967.
“Through our two controlled companies (Diversified Retailing and Berkshire Hathaway), we acquired two new enterprises in 1967. Associated Cotton Shops and National Indemnity (along with National Fire & Marine, an affiliated company). These acquisitions couldn’t be more gratifying. Everything was as advertised or better. The principal selling executives, Ben Rosner and Jack Ringwalt, have continued to do a superb job (the only kind they know), and in every respect have far more than lived up to their end of the bargain.”
This brings us to 1978, almost ten years after the initial purchase and Buffett is still praising Ben Rosner.
“Associated was launched in Chicago on March 7, 1931 with one store, $3200, and two extraordinary partners, Ben Rosner and Leo Simon. After Mr. Simon’s death, the business was offered to Diversified for cash in 1967. Ben was to continue running the business – and run it, he has.”
“Associated’s business has not grown, and it consistently has faced adverse demographic and retailing trends. But Ben’s combination of merchandising, real estate and cost-containment skills has produced an outstanding record of profitability, with returns on capital necessarily employed in the business often in the 20% after-tax area.”
Ben Rosner was the key to Associated. Snowball, the biography from Alice Schroeder, provides a few excellent anecdotes of his “greatness.”
“Buffett felt at one with the Ben Rosners of the world— he saw in their relentlessness the spirit of success. He was sick of problem companies like Hochschild-Kohn and was looking for more Ben Rosners, people who had built excellent businesses that he could buy. He and Rosner shared a mutual obsession. As Buffett liked to put it, “Intensity is the price of excellence.”
While negotiating to buy Associated from Rosner, Buffett was not concerned that Rosner would retire at the end of the year as Rosner had insisted on during the negotiations.
“He loved it too much to quit. He kept a duplicate set of store records in the bathroom so that he could look at them while he was sitting on the can. He had this rival, Milton Petrie of Petrie Stores. One time, Ben went to a big bash at the Waldorf. Milton’s there. They immediately started talking business. Ben said, ‘How much do you pay for lightbulbs? How much do you mark up …?’ And that’s all Ben could talk about. Finally, he said to Milton, ‘How much are you paying for toilet paper?’ And Milton said so much. Ben was buying his quite a bit cheaper, and he knew that you want to be not just cheaper but right. Milton said, ‘Yeah, that’s the best I can get.’ And Ben said, ‘Excuse me,’ and he got up, left the black-tie benefit, drove out to his warehouse in Long Island, and started tearing open cartons of toilet paper and counting the sheets, because he was suspicious. He knew that Milton could not be paying too much by that wide a margin, and therefore that he must be getting screwed himself somehow on toilet paper. “And, sure enough, the vendors were saying there were five hundred sheets per roll in one of these things. And there weren’t. He was getting screwed on toilet paper.”
However, by 1986, Associated disappears from Berkshire’s financials. What happened? Also from Snowball:
“[Buffett] was equally loath to lose Ben Rosner, who had finally retired from Associated Cotton Shops. Rosner’s underlings had made fun of his toilet-paper-pickin’ ways. Sure enough, as soon as they took charge, Associated fell into the tank. For months, Verne McKenzie slogged back and forth to New York’s garment district, peddling its soggy carcass. Finally, he found some buyer willing to pay half a million dollars to haul away the remains of a business that only recently had earned Berkshire as much as $ 2 million a year.”
What are the lessons from these stories? I would like to propose a few.
First, bad businesses at great prices make poor long-term investments and a poor long-term investment strategy. The general idea is that a cigar butt strategy will allow you to potentially make outsized returns in the near term if you get the timing right. However, you will have to sell shortly and find another idea. Each new decision you are forced to make compounds your opportunity for failure. Buffett was able to capitalize on this method in his earlier years because there were a lot of net-nets, therefore his capital was safe and he had a potential for near-term upside in his “trading security.” However, these opportunities are basically gone now and the cigar butts people now discuss are much more likely to file for bankruptcy in the near term than provide the equity investor with one more puff.
Second lesson: bad businesses, even with great leaders and at great prices still make bad long-term investments.
Buffett, from his 1989 letter:
“That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire’s textile business and Hochschild, Kohn had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand. I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. I just wish I hadn’t been so energetic in creating examples.”
Third and most important lesson, Buffett takes us 49 years into the future after his purchases of Associated Retail ($6M) and National Indemnity ($8.6m). And here is the payoff to this round about Back to the Past/Back to the Future story….Associated Retail is what my 10 year-old would call, “ungoogleable,” translated as: it is almost as if it never existed. On the other hand, National Indemnity turned out to become the cornerstone of what Berkshire Hathaway is today.
Here is Buffett’s description of National Indemnity in his 2015 letter:
“Let’s look first at insurance. The property-casualty (“P/C”) branch of that industry has been the engine that has propelled our expansion since 1967, when we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, National Indemnity is the largest property-casualty company in the world, as measured by net worth. Moreover, its intrinsic value is far in excess of the value at which it is carried on our books [Note: Net worth for National Indemnity at the time of this letter was over $111 billion]. One reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float. And how we have grown, as the following table shows:
Year Float (in millions)
- 1970 $ 39
- 1980 237
- 1990 1,632
- 2000 27,871
- 2010 65,832
- 2015 87,722
Over the years Buffett learned to stay away from poor businesses regardless of the price he was being offered (however, he did fall off the wagon a few times along the way, most notably, USAir Group in 1989). Looking back over the 50 years that have passed, it is comically easily to see how important it is to long-term wealth creation to remain invested in businesses that grow their intrinsic value over time instead of merely “posting” short-term results from investing in undervalued companies to sell them repeatedly. It is my contention that you do not need many great investments over your career or lifetime, but you do need the patience to avoid the numerous poor businesses that will come across your desk while you wait for the few great ones.