” Risk comes from not knowing what you are doing.” Quote by Warren Buffett
Buffett and Graham
Warren Buffett worked for Benjamin Graham for two years during the 1950s. It was here where Warren learnt the investing strategies Benjamin used at Graham-Newman Corporation.
Benjamin Graham taught Warren the most important lesson of his life – stocks are businesses.
These early days provided Warren with valuable experience which he used when he formed his first investment fund partnership Buffett Associates, Ltd in 1956.
Over the next several years he formed another seven partnerships and managed them all simultaneously.
These partnerships where all limited with between one and six partners and were run in a similar manner to today’s hedge funds.
By 1965 Warren Buffett had taken control of the financially distressed Berkshire Hathaway and started to use it as a holding company for his business and investing tactics.
While Warren did try to make the company’s textile business profitable, he ceased all the textile operations by 1985 and used the company purely as a holding company.
Warren Buffett’s strategies changed somewhat over the years.
In his earlier days he primarily utilized Benjamin Graham’s speculative strategies and his partnerships were run in a hedge fund like manner similar to that of Graham-Newman Corporation.
Arbitrage Deals
Warren Buffett made good use of the arbitrage strategies he learnt while working with Benjamin Graham, especially in his early days while managing his own partnerships which were essentially hedge funds.
While he continued to use arbitrage deals once he owned Berkshire Hathaway, they were becoming secondary considerations as he was now focusing more on purchasing companies outright, especially insurance companies.
The arbitrages were then used mainly when he had more cash than good ideas. These arbitrage operations included reorganizations, mergers, takeovers, and spin-offs.
Warren would only buy into an arbitrage after the proposal was publicly announced. He did not participate based on rumors or speculation.
For example, when an acquiring company publicly announced its proposal to takeover a company for a set price, Warren would buy on the announcement if there were sufficient profit based on time to completion and for the risk taken.
There is always the risk that the stockholders’ of the takeover company do not accept the takeover bid.
Warren would also buy into mergers and would select the company which gave him the better deal. If one company was overvalued and the other company was undervalued, Warren would buy stock in the undervalued company provided that the combined companies would provide better value based on the new stock issued.
Warren also liked merger acquisitions where a company ABC would merge with a second company XYZ and offered shares in the company ABC along with a cash payment to the stockholders’ of company XYZ. If the deal was attractive, Warren would buy shares in company XYZ.
Liquidations
Liquidations were another strategy that Warren Buffett learnt from Benjamin Graham and used extensively with his partnerships.
He would buy into companies where their stock price was trading below the liquidation value.
The liquidation value is not usually the same as the net tangible assets value and thus required a through analysis of the balance sheet statement to arrive at an accurate value.
Fortunately for Warren Buffett he learnt how to do this from the master himself – Benjamin Graham.
Warren Buffett also bought into company’s which announced it would liquidate some assets or return cash to stockholders’ from the sale of assets – he would buy stock if the end result netted him a sufficient profit.
Outright Acquisitions
Warren Buffett is a businessman and decided to use the financially troubled Berkshire Hathaway as a holding company for his acquisitions.
In his earlier days with Berkshire Hathaway, one of his favorite tactics was to buy financially troubled companies which he could acquire at prices that were less than its working capital – a Benjamin Graham tactic.
Warren ended up closing all the textiles operations that Berkshire Hathaway operated. His focus was more on owning companies outright that were acquired at bargain prices.
Insurance companies provided a lucrative opportunity for businessmen with a solid financial market background.
Warren Buffett started to acquire insurance companies and by now was more willing to pay reasonable prices provided that the companies were financially sound.
Nowadays Berkshire Hathaway owns the insurance company GEICO and owns a large variety of other insurance companies, including a bond insurance company which insures municipal bonds for public works projects.
Berkshire Hathaway also owns outright dozens of various other consumer based companies which Warren has acquired over the years.
Insurance Premiums
This is one of Warren Buffett’s secret weapons which he uses with Berkshire Hathaway. Warren’s main interest in acquiring insurance companies is due to their business operations.
Insurance companies receive their premiums upfront and at a later date some of these policy holders will make a claim.
Obviously the premiums are calculated so that the dollar value of the premiums received is greater than that paid out.
But the real bonus to a financial market investor is that these premiums are held as cash until the policy holders make a claim.
So what to do with the cash held – it is invested in liquid assets such as stocks and bonds.
But here is the real bonus – the dividends, capital gains and bond coupon payments are keep by the insurance company and not paid to the insurance policy holders.
This means the owners of an insurance company get to use free money to invest with. In other words, the insurance company is receiving a return from the policy holders’ money – it’s not even Warren’s own money.
This is Warren Buffett’s interest in acquiring insurance companies – free money to invest with.
Warren Buffett uses his financial market skills to his advantage with all this free money and fortunately for the stockholders’ of Berkshire Hathaway, Warren is especially good at investing.
Warren invests this money in both stocks and bonds.
Through his experience with Benjamin Graham, Warren preferred to invest this money in large-cap stocks as the liquidity would make it easy to sell when an insurance claim was lodged.
Due to Warren’s business sense he looked for companies trading at a reasonable price. Since he was using lots of free money, Warren was no longer looking for bargains as these were hard to find, he simply looked for reasonable value which was much easier to find.
He preferred companies with a solid earnings history and favored consumer based companies.
The reason Warren Buffett did not invest in overpriced growth stocks was due to the high risk of the stock price collapsing, as he was using insurance money.
Retained Earnings
Warren Buffett is a strong believer in retained earnings and looks for businesses which do not need to reinvest in maintaining operations or financing debt. In other words, the companies Warren acquires use their retained earnings to further increase Warren’s wealth.
All of these retained earnings go towards increasing the value of Berkshire Hathaway.
In addition, Berkshire Hathaway itself does not pay any dividends and Warren instead uses the retained earnings of Berkshire Hathaway for further acquisitions.
All the money Berkshire Hathaway makes is used for acquisitions – the more money it makes then the more companies it buys.
Summary
Warren Buffett is an exceptionally good businessman and he is an exceptionally good investor. This is a powerful combination and the reason he became a billionaire.
In Warren’s earlier days with his partnerships, he was making a considerable amount of money which he invested with his father in their personal investment account.
He mostly bought smaller illiquid stocks, especially distressed companies selling below their book value.
It was here that Warren modified Benjamin’s bargain hunting approach and formed his own version of value investing.
Warren realized that if he paid a fair price for a good quality company with a solid earnings history, he could simply hold the company and not need to worry about the stock price as it would follow the company upwards in the long-term.
It was this approach which Warren Buffett ultimately ended up using with any stocks he purchased through Berkshire Hathaway.
He used this strategy whether they were acquisitions or stocks bought with the free insurance premium money.
Once Warren Buffett acquires a company or buys stocks he does not care about the future stock price – he buys quality businesses and any future stock price will reflect that in the long-term.
He nowadays is forced to concentrate on large companies since he has so much money to invest which needs to find a home.
The liquidity is especially important with any investments made with the free insurance premium money, as these funds may be needed later for insurance claims made by the policy holders.