Financial History Issue 125 (Spring 2018) - Page 26

Photograph of Warren Buffett, dated July 1, 1965. that.” With this lesson absorbed, it later led to some of his best buys as he sought companies with the most pronounced cus- tomer loyalties in their industries, such as Coca-Cola. But, at the time, the 22-year-old was smarting from losing $2,000 on petrol. Dempster Mill  Based in Beatrice, Nebraska, Dempster Mill supplied agricultural irriga- tion systems. Buffett began acquiring shares in 1956 at $16–$18. It had a net worth (book value) of about $4.5 million, or $75 per share. Net current asset value was about $50 per share and annual sales about $9 million. The price was so low because it kept making small profits or losses, and the manage- ment seemed clueless as to how to correct this miserable pattern. Also, it had high debt and was in an industry with very poor economics. BPL became the 70% shareholder in mid-1961, spending $1 million at an aver- age price of $28. Buffett was appointed chairman. The company engaged in a lot of unprofitable business ventures, using large amounts of shareholders’ money in inventory and receivables. The logical thing to do was to cut drastically, releasing cash for deployment elsewhere, especially the purchase of other stock market quoted value shares. The managers nodded when Chairman Buffett spoke about reducing inventory on his monthly visits from Omaha — and then promptly did nothing. The cash shortage was so worrying that Dempster’s bankers considered closing the company down, and in 1962 it was months away from disaster. Buffett faced the prospect of explaining to his partners that 21% of their assets had disappeared. Then, Harry Bottle was put in charge. He quickly identified loss-making areas, fired people, sold equipment, introduced a cost data system, slashed inventory, closed five branches and raised prices for the rump business (for items where they were the sole suppliers, they increased prices by up to 500%). The value of the BPL stake rose threefold to $3.3 million. Buffett learned the value of excellent managers, exhibiting competence and integrity. He also learned that many busi- nesses use too much money in operations (40% of the capital was taken from opera- tions for Buffett to invest elsewhere) and that patience can be rewarded — it took seven years to realize this investment. Hochschild-Kohn  In 1966, Hochschild- Kohn (HK) was uncompetitive and needed investment. Buffett knew he was buying “a second-class department store at a third-class price.” Still, he liked the look of the net asset level, which was 24    FINANCIAL HISTORY  |  Spring 2018  | www.MoAF.org more than the market capitalization, and the hidden assets: unrecorded real estate values and a significant LIFO (last-in-first- out) inventory cushion. It was sold at $12 million, and BPL bought 80%. In 1968, sales plummeted. It was sold in December 1969, leaving Buffett with a loss. Buffett learned about the dangers of retailing. The managers are usually under constant attack from competitors. If they come up with a good idea, it is usually not long before rivals copy. In other industries the managers do not destroy the business even if they perform in a mediocre fashion for a period. Thus, brands such as Gillette, Wrigley and Disney maintain the largest part of their franchises (their position in customer’s minds) even if they have poor managers for a year or two. The HK episode also helped crystal- ize in Buffett’s mind that quantitative investment factors were not sufficient to make a great investment. He increasingly began to focus on qualitative factors as his career developed. He particularly looked for strong economic franchises, being will- ing to offer a fair price for a wonderful company rather a low price for a mediocre business. If the economic characteristics of the business and its industry are poor, then managers — even if excellent — will not succeed in generating high rates of return on capital. Buffett’s early years show the wisdom of the imperative to fail fast, and fail young, for that way lies insight and the knowledge to create future success.  Despite holding the position of Professor of Investment, Glen Arnold concluded that academic life was not nearly as much fun (nor as intellectually stimulat- ing) as making money in the markets. As a wealthy investor, he now spends most of his time running his equity portfolio from an office in rural Leicestershire, far from the noise of the City of London. His main research focus explores the question, “What works in investment?” drawing on the ideas of the great inves- tors, academic discoveries and corporate strategic analysis. He is the author of the UK’s best-selling investment book and best-selling corporate finance textbook. His most recent book is The Deals of Warren Buffett, Volume 1: The First $100m, published by Harriman House, from which this article has been adapted. See: www.glen-arnold-investments.co.uk