Distress, control, and Buffett (weekend thoughts)

Earlier this month, I posted our fintwit book club podcast on the Snowball (Buffett’s biography). I really enjoyed that episode, and the feedback has been excellent…. so if you haven’t checked it out yet, I’d encourage you to!

As I mentioned many times on the podcast (and in some other posts), rereading Snowball was really interesting. I’m at a different point in life than I was when I read it for the first time (when it came out almost 20 years ago), so I was picking up on much different things / themes than I was the first time I read it. In particular, I was hit a lot harder by the personal items (awful relationship with his mom, issues connecting with his children, etc.) and a lot less by the investments.

But I don’t want to talk about that here (again, you can listen to the pod for that discussion and much more!). What I wanted to talk about was how my reread of the book has made me think about my investing process and refining it. In particular, on the reread what jumped out to me is how focused Buffett’s major winners are on two particular strategies. Those are:

1. Control Investments

2. Distressed Investments.

Before diving into what exactly I mean by those investments, let me start with what every reader wants to read in a post: caveats!

First, I’ll caveat that the Snowball is not focused on breaking down each and every Buffett investment. It’s much more focused on talking about Buffett’s life, background, and relationships, while only really hitting high level on his major investments. If I remember correctly, I think Lowenstein’s Buffett book spends more time on Buffett’s investments, so I’ll probably go reread that soon to get another check on Buffett’s investments.

Second, I’m far from claiming that these two categories (distress or control) are the only places Buffett made money, or even that he didn’t have huge winners in other categories…. in fact, I know he did! But investing is generally a game of slugging percentage, not batting average; Munger even noted that Berkshire’s track record is largely based on a handful of great decisions, and without them Berkshire’s track would be average. When you look at the handful of large winners across Buffett’s career (both pre and post-Berkshire¹), I believe they tended to fall into one of the two categories I mentioned.

Third, I’ll note that I am personally partial to distress and control investments, so consider that I might have some bias in reading the Snowball / looking at Buffett’s track and saying, “hey, these two areas that I like to participate in are exactly the areas that Buffett’s track is built on!”

Ok, caveats out the way, let’s go back to the my contention. When most people think early Buffett, they think of Buffett practicing a Ben Graham “buy a super cheap cigar butt and wait for the market to wake up” style. And Buffett certainly did quite a bit of that style… in particular, in his pre-Buffett partnership days he is doing a lot of the Graham style investments.

I know a lot of people point to those early Graham style investments and suggest that’s how an early Buffett would invest today / that’s how smaller investors should invest. And there’s probably a kernel of truth to that…. but what’s notable is that the market structure in those days was very different than it is today. A lot of the Graham style stocks Buffett was buying were the equivalent of expert market stocks today… they didn’t trade on the exchange, and they were so illiquid that you often had to go out and find specific buyers. Some of Buffett’s early trades literally involved going to a town and talking to people whose family have held shares of a company in certificate form since before the Great Depression and offering to buy those shares. If you’ve ever read Red Notice, the early part of the book talks about making a fortune by going almost door to door in post-Soviet countries and offering to buy shares of businesses that have been privatized / denationalized by giving stock to citizens (i.e. the local water utility used to be owned by the government, but they privatize it by giving every citizen 100 shares). The citizens who get the shares might not realize those shares are worth anything (or might just need the cash), so they’re willing to sell them for insanely cheap prices (maybe at 1x P/E, or maybe just trading all of their shares for a bottle of vodka). A lot of the early Buffett Graham-style investments have a lot of that feel to them. Something like, “my grandpa paid 100 dollars for these shares 50 years ago and they’ve sat in our desk collecting dust for 50 years, if you can pay us $100 for them we’ll happily give them to you.” You may think that I’m being hyperbolic there, but I’m not…. that’s almost exactly the story of his National American Fire Insurance investment. From the Snowball,

buying the stock of an Omaha-based insurer, National American Fire Insurance. This company’s worthless stock had been sold to farmers all over Nebraska in 1919 by unscrupulous promoters in exchange for the Liberty Bonds issued during World War I. Since then, its certificates had lain crumbling in drawers, while their owners gradually lost hope of ever seeing their money again…. The defrauded farmers had no idea that their moldering paper was now worth something…. So Dan Monen, Warren’s partner and proxy, went off to the countryside carrying wads of Warren’s money and some of his own. He cruised around the state in a red-and-white Chevrolet, showing up in rural county courthouses and banks, casually asking who might own shares of National American. He sat on front porches, drinking iced tea, eating pie with farmers and their wives, and offering cash for their stock certificates.

So, yes, early Buffett does tons of Graham style investments, but I think that’s as much a function of market structure as anything else. By the time he launches the Buffett Partnerships, Buffett had started to move beyond Graham style cigar butts. As the Snowball notes:

The days when Warren simply sat in his study at home, picking stocks out of Security Analysis or the Moody’s Manuals, were gone. Increasingly, he began to work on large-scale, lucrative projects that required time and planning to execute—even more so than buying up the shares of National American insurance. These projects would sometimes evolve into complicated, even dramatic episodes that would absorb his attention for months, or occasionally years, at a stretch. Sometimes several of these investing projects operated simultaneously. Already preoccupied to the point that he was barely present to his family much of the time, this expansion of scale would exacerbate that tendency, while binding him more tightly to his friends.

These “lucrative” projects that required time and attention generally fit into my two categories.

First, you’d have control investments. When I say control, it’s easy for your mind to drift to later stage Buffett where he’s buying whole companies (BNSF, Lubrizol, See’s Candy, insurance companies, etc.). But early stage Buffett generally wasn’t buying whole business; his control investment involved some form of activism that generally (but not always) lead to a liquidation or capital return. Berkshire would obviously be the most famous example (though it also famously did not lead to a liquidation or really any type of capital returns!), but there are plenty of others. Most Buffett watchers know the stories of Sanborn Maps and Dempster Mills, and each of those would fit very cleanly into the control investments bucket. I’m particularly fascinated by the Sanborn Map example; when you read how it’s described in the Snowball Buffett’s interaction and investment there sound very much like a modern day activist campaign:

Sanborn’s board consisted almost entirely of insurance-company representatives—its biggest customers—so it operated more like a club than a business. None of the board members owned more than token amounts of stock. At the meeting, Warren proposed that the company distribute the investments to the shareholders. But since the Depression and World War II, American businesses treated money as a scarce commodity to be hoarded and husbanded. This way of thinking had become automatic even though the economic justification for it had long disappeared. The board responded to the idea of separating the investment portfolio from the map business as preposterous. Then, toward the end of the meeting, the board broke out the humidor and passed around cigars. Warren sat fuming. “That’s my money paying for those cigars,” he thought. On the way back to the airport, he took pictures of his children out of his wallet and looked at them to bring his blood pressure down.

I’ve been up on a soap box recently discussing the busted biotechs; it’s impossible to read that clip about directors not owning any stock and literally lighting shareholders’ money on fire in the form of cigars paid for by the company and not think about the direct parallels between biotechs with no board ownership who are willing to just light shareholder money on fire in one quixotic quest after another in order to justify their huge salaries / bonuses /board fees.

So early stage Buffett was using control investments in an almost activist like manner to take over capital allocation and unlock value. But, either way, one of the places his big winners was coming from was form control / pseudo-activism.

The other place Buffett has success is in distressed investing. In fact, I’d argue this is where almost all of his best investments are made, and I actually think people under play how frequently Buffett’s best investments involved some form of distress.

Before I discuss that, let me give a slight clarification. Distress investing often carries the connotation of buying an over-levered stock that’s on the verge of bankruptcy or in bankruptcy. And Buffett certainly does do some of that; in particular, the 70s investment into GEICO was quite distressed. When he’s buying the stock, Buffett admits, “I bought some stock that really might be worthless tomorrow,” and GEICO would have gone bust without new financing: “To get the financing done, Salomon had to convince investors that GEICO would survive, yet the financing was what would enable GEICO to survive.” You’ll often see this type of financing paradox in banks, and it is very hard to overcome / most firms end up failing when they run into the financing paradox…. but even here, Buffett had an edge, as his balance sheet was big enough that he could personally plop down the entire financing that would enable GEICO to survive.

So, yes, Buffett will do flat out distress, but I mean distress more in broader terms of “organization in crisis.” Buffett’s a master of going into businesses whose stocks have been hammered by near term set backs but where the long term business is unlikely to be impaired. In fact, almost every one of the investments Buffett is most known for carries a bit of that flavor; consider:

• AMEX in the 60s: The story of Buffett buying the stock on the heels of the salad oil scandal is legend, so I won’t recount it here!

• Blue Chip Stamps in the 60s: Buffett (and, working together, Munger and their friend Rick Geurin) buy tens of thousands of shares of Blue Chip stamps while it’s getting sued by a competitor and the DOJ for being a monopoly in California. This turns out to be a homerun of a trade; “When a settlement was reached, this stock—which the Buffett partners didn’t know they owned—showered nearly $7 million in profit on them in return for a $2 million investment less than a year ago.”

  • Interestingly, Buffett buying Blue Chip has some throwbacks to the “buying in cash from farmers” story I mentioned earlier. As part of their settlement, Blue Chip has to give stock to a bunch of grocery stores, and Buffett directly buys “large blocks of Blue Chip stock from grocers.”

    • Perhaps this is a signal that buying from off-market / non-economic sellers can present lucrative opportunities (I almost feel silly writing that as most people would agree with that if I said it…. but, in practice, I don’t see tons of investors spending insane amounts of time on this strategy / most kind of treat opportunities in this bucket as a random one off)

  • Not only would Buffett profit from Blue Chip directly, but Blue Chip is how Buffett ultimately becomes aware of See’s Candy (and what he uses to buy See’s), so it has a big impact on how Buffett evolves as an investor over time!

• Washington Post in the 70s: On the heels of Watergate, a friend of Nixon’s seeks payback by challenging “the renewal of the Post’s two Florida television licenses. The challenge threatened half of the company’s earnings, an attack on the heart of the business.” Combine that attack with the stock market sell off of the mid-70s plus the Post’s union contracts expiring (leading to the pressman sabotaging the pressroom at 4 AM on their way out the door to go on strike), and the stock falls from $38 to $16… giving Buffett his opportunity to buy into one of the premier media assets in the country on the cheap (and unlocking his relationship with Kay Graham).

• Coke in the 80s: Buffett buys Coke stock when it drops ~25% in 87/88. Yes, some of that decline was caused by the general stock market / Black Monday, but a decent bit of it was company specific. Per the snowball, Coke “had gotten into trouble, its bottlers locked in a fierce price war with Pepsi.”

• Wells Fargo in the 90s: It’s easy to forget after Wells kind of torched their brand equity over the past ten years, but in the 2000s Buffett was very well known for his investment in / love of Wells Fargo…. and that relationship generally dated back to Buffett buying their stock at the height of the S&L crisis in the early 90s.

So rereading the book, it kind of jumped out to me that Buffett’s major winners seemed to have those two flavors to them. The other thing that jumped out to me is that it wasn’t until very late in his career that Buffett became the “buy and hold / compound” guy; while he did hold on to a lot of his investments for years / decades, for the most part his initial investments came during some kind of dislocation / distress. Buffett was rarely just buying huge slugs of stock in a business that was doing well just betting the business would keep doing well / accelerate; he was generally looking for a dislocation or event that got him an advantaged entry price.

Anyway, my personal takeaways from my reread / thinking about all of this: every investor has their own style, and needs to make investments that fit into their own strengths / skillset. But a lot of the investments I've historically had the most success with and have been the most interested in have shared a lot of the characteristics with what I laid out above. I get that sounds trite (most investor’s best investments come from buying something that the stock market thinks is facing an existential problem that eventually goes away!), but increasingly I want to focus my investments on things that sound / look like those types of processes (things where a control investor / activist can come along and serve as their own catalyst by unlocking value, or things with a lot of hair on them where you can take a bet and get paid significantly if the problem turns out to be temporary).

1. Disclosure: a small position in Berkshire