Buffett

by Roger Lowenstein

  He came into the world as Benjamin Grossbaum, in London, in 1894.3 When he was a year old, his father moved the family to New York to open a branch of a china-importing business. However, he died when Ben was nine. His mother put her savings in the market, and was wiped out in the panic of 1907. Ben took odd jobs, excelled at Boys High in Brooklyn, and entered Columbia. When he graduated, in 1914, he was offered posts in three departments—English, mathematics, and philosophy. But he took the advice of a college dean and went to Wall Street.4

  Graham started at the lowest rung, earning $12 a week chalking prices on a blackboard.5 While there were no securities analysts in those days, merely “statisticians,” he quickly made his mark as an investor and also began to write. By the late 1920s, he was lecturing on finance after work.

  His Wall Street lectures reflected his passion for geometry. Namely, he was anxious to systematize investing—to devise a set of Euclidean principles that would work for the stock market.

  Graham’s approach—an oddity in the speculative climate of the late 1920s—was to look for companies that were so cheap as to be free of risk. In 1926, for example, he discovered that Northern Pipe Line, an oil transporter, owned, in addition to its pipeline assets, a portfolio of railroad bonds worth $95 for each of its shares. Yet the stock was trading for only $65. Graham bought two thousand shares, and suggested that the company sell its bonds as a means of recouping its buried portfolio value. The management, which was controlled by the Rockefellers, refused. But Graham mounted a proxy fight and was elected to the board. Northern Pipe capitulated, liquidated its bonds, and paid a $70-a-share dividend.

  By 1929, the “Benjamin Graham Joint Account,” Graham’s partnership, had $2.5 million of capital, and Graham was riding high.6 By then, of course, Wall Street was full of rich men. Speculators were driving prices to the moon. That very year, the unfortunate Professor Irving Fisher of Yale proclaimed: “Stock prices have reached what looks like a permanently high plateau.”7

  Graham, though, was careful. When the Crash came, the Joint Account lost a tolerable 20 percent. In 1930, Graham—like so many—was convinced that the worst was over. He borrowed on margin and plunged into stocks. And then the bottom fell out. “The singular feature of the great crash,” as John Kenneth Galbraith observed, “was that the worst continued to worsen.”8

  The smart money—the fellow who had waited out the panic—was wiped out with the rest. By 1932, the Joint Account had fallen 70 percent. Graham was close to ruin. His family left its park-view duplex in the Beresford for the relative austerity of a small rear apartment in the nearby El Dorado, where space was going empty. His wife, a dance teacher, went back to work. Graham was ready to quit, but a relative of Jerome Newman, Graham’s partner, put up $75,000 of capital that enabled the firm to survive.9 When Security Analysis appeared, in 1934, its forty-year-old coauthor had gone five straight years without being paid.10

  Graham, in the introduction, frankly acknowledged that investing in common stocks seemed “discredited.”11 At the market’s recent lows, a third of American industry was selling at less than its liquidation value.12 The experts who only a few years back had seen in Wall Street a place of unending milk and honey now advised, as one said, that “common stocks as such are not investments at all.”13 Gerald M. Loeb, a commentator whose popular book The Battle for Investment Survival appeared at about the same time as Security Analysis, held that investing for profit was impossible. If the Dow Jones Industrial Average could register 381.17 in 1929 and 41.22 in 1932, who was to say what “real” value was? “I do not think anyone really knows,” he averred, “when a particular security is ‘cheap’ or ‘dear.’ ” Instead, Loeb counseled, “It is necessary to speculate … to foresee [the] tides.”14

  Loeb stressed that the thing to watch was not the earnings of an enterprise but the public psychology:

  The importance of full consideration of popular sentiment, expectations and opinion—and their effect on the price of the security—cannot be overstressed.15

  Yet how was one to gauge the public sentiment? The chief method was to follow the prices of stocks themselves, to “watch the tape.” If a stock declined it should be sold, and quickly; if it advanced, it should be purchased. It was not enough to buy something cheap—one must only buy “just as it starts to get dearer.”16

  If Loeb failed to grasp the paradox of millions of investors each reacting to one another and yet all trying to stay a step ahead of the crowd, it was not lost on Graham and Dodd:

  For stock speculation is largely a matter of A trying to decide what B, C and D are likely to think—with B, C and D trying to do the same.17

  Security Analysis offered an escape from such a trap. Graham and Dodd urged that investors pay attention not to the tape, but to the businesses beneath the stock certificates. By focusing on the earnings, assets, future prospects, and so forth, one could arrive at a notion of a company’s “intrinsic value” that was independent of its market price.

  The market, they argued, was not a “weighing machine” that determined value precisely. Rather, it was a “voting machine,” in which countless people registered choices that were the product partly of reason and partly of emotion.18 At times, these choices would be out of line with rational valuations. The trick was to invest when prices were far below intrinsic value, and to trust in the market’s tendency to correct.

  Given that the Depression had far from run its course, it was a remarkable time to assert one’s faith in markets. Many companies’ shares were being quoted for less than the value of their cash in the bank.19 But Graham, a classicist, could recognize Wall Street’s gloom as part of an all-too-human cycle:

  That enormous profits should have turned into still more colossal losses, that new theories should have been developed and later discredited, that unlimited optimism should have been succeeded by the deepest despair are all in strict accord with age-old tradition.20

  Graham dissected common stocks, corporate bonds, and speculative senior securities (what Michael Milken would call junk bonds) as the biologist did the frog. At first blush, then, Security Analysis was a textbook for a profession still in the making.* But written during the madness of 1929 and its aftermath, the book was also a call to arms against the sins of speculation. In that sense, it was a total break. Loeb’s speculator regarded stocks as pieces of paper, worth however much or little the next fellow might pay. His aim was to anticipate that next fellow, and the fellow after that. The Graham-and-Dodd investor saw a stock as a share of a business, whose value, over time, would correspond to that of the entire enterprise.

  It is an almost unbelievable fact that Wall Street never asks, “How much is the business selling for?”21

  That was the question Graham and Dodd proposed as a guide to valuing stocks. It was not an exact science, but (and this was key) one did not need exactitude—only the skill to identify the occasional company that was priced well below its value.

  To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his weight.22

  Left unresolved was the nagging question of what to do when a cheap stock, after its purchase, became even cheaper. For if prices were sometimes wrong, the authors admitted, it could take an “inconveniently long time” for them to adjust.23

  The answer appeared the year before Buffett arrived at Columbia. The Intelligent Investor boiled Graham’s philosophy down to three words—“margin of safety.”24 An investor, he said, ought to insist on a gap—a big gap—between the price he was willing to pay and his estimate of what a stock was worth. This was identical to leaving room for error in driving an automobile. If the margin was great enough, the investor ought to be safe. But what if he was not? Suppose, that is, that the stock kept dropping. Assuming that nothing about the business had changed, Graham said, the investor should pay no heed to the ticker, no matter how grim its tidings.
<
br />   Indeed, an investor who became unduly discouraged by a market drop and who allowed himself to be stampeded into selling at a poor price was “perversely transforming his basic advantage into a basic disadvantage.”25 Basic advantage? Most investors did not know they had one. Graham explained in a parable:

  Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible.… Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.26

  The true investor was in that very spot. He could take advantage of the daily market quote or choose to ignore it—Mr. Market would always return with a new one.

  To Buffett, these ideas were the Rosetta stone. He had already run the gamut of speculative technique; he had done stock tips, Magee charts—one system after another in the name of keeping up with the trend. But here was an approach to investing that absolved him from having to imitate “B, C and D”—that required only the sweet independence that he had learned from his father. Buffett experienced it as a revelation, “like Paul on the road to Damascus.”27 Quite simply, he had found his idol.

  At Columbia, Buffett found that Graham was personally captivating. He looked a good deal like Edward G. Robinson, and his lectures had an air of drama. In one class, Graham depicted the vastly different balance sheets of Company A and Company B. It turned out that each was Boeing—at an up and down moment in the aircraft manufacturer’s history.28

  Graham had twenty students in 1950. Most were a good deal older than Buffett, and some were already working on Wall Street. But, almost comically, the lecture devolved into a two-way seminar.29 Graham, who used the Socratic style, would pose a question, and even before he had the words out of his mouth the twenty-year-old from Omaha would shoot his hand skyward.

  Graham would rarely say yes or no to Buffett’s answer. He wouldn’t wrap the universe in a ball. It was more like: “That’s interesting. What line of thought brought you to that conclusion?”30 And Buffett would run with it. As recalled by Jack Alexander, a Buffett classmate:

  Warren was probably the youngest person in the class—definitely the precocious pupil. He had all the answers, he was raising his hand, he was leading the discussions. He had tremendous enthusiasm. He always had more to say than anyone else.

  Graham’s accent was on cheap stocks—“cigar butts,” or stocks that one could pick up almost for free, like spent cigars, and that might have a couple of valuable “puffs” left in them. One of his assignments that year was to research the performance of shares trading for less than $5.31

  Buffett also learned the details of reading a financial statement, and how to spot a fraud. In essence, Graham taught him how to get from a company’s published material to a fair value for its securities.

  But he didn’t do it in merely a theoretical way. Graham lectured about live stocks. He was quite indifferent to the fact that students were profiting from his ideas. By 1950, the fifty-six-year-old Graham was prosperous, but his attitude had been no different in the 1930s.

  “These smart Wall Street guys,” one of his students recalled, “they’d all go out and make a lot of money off Ben and he didn’t seem to mind.”32 Graham was the sort of absentminded theoretician who would sleep with a notepad by his pillow—and then come to work in shoes of different colors. Marshall Weinberg, Buffett’s contemporary and later his broker and friend, took Graham’s course twice. He recalled:

  He was giving you ideas. Youngstown Sheet & Tube I bought at 34 … and sold between 75 and 80. I bought GM on his recommendation, also Easy Washing Machine. He’d say, “This is a stock that looks cheap to me”—now, this morning. Real Silk Hosiery was another stock. The class paid for my degree.

  Buffett was fanatical about following in Graham’s footsteps. He invested in stocks held by Graham-Newman Corp., Graham’s investment company, such as Marshall Wells and Timely Clothes.33 He also looked up his professor in Who’s Who and discovered that Graham was chairman of the Government Employees Insurance Company. GEICO, as the company was known, was based in Washington. Buffett felt that anything that Graham was chairman of he wanted to know about, so he decided to pay a visit.34 Conveniently enough, Warren’s father had been reelected to Congress in 1950, and was back in Washington by the spring of 1951, during Warren’s second term at Columbia.

  Buffett took the train on a Saturday. Downtown Washington was desolate, but he went straight to GEICO’s offices, on 15th and K streets. Finding the door locked, he banged until a janitor appeared.

  “Is there anybody here I can talk to besides you?” Buffett queried.35 The janitor said there was a man working on the sixth floor, and agreed to take him there. Lorimer Davidson was taken aback to see a youngish student hovering at his desk—and stunned when he started peppering Davidson with questions. But the two of them talked for four hours.

  After we talked for fifteen minutes I knew I was talking to an extraordinary man. He asked searching and highly intelligent questions. What was GEICO? What was its method of doing business, its outlook, its growth potential? He asked the type of questions that a good security analyst would ask. I was financial vice president. He was trying to find out what I knew.

  Davidson knew plenty—about GEICO and about Graham. GEICO had been founded in Texas in 1936 by Leo Goodwin, who had the ingenious idea of selling automobile insurance via direct mail, thus cutting out the usual network of agents. Also, GEICO sold policies only to government employees, a group with fewer than average claims. Its one-two punch of low distribution costs and superior policyholders made it a winner. In 1947, the majority owner wanted to cash out, and he hired Davidson—then an investment broker—to sell it. At first, no one took the bait. Then, in 1948, he shopped it to Graham, who saw that it was a gold mine. Graham-Newman immediately put up $720,000—one-quarter of its assets—for a half-ownership in GEICO. Shortly thereafter, Graham-Newman divested its GEICO stock to its shareholders, and GEICO stock began to trade publicly. Davidson, meanwhile, had done such a good sales job that he had convinced himself and gone to work for GEICO.

  Buffett returned to New York enamored with GEICO. With a little research, he discovered that its profit margins were five times that of the average insurer, and that its premiums and profits were soaring.36 Then he went to see insurance experts—the B, C, and D of the day. Every one told him that GEICO’s stock was overpriced. Buffett’s reading of the facts was just the opposite, but he found them daunting.37 They were experts; he was in B-school.

  Every stockpicker worth his salt eventually comes to such a crossroads. It is extremely difficult to commit one’s capital in the face of ridicule—and this is why Graham was invaluable. He liked to say, “You are neither right nor wrong because the crowd disagrees with you.”38 Picking a stock depended not on the whim of the crowd, but on the facts. And Buffett took this to heart, partly because he saw Graham in idealized terms—as a “hero,” like his father.39

  Graham had a similar effect on others. Though generally reserved, he had an almost parental fondness for his students.40 To Jack Alexander, Graham was “almost like a father figure.” In a way, it was a curious description—more likely to have been uttered by a student than by one of Graham’s offspring.

  With his own family, Graham was remote, a condition exacerbated by his roving eye. He left his first wife for a young model, and by the time Buffett met him, Graham was on wife number three, his former secretary, Estelle. In an incident telling of Graham’s disregard for convention, the professor was lying in bed with Estelle one morning when a just-married young woman came calling. Graham suggested that she hop in with them.

  Graham’s children found him distant, especially after he lost a nine-year-old son.41 They knew him as
a figure of ideas, strolling around Central Park with a hat and walking stick, reciting poetry. His son Benjamin, Jr., once asked him a simple question from high school Latin, and Graham responded by reciting an oration of Cicero’s from memory, as if giving a lecture. He lacked the patience for small talk, and would often disappear to read in the middle of his own dinner parties.

  But to be Graham’s student in the 1950s was to inhabit a special place. Wall Street was lined with cigar butts; one needed only the tools, and the cast of mind, to spot them. For the would-be money manager, the Columbia of Graham and Dodd produced a kinetic and communal surge, akin to the jolt that a young writer of the twenties might have experienced at a table at the Café des Amateurs in Paris, within earshot of Hemingway.

  Buffett quickly fell in with a nucleus of Graham stalwarts. He went home with Fred Stanback, a retiring classmate from North Carolina, who reported to his mother that Buffett “just eats hamburgers and drinks Pepsi-Colas” and hence would be no trouble. Then Buffett and Stanback went to Jersey City for the annual meeting of Marshall Wells, and there met Walter Schloss, a devotee who was working for Graham-Newman. The three went to lunch and talked stocks to the point of exhaustion.

  On another excursion, to the downtown Wall Street Club, Buffett met Tom Knapp, an unassuming Long Islander who had switched from chemistry to stocks after taking a night class with David Dodd. Buffett also became close to William Ruane, an earnest Harvard Business School graduate who was auditing Graham’s class. Right off the bat, these students were united by their burning devotion to Graham. As Buffett would observe later, people either took to Graham right away or not at all.42 For people of a certain temperament, no amount of persuasion worked. Buffett’s new pals were hooked immediately. They found the Graham strategy—in a nutshell, trying to buy $1 worth of securities for fifty cents—powerful and absurdly simple, whereas most of Wall Street seemed like shooting craps. They had the beginnings of tribe, and they gravitated to Buffett, who was witty, likable, and—they knew—a step ahead of themselves. Knapp’s first impression was that “Buffett knew almost every balance sheet on the New York Stock Exchange.”