by Lewis Schiff
Although Kildall didn’t live long enough to see it, the day eventually came when a successor company to Digital Research got the best of Gates. The company, Caldera Systems, did it by beating Gates at his own game—imitation.
Even before Kildall sold his interest in Digital Research, the company had hit on a strategy of cloning MS-DOS and then adding some superior features while undercutting MS-DOS on price. Since MS-DOS itself was a clone of Digital Research’s own CP/M, the company had Microsoft in a bind. Gates could hardly sue Digital Research for copyright infringement without opening up the whole can of worms over where he had gotten MS-DOS in the first place. Digital Research’s MS-DOS clone, called DR-DOS, drove Gates nuts. In e-mails since made public, Gates whined to Steve Ballmer that competition from DR-DOS was cutting into MS-DOS profits by 30 or 40 percent.
In 1996, Novell spun off ownership of DR-DOS into a small private company called Caldera Systems. Caldera promptly sued Microsoft for $1 billion, claiming that Gates had personally engaged in restraint of trade and other illegal monopolistic behaviors, including making a public threat to retaliate against IBM if Big Blue dared to start doing business with DR-DOS. The lawsuit dragged on for almost four years before Microsoft settled out of court for what the Wall Street Journal calculated was $275 million. According to They Made America, some estimates say Microsoft settled for as much as $500 million.
Fourteen years earlier, Gates could have bought out Kildall for a mere $26 million. But Gates never foresaw how buying CP/M outright would insulate Microsoft from the legal troubles that would end up costing the company hundreds of millions of dollars years later. Gates was never any good at seeing around corners or intuiting the future, despite all the myths to the contrary. His prediction record about most things was always very poor, because Gates was an imitator, not an innovator. He achieved his vast fortune not by chasing after vague visions of a better world but by seizing on concrete opportunities to follow the money. And that should be inspiring news to most of us, who aren’t innovators or visionaries, either.
5
Know-How Is Good, “Know-Who” Is Better
NEARLY 9 IN 10 MIDDLE-CLASS SURVEY RESPONDENTS BELIEVE THAT FINANCIAL SUCCESS REQUIRES PUTTING ONE’S OWN CAPITAL AT RISK.
LESS THAN 4 IN 10 SELF-MADE MILLIONAIRES BELIEVE IN THE NEED TO RISK ANY OF ONE’S OWN CAPITAL.
The Ogre of Omaha
In 1951, a twenty-one-year-old stockbroker we’ll call “Ed” bought a Sinclair gas station in a 50-50 partnership with a buddy from his National Guard days. The two friends didn’t know much about running a gas station, but they had a good location near a busy intersection in eastern Nebraska and America’s love affair with the car was taking off. It seemed like a can’t-miss proposition.
Ed and his buddy worked evenings and weekends, pumping gas and cleaning windshields, only to watch most cars pull into a Texaco station across the road. It took a while for them to realize that this rival station was owned by someone who was a pillar of the local community. This man had built up a great deal of customer loyalty over the years and no amount of hard work and service with a smile would change that. Losses at the Sinclair station continued to mount, and the two partners finally gave up. Ed lost his entire $2,000 investment. A big chunk of what had been $10,000 in life savings was gone.
The main reason Ed had taken such a costly gamble on buying a gas station was that he was miserable in his stock brokerage job. He liked analyzing stocks, but he was shy and hated selling. He especially disliked his firm’s dependency on brokerage commissions. To Ed, the whole brokerage business seemed dishonest. He felt like a doctor who gets paid according to how many prescriptions he writes, regardless of how sick his patients get.
The postwar economy was booming in the early 1950s and Ed managed to build up a nice portfolio of stocks for himself by investing on the side. But this was a source of frustration, too. Most of Ed’s stocks were doing well, thanks to a value-investing strategy he’d learned from a book, but his gains were limited by his small pool of capital. Ed often faced the wrenching choice of selling one stock before its time, just because he needed cash to buy a better one. And all the while Ed knew that every stock boom ends with a bust. In 1955, the Dow Jones industrial average hit a historic high, beyond the peak that preceded the Great Crash of 1929. Older men in the brokerage business were cautioning him that the stock market was bound to fall.
With his limited capital and the prospect of a down market looming, Ed realized that his personal financial goal of retirement at age thirty-one was impossible for him to reach all by himself. He needed to get others to invest with him. So even though he was painfully shy and not a natural salesman, Ed started an investment partnership so he could use other people’s money to leverage his market smarts. He raised $70,000 from a handful of close friends and family members. Seven people each kicked in $10,000.
Ed limited his own financial contribution, however, to exactly $100. He wanted to make sure this venture would not become another money-losing debacle like the Sinclair station. The deal was this: Ed would charge a flat annual 4 percent fee for managing the money. And even though he had contributed just $100 of his own capital, he would be entitled to keep half of all annual returns from the partnership’s holdings above 4 percent. If the partnership’s investments should lose money over the year, Ed would share in only one-quarter of the paper losses. But as it turned out, there were no losses. The stocks in Ed’s new partnership rose by 10 percent in 1957, even though the stock market dropped by 8 percent. The next year, when the Dow recovered and rose 38 percent, Ed’s partnership holdings grew by 41 percent.
This early record of success enabled Ed to start a second partnership, and then a third. By the time Ed organized his fourth and largest investment partnership, he structured it so that the table was tipped entirely in his favor. Now Ed was entitled to one-quarter of all the gains above his 4 percent management fee, and none of the losses. He could place bets on the market without the fear of risking a dime of his own capital. It was as though he were playing a coin-flip game called “Heads I win, tails I don’t lose.”
With millions of dollars under his management, Ed went on to ride one of the greatest bull markets in Wall Street history. The DJIA climbed by 74 percent between 1957 and 1961, while Ed’s partnership holdings grew by 251 percent. Ed managed to achieve his goal of independent wealth by the age of thirty-one. Eventually, he became richer than he ever imagined was possible. But in 2011, on his eightieth birthday, Ed still hadn’t retired.
Ed, if you hadn’t figured it out by now, is Warren Edward Buffett. The native Nebraskan, a self-made billionaire, is the third-richest man in the world. He controls assets worth $411 billion as chairman of Berkshire Hathaway, the holding company descended from his original investment partnerships. Buffett’s personal net worth peaked at $62 billion in 2008 before he started moving billions of his money into a charitable foundation. In 2010, Buffett was granted the Presidential Medal of Freedom, in recognition of his status as a “legendary investor” and for his pledge to donate 99 percent of his wealth to philanthropic causes.
Buffett has been lionized as the Oracle of Omaha for his seeming ability to foresee the direction of the stock market over the past 50 years. Investors have pored over Buffett’s stock-picking methods for decades, trying to emulate his famed strategy of buying stock in cheap, out-of-favor companies. The Buffett name has become a brand, invoked by countless self-help books and seminars that promise to teach value-investing “the Warren Buffett way.” All of them promote the notion that with hard work and careful study, individual investors can learn from Buffett’s example and stock-pick their way to their own personal fortunes.
The problem with this notion is that it assumes Buffett’s investing success is entirely due to his stock-picking know-how, when the truth is that Buffett’s billions would have been impossible without his adeptness at know-who. It is a myth that Buffett’s fortune was built on a series of crafty, well-timed b
uy-and-sell decisions. The true secret of Buffett’s success from the beginning was that he used the brute strength of his investors’ dollars to squeeze profits from the companies he invested in. He earned outsized returns for himself and his investors via bare-knuckled boardroom tactics that no individual investor could ever even attempt. To the management teams of some undervalued companies in the late 1950s, Buffett wasn’t the Oracle of Omaha. He was the Ogre of Omaha.
Back in 1958, Buffett was managing just over $1 million in his partnerships. That year he poured 35 percent of this money into a sleepy little enterprise called Sanborn Maps. The company’s main line of business was declining, but Buffett had discovered that Sanborn’s stock price was nonetheless trading far below its true value. The reason was that Sanborn had invested its cash in a portfolio of stocks in other companies, a portfolio that was growing right along with the Wall Street bull market of the 1950s.
That little bit of know-how allowed Buffett to put his know-who to work. He persuaded a number of wealthy people he knew outside his investment partnership to also buy stock in Sanborn. Eventually, Buffett was the leader of a force of allied stockholders who controlled a big enough stake to secure a seat on Sanborn’s board of directors. Then Buffett began pushing Sanborn’s management to realize its portfolio gains and lift the company’s stock price. The management hemmed and hawed about tax liabilities, but Buffett persisted. He was not shy at all about asserting his rights as a board member. Buffett threatened to force a stockholder vote and take over the company. The frightened management agreed to buy back existing shares of the company at a premium price. Sanborn essentially paid Buffett to go away by giving him and his friends a fast 50 percent return on their investment.
Not long after this victory, the Ogre of Omaha bought a $1 million stake in another tired Midwestern company, called Dempster Mill Manufacturing. Again, Buffett’s know-who enabled him to rally wealthy friends and colleagues to put their own money behind his strategy. Buffett eventually controlled the entire board and then set the company on a course that maximized profits for himself and his friends. He fired the CEO and hired a cutthroat replacement who shut down factories, laid off workers, and liquidated inventory. Buffett milked Dempster for everything it was worth, taking stock dividends out of the company and reinvesting the proceeds in more promising companies. Then Buffett sold off what was left of Dempster at a price that nearly tripled his partnership’s initial investment.
These are not the actions of some oracle who foresaw rising stock prices in Sanborn’s and Dempster’s futures. They are the actions of a well-financed, well-connected corporate raider. True, Buffett’s skilled analysis identified Sanborn and Dempster as ripe victims for raiding in the first place. But Buffett never would have been able to unlock the value of his shares in these moribund little companies without the clout of his partnership and his wealthy allies.
Pretend for a moment that some small investor in 1958 had arrived at the exact same insight about Sanborn’s potential value and bought a hundred shares of underpriced stock in the company. That lone investor might have hung onto Sanborn stock for years to come, waiting and hoping for the stock to achieve its potential. Meanwhile, in the space of 18 months, Buffett bullied the management, took his profit, and ditched the company. That’s the crucial difference between the mythical “Warren Buffett way” and the actual methods Buffett used to amass his fortune. The power to pull off these moves, and to do it with other people’s money, is why young Warren Buffett gave up on investing the Warren Buffett way as soon as he could.
Over his lifetime, Buffett has uttered a series of witticisms that are repeated avidly by his fans. One favorite is: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Most people assume that this is Buffett’s playful way of saying, “Never make a bad investment.” But that’s ridiculous. Buffett would be the first to admit he’s made many bad investments. What Buffett hasn’t done for the past 60 years is lose money the way he did in 1951, by sinking 20 percent of his savings into a Sinclair station. Buffett jokes to this day that the Sinclair station was the worst investment he ever made. It also happens to be the last time Buffett put such a large share of his own capital completely at risk, with no protection from other people’s money.
Buffett’s Rule No. 1 is really a warning to not go all in with your own money. You want to invest if you can in ways that limit your risk, so you won’t lose your money even if your partners lose theirs. Warren Buffett has been playing this game of “heads I win, tails I don’t lose” ever since he started his first partnership. It’s a game that requires a little know-how and a lot of know-who. Buffett is a multibillionaire because he has played the game better than anyone else.
The Premier’s Mistress
The idea that it takes other people’s money to get ahead financially is not very popular among middle-class survey respondents in the Business Brilliant survey. Less than 1 in 5 said that “getting others to invest with you” is important to financial success. An overwhelming middle-class majority—nearly 9 in 10—believe that financial success requires putting one’s own capital at risk. That’s 90 percent of the middle class doing the one thing that Warren Buffett advises against.
Self-made millionaires, on the other hand, think a lot more like Buffett. About 6 out of 10 self-made millionaires reported that it’s important to get others to invest with them. Less than 4 in 10 believe in the need to risk any of one’s own capital at all. People who have already achieved significant financial success understand that self-made does not mean self-financed. This is why know-who is more important than know-how.
Chapter 2 showed how Guy Laliberté, the billionaire founder of Cirque du Soleil, and Damien Hirst, the world’s richest fine artist, both made their fortunes by doing what they loved while following the money. Look a little closer at Laliberté’s and Hirst’s stories, however, and we see that following the money for these two wasn’t really about money at all. It was about people. It was about know-who.
During its first four seasons, Cirque du Soleil was constantly pitched at the brink of insolvency. It was Laliberté’s skills at know-who among government funders and private donors in Quebec that kept the troupe going. During Cirque’s inaugural summer tour of the province, Laliberté ingratiated himself among as many government officials as he could, plying them with special VIP treatment at the shows and arranging publicity events with supportive politicians. Laliberté especially cozied up to Quebec’s premier, René Levesque, and Levesque’s inner circle. According to an unauthorized biography of Laliberté, he even exploited the happy coincidence that Levesque’s mistress was a trampolinist who was friendly with several Cirque performers.
Although Cirque was founded as a one-year project, Laliberté’s savvy know-who secured Cirque’s government funding for four successive years, which was long enough for Cirque to build a following and take off as a profit-making concern. But Cirque was hardly a government welfare case. It required indulgent private sector friends, too. In 1985, when a failed national tour left Cirque $750,000 in debt, Laliberté was able to turn to Quebec’s more conservative business community, cultivating a friendship with a prominent insurance mogul who helped raise funds to keep Cirque’s creditors at bay. Cirque’s bank overlooked $200,000 in bounced checks. “Guy was a master networker,” one Cirque executive recalled. “He gave circus tickets to everyone he thought he could use for future purposes. He treated them like kings. He knew that it would be well worth it down the line, and he turned out to be right.”
Laliberté did these things because he had to. He had no other way to keep his pet project and his sole source of income alive. In that sense, he and Hirst encountered similar problems and came up with similar know-who solutions. As first discussed in chapter 2, Hirst in his youth faced meager prospects for personal success as an artist, so just like Laliberté, he distinguished himself instead by becoming an organizer and a showman.
Hirst took on the curatorship of the Freeze
exhibition out of desperation. He was living in public housing and had no money to produce any of his conceptual artwork designs. Like so many entrepreneurs, all Hirst had was his desire to create something from nothing, and, very much like Laliberté and Gates, to follow the money by following the people with money. Hirst knew, for instance, that there was a rich real estate firm with land holdings in the desolate Docklands area that probably would like having the biggest names in art come through the area for a visit. So Hirst went to the firm and raised the $10,000 in seed money he needed to get things going. During the exhibit’s run, Hirst knew that VIP dealers might be wary of venturing into the unfamiliar industrial area, so he made arrangements to be helpful. He offered to pick them up at the nearest train station and drive them to the station personally, winning himself some valuable face time with some of the biggest names in the field.
Finally, his role as curator of Freeze sparked the one conversation that got his career on its feet. A dealer he met at the exhibit commissioned Hirst’s $6,000 piece with the rotting cow’s head sealed in the glass case. Revolting as it was, Charles Saatchi, London’s most famous art collector, fell in love with it. Saatchi became Hirst’s prime patron for the next dozen years, commissioning subsequent pieces and helping Hirst become a multimillionaire before the age of thirty.
Both Laliberté and Hirst figured out at an early age that achieving their career goals required them to follow the money, which in turn required them to follow people with money. Hirst took on the role of curator of Freeze because he had no other avenue for stirring interest in his work among people who mattered. Laliberté needed years of generous backing from public and private funders because Cirque shows were expensive to produce. They were more Broadway than Barnum and Bailey, and that was a big part of what made Cirque so special. Laliberté never could have worked his way up from fire-breathing street performer to $1 billion in annual ticket sales without his know-who, without other people and their money.