What Warren was learning about by keeping his ears open was the art of capital allocation—placing money where it would earn the highest return. In this case, Graham-Newman was using money from one business to buy a more profitable business. Over time, it could mean the difference between bankruptcy and success.
Transactions like this made Warren feel that he was sitting on the windowsill looking in at high finance as it was taking place. Yet, as he soon found, Graham did not behave like anyone else on Wall Street. He was always mentally reciting poetry or quoting Virgil and was apt to lose packages on the subway. Like Warren, he was indifferent to how he looked. When someone observed, “That’s an interesting pair of shoes,” Graham looked down at the brown oxford on one foot and the black one on the other and said, without blinking, “Yes, as a matter of fact, I’ve got another pair just like them at home.”24 Unlike Warren, however, he cared nothing about money for its own sake, nor was he interested in trading as a competitive game. To him, stock-picking was an intellectual exercise.
“One time, we were waiting for an elevator. We were going to eat in the cafeteria down at the bottom of the Chanin Building at Forty-second and Lex. And Ben said to me, ‘Remember one thing, Warren: Money isn’t making that much difference in how you and I live. We’re both going down to the cafeteria for lunch and working every day and having a good time. So don’t worry too much about money, because it won’t make much difference in how you live.’”
Warren was in awe of Ben Graham, but nonetheless he was preoccupied with money. He wanted to amass a lot of it, and saw it as a competitive game. If asked to give up some of his money, Warren responded like a dog fiercely guarding its bone, or even as though he had been attacked. His struggle to let go of the smallest amounts of money was so apparent that it was as if the money possessed him, rather than the other way around.
Susie had learned this only too well. Even within their apartment building, Warren had quickly earned a reputation for tightfistedness and eccentricity. It was only after he was embarrassed by the state of his shirts at work—for Susie never ironed more than the collar, front placket, and cuffs—that he allowed her to send the shirts to a laundry.25 He made a deal with a local newsstand to buy week-old magazines at a discount as they were about to be thrown away. He had no car, and when he borrowed that of a neighbor, he never filled up the tank. (When he finally got a car, he washed it only when it was raining, so the rain could do the manual labor of rinsing.)26
For Warren, holding on to every penny this way, since he had sold that first pack of chewing gum, was one of the two things that had made him comparatively rich at age twenty-five. The other was collecting more cash. Since Columbia, he had started making money at an accelerating rate. Now, much of his time Warren spent in a reverie, statistics about businesses and their stock prices swirling in his head. When he wasn’t studying something, he was teaching it. To keep his Dale Carnegie skills limber so he would not freeze in front of an audience, he got a gig teaching investing for the Scarsdale Adult School at the high school in a nearby suburb. Meanwhile, the Buffetts’ social set consisted of couples whose breadwinners were mainly interested in stocks.
Now and then he and Susie were invited to a country club or to dinner parties with other young Wall Street couples. Bill Ruane had introduced him to several new acquaintances like Henry Brandt, a stockbroker who looked like a disheveled Jerry Lewis and had graduated at the top of his class from Harvard Business School, and his wife, Roxanne. Among the Wall Street set, Warren struck people as the “hickiest person you ever saw,” as one of them put it. But when he started holding forth about stocks, the others sat transfixed at his feet, like “Jesus and the apostles,” said Roxanne Brandt.27
The wives sat by themselves and had their own conversations, and there Susie stood out as much as her husband did among the men. Warren wove his financial spells, and Susie charmed the wives with her engaging simplicity. She wanted to know all about their children, or their plans to have children. She knew how to get people to open up to her. She would ask about some big life decision, then, with a soulful look, say, “Any regrets?” Out would come pouring the other person’s most intimate feelings. Soon someone she had met half an hour before felt she had a new best friend, even though Susie never confided intimacies in return. People loved her for being so interested in them.
But mostly Susie was on her own as she waited for their second child to be born, her days filled with laundry, shopping, cleaning, and cooking, as well as feeding, changing, and playing with Little Susie. All this felt right and normal to both of them. As Ricky Ricardo had said in the first season of I Love Lucy three years before, “I want a wife who’s just a wife.”28 Lucy’s ambitions and her fruitless efforts to fulfill them made the show comical. So, as Susie fed Warren dinner, she supported him at his work as if it were a daily sacrament; she recognized the reverence he felt for Mr. Graham. But she also observed from a distance. Warren didn’t share the details of his job, which in any case didn’t interest her. She continued the patient work of bolstering his confidence, and of “putting him together” by showering him with affection and teaching him about people. One thing she was firm about at home was the importance of his bonding with their daughter. Warren was not the type to play peekaboo or take over the diaper changing, but he would sing to Little Susie every night.
“I sang ‘Over the Rainbow’ all the time. It got to be hypnotic, almost like Pavlov’s dogs. I don’t know whether it was too boring or what—but she’d fall asleep as soon as I started. I’d put her up on my shoulder, and, basically, she would just sort of melt in my arms.”
Having hit on a reliable system, Warren never messed with it. While singing, he could easily be off rummaging around in his mental files. So “Over the Rainbow” it was, night after night.
On her own, housekeeping, raising a baby, and taking care of Warren in a sterile suburb of New York, Susie may have welcomed anybody who showed up at the door. One day in late 1954, a salesman for Parents magazine dropped by the apartment. Whatever the salesman told Susie, when Warren got home he concluded that the paperwork she’d signed committed them to less favorable terms than she had thought. He was incensed that his wife had been misled. He called several times and talked to the magazine’s representatives, but they apparently said “nothing doing” when he asked for his money back.
Warren mounted a crusade. He wanted more than his $17 back; he wanted to right an injustice, to bring the reprobate Parents magazine to its knees. He went around the apartment building and found a number of others willing to join the cause. He sued the magazine in small-claims court in Manhattan and looked forward to testifying on behalf of all the allegedly swindled subscribers of Parents magazine. He clicked his heels with glee at the thought of the magazine’s lawyers running their meter. There was a bit of his father in this episode, but with a pecuniary slant and better odds of winning, so that his mother would have approved.
But to his chagrin, before the trial took place he got a check in the mail. Parents magazine had settled. The crusade was foiled.
On December 15, 1954, Warren had come home from work because Susie’s labor was beginning, and then came a ring at the door. Susie answered it and found a door-to-door missionary who had come to call. She politely invited him to sit down in the living room. And she listened.
So did Warren, who was thinking to himself that only Susie would have let the man inside. Warren began to encourage the conversation to wind down. Agnostic for a number of years, he had no interest in being converted, and his wife was in labor. They needed to get to the hospital.
Susie continued listening. “Tell me more,” she said. Now and then she pulsed and moaned slightly as the missionary kept talking.29 She ignored Warren’s signals, obviously feeling it more important to be polite to the visitor and make him feel understood than to get to the hospital. The caller seemed oblivious to the fact that she was in labor. Warren sat there, helpless and increasingly agitated, until the pr
eacher ran out of steam. “I wanted to kill the guy,” he says. But they made it to the hospital in ample time, and Howard Graham Buffett arrived early the next morning.
21
The Side to Play
New York City • 1954–1956
Howie was a “difficult” baby. Whereas Little Sooz had been quiet and placid, Howie was like an alarm clock you couldn’t turn off. His parents kept waiting for the clamor to lessen, but it only increased. The apartment suddenly seemed full and noisy all the time.
“He had some kind of digestive problem. We experimented with all these different kinds of milk bottles. I don’t know whether he was getting air in or not, but he was up all the time. Compared to Little Sooz, Howie was a trial.”
It was Big Susie who jumped to the sound of the alarm clock. Since Warren had grown up between a speechifying father and a mother who alternated grotesque rages with pitter-patter chatter, perhaps it was not surprising that he had learned to shut his ears to what was going on around him. Not even Howie’s howling nights distracted him much. In his little office in the apartment’s third bedroom, he could lose himself for hours in his thoughts.
At work he had become absorbed in a complicated new project that would become a seminal event in his career. Shortly after Warren joined Graham-Newman, the price of cocoa suddenly spiked from a nickel to more than fifty cents a pound. Over in Brooklyn, Rockwood & Co., a chocolate maker “of limited profitability,”1 faced a dilemma. Its number one product was Rockwood chocolate bits, the kind of nuggets used in chocolate chip cookies, and the company couldn’t raise its prices much on this grocery item, so it began running a huge loss. However, with cocoa-bean prices so high, Rockwood also had a chance to unload the cocoa beans it already owned to reap a windfall profit. Unfortunately, the ensuing tax bill would eat up more than half those profits.2
Rockwood’s owners approached Graham-Newman as a possible buyer of the company, but Graham-Newman wouldn’t pay the asking price. So they turned instead to the investor Jay Pritzker, who had spotted a way to avoid the huge tax bill.3 What he realized was that the 1954 U.S. Tax Code said that if a company was reducing the scope of its business, it could pay no tax on such a “partial liquidation” of its inventory. So Pritzker bought enough stock to take control of Rockwood, choosing to keep the company going as a maker of chocolate bits, and to get out of the cocoa-butter business. He attributed thirteen million pounds of cocoa beans to the cocoa-butter side of the business, the amount of beans that would be “liquidated.”
Rather than sell the beans for cash, however, Pritzker offered them to the other shareholders in exchange for stock. He did so because he wanted their shares to increase his ownership of the company. So he offered them a good deal as an incentive—$36 worth of beans4 for shares that were trading at $34.5
Graham spotted a way to make money from this offer—Graham-Newman could buy Rockwood stock and swap it to Pritzker for cocoa beans it could sell to make a $2 profit on every share. This was arbitrage: two nearly identical things trading at a different price, which enabled a canny trader to simultaneously buy one and sell the other and profit on the difference, with virtually no risk. “In Wall Street the old proverb has been reworded,” as Buffett wrote later. “Give a man a fish and you feed him for a day. Teach a man to arbitrage and you feed him forever.”6 Pritzker would give Graham-Newman a warehouse certificate, which is just what it sounds like: a piece of paper that says the holder owns so many cocoa beans. It could be traded like a stock. By selling the warehouse certificate, Graham-Newman would make its money.
$34 (G-N’s cost for a share of Rockwood—which it turns in to Pritzker)
$36 (Pritzker gives G-N a warehouse receipt—which it sells at this price)
$ 2 (Profit on each share of Rockwood stock)
Virtually no risk, however, means there is at least some risk. What if the price of cocoa beans dropped, and the warehouse receipt was suddenly worth only $30? Instead of making two dollars, Graham-Newman would lose four bucks for every share of stock. To lock in its profit and eliminate that risk, Graham-Newman sold cocoa “futures.” It was a good thing, too—for cocoa prices were about to drop.
The “futures” market lets buyers and sellers agree to exchange commodities like cocoa or gold or bananas in the future at a price agreed upon today. In exchange for a small fee, Graham-Newman could arrange to sell its cocoa beans at a known price for a specified period of time, thus eliminating the risk that the market price would drop. The person on the other side of the trade—who was acquiring the risk that the price would drop—was speculating.7 If cocoa beans got cheaper, Graham-Newman was protected, because the speculator would have to buy Graham-Newman’s cocoa beans for more than they were worth.8 The speculator’s role, from Graham-Newman’s perspective, was to sell what amounted to insurance against the risk of the price dropping. At the time, of course, neither knew which way cocoa prices would move.
Thus, the goal of the arbitrage was to buy as many Rockwood shares as possible while at the same time selling an equivalent amount of futures.
Graham-Newman assigned Warren to the Rockwood deal. He was made for it; he had been arbitraging stocks for several years, buying convertible preferred stock and shorting common stock issued by the same company.9 He had studied arbitrage returns over the preceding thirty years in detail and had discovered that these “riskless” deals typically returned twenty cents for every dollar invested—a lot more than the seven or eight cents profit from the average stock. For several weeks, Warren spent his days shuttling back and forth to Brooklyn on the subway, exchanging stock for warehouse certificates at Schroder Trust. He spent his evenings studying the situation, sunk in thought while singing “Over the Rainbow” to Little Sooz and shutting out the screams as Big Susie struggled to give Howie a bottle.
On the surface, Rockwood was a simple transaction for Graham-Newman: Its only cost was subway tokens, thought, and time. But Warren recognized the potential for even more “financial fireworks” than Graham-Newman had.10 Unlike Ben Graham, he did not do the arbitrage. Thus he did not need to sell cocoa futures either. Instead, he bought 222 shares of Rockwood stock for himself and simply kept it.
Warren had thought through Pritzker’s offer carefully. When he divided all the beans Rockwood owned—not just the beans attributed to the cocoa-butter business—by the number of Rockwood shares, it amounted to more than the eighty pounds per share that Pritzker was offering. So people who did not turn in their shares would end up with stock worth more cocoa beans per share. Not only that—all the extra beans left on the table by those who did turn in their stock would bump the number of beans per share even more.
Those who kept their stock would also profit because they wound up with a share of the company’s plant, its equipment, money due from customers, and the rest of the Rockwood business that was not being shut down.
Warren had inverted the situation, thinking about it from Pritzker’s point of view. If Jay Pritzker was buying, he wondered, why did it make sense to sell? And after doing the math, he could see that it didn’t make sense. The side to play on was Jay Pritzker’s. Warren had looked at the stock as a little slice of the business.
With fewer shares outstanding, his slice was worth more. He was taking more risk than had he simply done the arbitrage—but he was also making a calculated bet with odds heavily in his favor. The $2 profit from the arbitrage was easy to earn, however, and riskless. When the price of cocoa beans dropped, the futures contracts protected Graham-Newman. They, and a significant percentage of other shareholders, accepted Pritzker’s offer and left a lot of cocoa beans on the table.
Hanging on to the stock, however, turned out to be a brilliant call. Those who played the arbitrage, like Graham-Newman, made their $2 a share. But Rockwood stock, which had traded for $15 before Pritzker’s offer, shot up to $85 after it was over. So instead of making $444 from his 222 shares, as he would have from the arbitrage, Warren’s calculated bet earned him an extraordinary sum�
��around $13,000.11
In the process, he had also made a point of getting to know Jay Pritzker. He figured anybody smart enough to have figured out that deal “was going to do more smart things later.” He went to a shareholders’ meeting and asked some questions, and that was his introduction to Pritzker.12 Warren was then twenty-five, Pritzker thirty-two.
Even working with a relatively small amount of capital—less than $100,000—Warren saw that by using this kind of thinking he could open up a world of possibilities for himself. His only constraints were the money, energy, and time he had available. It was lumberjack labor, but he loved doing it. This was nothing like the way most people invested: sitting in an office and reading reports that described research performed by other people. Warren was a detective, and he naturally did his own research, just as he had collected bottle caps and thought about fingerprinting nuns.
To do his detective work he used the Moody’s Manuals—Industrial, Banks and Finance, and Public Utility. Often he went down in person to Moody’s or Standard & Poor’s. “I was the only one who ever showed up at those places. They never even asked if I was a customer. I would get these files that dated back forty or fifty years. They didn’t have copy machines, so I’d sit there and scribble all these little notes, this figure and that figure. They had a library, but you couldn’t select from it yourself. You had to request things. So I would name all these companies—Jersey Mortgage, Bankers Commercial, all these things that nobody’d ever requested, ever. They’d bring them out, and I’d sit there taking notes. If you wanted to look at SEC documents, as I often did, I went down to the SEC. That was the only way to get them. Then, if the company was nearby, I might very well go see the management. I didn’t make appointments ahead of time. But I got a lot done.”
The Snowball Page 24