Sitting in the first row alongside Buffett, the frail, aged David Dodd leaned over and whispered, “Take his pants off, Warren.”
Buffett had spent weeks preparing for this event. He’d anticipated the coin-flipping argument. When he got up for his turn, he said that while this might be so, the row of heads would not be random if all the successful coin-flippers came from the same town. For example, if all the coin-flippers who kept flipping heads came from the tiny village of Graham-and-Doddsville, something specific that they were doing must be making those coins flip heads.
He then pulled out a chart with the track record of nine money managers—Bill Ruane; Charlie Munger; Walter Schloss; Rick Guerin; Tom Knapp and Ed Anderson at Tweedy, Browne; the FMC pension fund; himself; and two others.44 Their portfolios were not similar; despite a certain amount of coattailing in the early years, they had largely invested on their own. All of them, he said, came from the village of Graham-and-Doddsville, had been flipping straight heads for more than twenty years, and for the most part had not retired and were still doing it. Such a concentration proved statistically that their success could not have come by random luck.
Since what Buffett said was obviously true on its face, the audience broke into applause and lobbed questions at him, which he answered gladly and at length. The random-walk theory was based on statistics and Greek-letter formulas. The existence of people like Buffett had been waved away using bafflemath. Now, to the Grahamites’ relief, Buffett had used numbers to disprove the absolutist version of the efficient-market hypothesis.
That fall, he wrote up “The Superinvestors of Graham-and-Doddsville” as an article for Hermes, the magazine of the Columbia Business School. Firing a flamethrower at the edifice of the EMH, this article did much to cement his reputation among investors. And over time, the random walkers revised their argument into “semi-strong” and “weak” forms that allowed for exceptions.45 The one great service EMH would have performed, if anybody listened, was to discourage the average person from believing they could outwit the market. Nobody except the toll-takers could object to that. But the tendencies of humankind being what they are, EMH became de rigueur in business school classrooms, yet the number of individual investors and professional money managers who assumed that they were smarter than average only grew, the toll-takers kept taking their cut, and the market went on as before. Thus the main effect of “The Superinvestors of Graham-and-Doddsville” was to add to the growing legend, even the cult, that was building around Warren Buffett.
Meanwhile, EMH and its underpinning, the capital asset pricing model, drove extraordinary and deep roots into the investing world; it launched a view of the stock market as an efficient statistical machine. In a reliably efficient market, a stock was risky not based on where it was trading versus its intrinsic value, but based on “volatility”—how likely it was to deviate from the market average. Using that information and newly unleashed computing power, economists and mathematicians started going to Wall Street to make more money than they ever could in academia.
Knowing every stock’s volatility allowed investment managers to shape and carve portfolios using stocks of greater and lesser volatility built around a core list of stocks that made up a near-replica of the market index and acted as ballast in the middle. Knowing a stock’s volatility allowed portfolio managers to pair up stocks and arbitrage them while considering their “betas” (the Greek letter assigned to volatility) to refine these bets.46 Arbitrage was the idea behind a “hedge fund” in its simplest form: Its manager sold a group of stocks short to help cushion results if the market went down.47 That was less risky than buying a stock or bond outright.
But to make big money on arbitrage—buying and selling two nearly identical things to profit from their difference in price—required scaffoldings of debt, in which more and more assets were sold short to buy more and more assets on the “long” side.48 This expansion of leverage from hedge funds and arbitrage was related to the rise of junk bonds and takeovers occurring at the same time. The models that supported the argument for leveraged buyouts using junk bonds were, like the models used by arbitrageurs, variations of the efficient-market hypothesis. Leverage, however, was like gasoline. In a rising market, a car used more of it to go faster. In a crash, it was what made the car blow up.
This is why Buffett and Munger considered defining risk as volatility to be “twaddle and bullshit,” as Munger would later put it. They defined risk as not losing money. To them, risk was “inextricably bound up in your time horizon for holding an asset.”49 Someone who could hold an asset for years could afford to ignore its volatility. Someone who was leveraged did not have that luxury—leverage costs; moreover the lender’s (not the borrower’s) time horizon defines the length of the loan. Thus a risk of leverage is that it takes away choices. The investor may not be able to wait out a volatile market; she is burdened by the “carry” (that is, the cost) and she depends on the lender’s goodwill.
But betting on volatility seemed to make sense when the market rose as predicted. When enough time passes and nothing bad happens, people who are making a lot of money tend to think it is because they are smart, not because they are taking a lot of risk.50
Throughout these profound changes in Wall Street’s ways, Buffett’s own habits had changed little.51 What still made his pulse race was buying a company like Fechheimer, which made prison-guard uniforms. People like Tom Murphy had to worry about whether they would be targeted by corporate raiders wielding junk bonds, but Berkshire Hathaway was impregnable because Buffett and friends of Buffett owned so much of its stock; his reputation made Berkshire a fortress where others could shelter. Berkshire had made $120 million on Cap Cities/ABC in the first twelve months it owned the stock; now the very mention that Buffett had bought a stock could, all by itself, move its price and revalue a company by hundreds of millions of dollars.
Ralph Schey, the head of Scott Fetzer, an Ohio conglomerate, got his company into a jam by trying to take it private in a leveraged buyout. With its stable of profitable businesses, from Kirby vacuums to the World Book encyclopedia, Scott Fetzer made appealing prey, and corporate raider Ivan Boesky quickly intervened to make a bid of his own.
Buffett sent Schey a simple letter saying, “We don’t do unfriendly deals. If you want to pursue a merger, call me.” Schey leaped at the proffer, and $410 million later, Berkshire Hathaway owned Scott Fetzer.52 Two and a half years after buying the Nebraska Furniture Mart, Buffett had bought a company eight times its size. For the first time, the CEO of a public—rather than private—company had approached Buffett because he would rather work for Buffett than work for (or be fired by) someone else.
The next to recognize the power of Buffett’s reputation was Jamie Dimon, who worked for Sanford Weill, the CEO of the brokerage firm Shearson Lehman, an American Express subsidiary.53 American Express wanted to sell its insurance arm, Fireman’s Fund, to Weill in a management buyout. Weill had already recruited Jack Byrne to leave GEICO and run Fireman’s Fund. Dimon approached Buffett to invest his money—and his reputation—in the deal.
Despite their friendship, Buffett was not sorry to lose Byrne. After repairing GEICO’s woes, the perpetually itchy Byrne had embarked on a series of acquisitions and entered into new business lines. Buffett wanted GEICO to concentrate on a sure thing, its core business. Furthermore, he had hired a new chief investment officer for GEICO, Lou Simpson, a retiring Chicagoan who had a distaste for rapid trading and expensive growth stocks. Buffett had added Simpson to the Buffett Group right away, and by now Simpson had become the only person besides himself whom Buffett trusted to invest in other stocks—he allowed Simpson to manage all of GEICO’s investments. But Simpson and Byrne acted like brothers who fought and made up. Periodically, Simpson tried to bolt; Buffett lured him back. Without Byrne, keeping Simpson would be easier.
Nonetheless, Buffett knew that Byrne was a powerful moneymaker for any business he touched. “Never let go of a meal ticket”
was Buffett’s verdict when asked to invest in the Fireman’s Fund deal. American Express decided to cut Weill out of the deal, however, and unload Fireman’s Fund in a public offering, with Byrne as CEO. To keep Buffett on the menu to attract investors, it offered Berkshire a sweetheart reinsurance deal. Buffett took the deal, and became an informal adviser to Byrne and his board. Weill, feeling double-crossed, blamed Buffett. He went on to buy Travelers Insurance and build it into a small empire, but by some accounts carried a grudge against Buffett from then on.
From American Express to Sandy Weill, however, the financial world now understood the power of Buffett’s name. At this point, Buffett was tending to so many major investments and advising so many managements that he was either an actual or de facto board member of Cap Cities, Fireman’s Fund, the Washington Post Company, GEICO, and Omaha National Corp. And now he reached a turning point, the moment when he had to consider whether to cross the Rubicon.
Buffett had for some time played a dual role. He ran Berkshire Hathaway as if he still managed money for his “partners”—albeit without collecting any fee. He wrote them letters explaining that he made decisions based on personal criteria; he set up the shareholder contribution program, a personal solution to the problem of corporate giving; he refused to split the stock, had never listed it on the New York Stock Exchange, and considered the shareholders tantamount to members of a club. “Although our form is corporate, our attitude is partnership,” he had written—and meant it.
At the same time, he enjoyed living the life of a major-company CEO. He served on board after board; he bumped with the biggest elephants. He took pride in the way politicians, journalists, and other CEOs sought out his knowledge and advice. More recently, his clout on Wall Street had become so great that entire deals—important deals—turned on whether he would participate. Above all, he was now so attached to Berkshire that it had become a virtual extension of himself.
The loosely defined dual role he was playing had so far suited him and his shareholders. Now, however, a decision faced him that required him to choose—he could either run a de facto partnership or continue his role as a major-company CEO. But he could no longer do both.
The reason was taxes. Berkshire was already burdened with corporate income taxes, a cost the partnership had not faced. On the other hand, Buffett charged his Berkshire partners no “fee” to manage their money. That was a good deal (for everyone but Buffett) or at least the shareholders’ loyalty suggests they saw it that way. Now, however, in 1986, Congress passed a major tax-reform act that, among other things, repealed what was called the General Utilities Doctrine. Formerly, a corporation could sell its assets without paying any taxes as long as it was liquidating and distributing the assets to the shareholders. The shareholders would be taxed on their gain, but the gain would not be taxed twice.
Once the General Utilities Doctrine was repealed, any liquidation of a corporation and distribution of its assets would result in a tax on the corporation’s profits and another tax on the shareholders upon distribution. Since the double tax added up to a staggering amount of money, closely held and family corporations all over the country rushed to liquidate themselves before the act went into effect. Buffett, who regularly said in his shareholder letters that Berkshire had gotten so large that its money was a barrier to investing success, could have distributed its assets, then raised a more manageable sum—still in the billions—set up a new partnership, and started over investing within weeks (collecting his fee again, to boot). With $1.2 billion of unrealized profits on Berkshire’s balance sheet, had Buffett liquidated Berkshire, he could have given his shareholders a total tax avoidance of more than $400 million and the chance to start over in a partnership free of the corporate double tax.54 But he didn’t.
Buffett wrote a lengthy dissertation on taxes in his annual letter, in which he addressed this topic and dismissed the idea of liquidating out of hand: “If Berkshire, for example, were to be liquidated—which it most certainly won’t be—shareholders would, under the new law, receive far less from the sales of our properties than they would have if the properties had been sold in the past.”55
The Warren Buffett of old would not have sneered at an extra $185 million in his own bank account and the chance to start over earning fees without the corporate income tax—which is what his decision not to liquidate Berkshire Hathaway in 1986 cost him personally. But ordinary greed no longer drove his decisions—for this cost him far more than any other shareholder. His long-standing attachment to Berkshire held him so firmly in its grip that he gave up the option of keeping Berkshire as a virtual partnership. Otherwise, he would have liquidated without a second’s hesitation.
Instead he had crossed the Rubicon and chosen the role of being the CEO of a major corporation, like Procter & Gamble or Colgate-Palmolive, one that would continue to exist after he was gone.
This company, Berkshire, with its disparate parts, was hard to value. Munger liked to joke that Berkshire was the “Frozen Corporation,” since it would grow endlessly but never pay a penny in dividends to its owners. If the owners couldn’t extract any money from their money-making machine, how much was that company really worth?
But Buffett was growing Berkshire’s book value far faster than his shareholders could have accumulated such wealth themselves, and he had the scorecard to prove it. Moreover, it was a long-term scorecard, far more comfortable for him than the year-to-year pressure of beating the market’s bogey. By shutting down the partnership, he had freed himself from that tyranny; in fact he no longer presented numbers in a fashion that allowed someone to calculate his investing performance from inception.56 Besides, being CEO of the Frozen Corporation was fun. He got to own a newspaper in Buffalo; he got to use his shareholder letters as the editorial column in a newspaper. Yet even though he had now officially joined the CEO club, he had no desire to acquire most of their habits—visiting five-star resorts, collecting wine or art, buying a yacht, or acquiring a trophy wife. “I’ve never seen a trophy wife yet that looks like a trophy,” he would later say. “To me they always look like a booby prize.”
One day in 1986, however, he called his friend Walter Scott Jr., a down-to-earth hometown boy who had worked for Peter Kiewit Sons’, Inc, all his life, just like his father before him. Scott was businesslike yet refreshingly open and relaxed. He had succeeded Peter Kiewit, then made his reputation during a federal highway bid-rigging scandal that threatened Kiewit’s existence by disqualifying it from bidding on any contracts that got government funds. By forthrightness, “groveling,” and thorough reforms, Scott led the company through a long restoration—a model for dealing with the government in a corporate life-or-death situation.57 He was such a trusted friend of Buffett that Katharine Graham stayed in the Scotts’ apartment on the few occasions that she visited Omaha.
“Walter,” Buffett asked, “how do you justify buying a private airplane?” Buffett knew that Kiewit had a fleet of private jets because it was always having to ferry its employees to remote construction sites.
“Warren,” said Scott, “you don’t justify it. You rationalize it.”
Two days later, Buffett called back. “Walter, I’ve rationalized it,” he said. “Now, how do you hire a pilot and maintain a plane?”
Scott offered to let Buffett piggyback the maintenance of his proposed new jet on Kiewit’s fleet, and Buffett went off and sheepishly bought a used Falcon 20—the same type of plane that Kiewit employees flew—as Berkshire’s corporate jet.58 It gave him an extraordinary degree of privacy, as well as control over his travel schedule—privacy and control over his time ranking in the top handful of things that Buffett cared most about on earth.
Of course, buying a private jet conflicted with another of the things he cared most about: not wasting money. Buffett had never lived down an incident in an airport in which Kay Graham had asked him for a dime to make a phone call. He pulled out the only coin he had, a quarter, started to bolt off to get change, but Graham had s
topped him by teasing him into letting her waste fifteen cents. So, for Buffett, it was like leaping in one bound over Mount Kilimanjaro to go from justifying twenty-five cents for a phone call to rationalizing two pilots and an entire airplane to carry him around like a pharaoh on a litter. But he was doing a fair amount of rationalizing this year, having just rationalized giving up $185 million in tax avoidance as well.
Still, it bothered him—the jet so plainly contradicted his upbringing and self-image. His tortured rationale to his former roommate from Penn, Clyde Reighard, explained with great earnestness and obvious embarrassment, was that the plane was going to save him money by getting him around faster.59 Next he started to make fun of himself to the shareholders, saying, “I work cheap and travel expensive.”
The plane ushered in a new phase of his life. Buffett clung tenaciously to his corn belt—even while wearing black tie—yet fraternized ever more often with hoity-toity sosoity, as CEO of the Frozen Corporation. In 1987, Ambassador Walter Annenberg and his wife, Leonore, invited Warren and Susie out to Palm Springs for a weekend with their friends Ronald and Nancy Reagan. Buffett had dined at the White House and already knew both the Reagans from visiting Kay Graham’s house on Martha’s Vineyard, but he had never spent a whole weekend with a sitting president.
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