The Snowball

by Alice Schroeder

  “Many people argue,” wrote Buffett in 2003, “that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.” On a micro level, Buffett wrote, these things often were true, but on a macro level, derivatives could someday cause midair collisions over Manhattan, London, Frankfurt, Hong Kong, and other parts of the globe. He and Munger believed that derivatives should be regulated, more disclosure should be required, they should be traded through a central clearinghouse, and the Federal Reserve should act as a central banker to the major investment banks, not just the commercial banks. Federal Reserve Chairman Alan Greenspan, however, defended the unregulated market and made sport of Buffett’s wariness.10 Buffett’s “financial weapons of mass destruction” was quoted everywhere, often paired with a question about whether he was overreacting.11

  Even as early as 2002, however, the beginnings of mass destruction could be seen in the mobile-home industry. Stung by bad loans, lenders were cutting off funding or raising interest rates to prohibitive levels. Clayton was not Buffett’s first foray into the mobile-home business. In late 2002, Oakwood Homes, a mobile-home manufacturer, and Conseco—a “subprime” lender that made loans to people without good enough credit ratings to get a cheaper loan—went bankrupt. Buffett knew that the first sign of a deflating credit bubble is when the bankruptcy wolf cuts a weak sheep out of the pack. He lent some money to Oakwood and made a bid on Conseco Finance, the lending arm of Conseco.12 Cerberus Capital and two other private equity firms, which had been bidding on the property, topped his offer to buy Conseco Finance out of bankruptcy for $1.37 billion. Because they had to outbid him, Buffett’s involvement had cost Cerberus, by some accounts, as much as $200 million, a fact the firm would not forget.

  Buffett then joined two other funds to finance Oakwood through its bankruptcy in a deal that would make him Oakwood’s largest shareholder once the mess unraveled—and that, incidentally, would help Oakwood in paying back its loans.13

  Not long after, a group of college students from the University of Tennessee had come to hear Buffett talk in the Cloud Room on the fifteenth floor of Kiewit Plaza. He took questions for a couple of hours and expounded at length on his latest interest, the manufactured-housing industry. Al Auxier, the professor who had arranged for this audience with Buffett, had a student present a gift—First a Dream,14 a memoir by Jim Clayton, who had founded Clayton Homes. Buffett called Clayton, who passed the call on to his son Kevin—who had succeeded him as CEO in 1999.15

  Clayton Homes was the class act of the troubled manufactured-housing industry. Even though it was fundamentally sound, its lenders were behaving, as Buffett said, like Mark Twain’s cat, who, having once sat on a hot stove, wouldn’t sit on a cold one. Buffett felt that Clayton’s problem was mainly that its financing was drying up, and with enough money it could lead the industry to a better business model. Clayton stock had fallen with the rest of the industry to as low as $9. The Claytons, like Salomon during its crisis, were starting to run out of funding sources. They were motivated to sell.

  Kevin Clayton: “We might entertain an offer in the twenty-dollar range.”

  Buffett: “Well, it’s not likely that we could ever come up with a number that would repay the sweat and time and energy that you and your father have built into this wonderful organization.”

  Clayton: “Our financing is getting tight. How about if you just lend to us?”

  Buffett: “That doesn’t work well for Berkshire Hathaway. Why don’t you just throw together whatever you have lying around that tells about your company and send it to me someday whenever you have a chance?”

  This classic Buffett maneuver, Casting the Line, resulted in the arrival of a massive Federal Express package the next day. The fish had snapped at the bait. The Claytons were like Z. Wayne Griffin, who had been willing to flip a coin over the phone to set a price for Blue Chip Stamps. Buffett knew the Claytons were ready to deal.

  Wall Street valued Clayton at more than all of its competitors combined, and its reputation was deserved: Most of the other mobile-home manufacturers were closing retail stores and losing money. Like most cult stocks, it had a founder with a strong, charismatic personality. Jim Clayton, the company’s guitar-picking chairman—a sharecropper’s son, who had started the business by refurbishing and selling a single mobile home—thought of his shareholder meetings as “mini-festivals” and had once strolled up the aisle from the rear of the room toward the stage singing “Take Me Home, Country Roads.” He delegated the negotiating to Kevin, who was a businessman like his father but not so much of a showman. Kevin, of course, had never heard of Buffetting.

  Buffett: “$12.50 bid.”

  Clayton: “You know, Warren, the board might entertain something in the high teens, more like $17 or $18 a share.”

  Buffett: “$12.50 bid.”

  Kevin Clayton got off the phone and went and talked to the board. Even though the stock had recently traded around nine bucks, it was a hard nut to swallow, that the company was worth only $12.50.

  Clayton: “The board would consider $15.”

  Buffett: “$12.50 bid.” Although not part of the official record, by this point he had almost certainly applied his other classic maneuver, the Circular Saw, slicing the floor out from under the Claytons by stressing—in a sympathetic way—how weak and vulnerable they were going to be with their funding sources drying up.

  The Claytons and their board went through some further processes.

  Clayton: “We’d like $13.50.”

  Buffett: “$12.50 bid.”

  More discussion.

  Clayton: “Okay, we’ll take $12.50, on the condition that we get Berkshire stock.”

  Buffett: “I’m sorry, that’s not possible. By the way, I don’t participate in auctions. If you want to sell to me, you can’t shop this bid against me to any other buyer. You have to sign an exclusive that you won’t entertain any other offers.”

  The Claytons, who perhaps understood the direction that their industry was headed better than most experts did at the time, capitulated.16

  After Buffetting the Claytons, Warren flew out to Tennessee to meet them, tour the plants, and visit with local Knoxville dignitaries. He had asked Jim Clayton to “pick and sing” with him, and they had rehearsed a couple of songs over the phone, but when the time came, “He forgot all about my guitar on the stand beside him,” wrote Clayton later. “Give our new friend Warren a microphone and he forgets all about time.”17 Not used to being upstaged, Clayton at least had the consolation of being the guy who brought the famous Warren Buffett to Knoxville.

  Yet while the local folks were mostly pleased with the deal, investors in Clayton were not. Buffett’s aura worked against him for the first time. Many of the investors knew about Buffetting, even if the Claytons didn’t, and they were in no mood to be Buffetted themselves.

  After the deal was announced, shareholders began to besiege the Claytons, pleading, “You’re a great company, the best in the industry; if I’m going to own somebody in the industry, I want to own you; please don’t go away, you’ll get through this and the industry will come bouncing back again,” or threatening, “How dare you sell this company at $12.50 when it’s been as high as $16 and we’ve weathered the storm; the industry is getting ready to come back. How could you even think of selling it that cheap?” Clayton’s large investors thought Buffett was buying at the “bottom of the cycle” for mobile homes and had opportunely timed the deal to catch a bounce. At its peak in 1998, the manufactured-housing industry, using aggressive lending tactics, had shipped 373,000 homes a year. By the end of 2001, that number was down to 193,000 as the economy suffered in the wake of 9/11, and the outlook for 2003 was a measly 130,000. But surely it would turn. Buffett’s history as a savvy trader convinced them that he must have bottom-ticked the price an
d that they would be suckers if they sold the company now.

  That was not what Buffett saw, however. He saw that the mobile-home market had backed itself into a corner by using easy financing terms to make a large percentage of its sales to people who could not afford to buy a home. Therefore the number of homes sold by the industry was not going to bounce.

  But the dissidents knew how successful Clayton had been, and, given the numbers, were sure the situation would reverse. They were stewing, talking on the phone far away from Omaha.

  Unperturbed by shareholder outrage, Buffett reveled in the thought of his future role as a mobile-home impresario. He kind of liked the trailer-park aspect of the thing. And buying a company from a sharecropper’s son appealed to the man who ate Dilly Bars at Dairy Queen, still lusted over model-train catalogs, owned a company that made prison uniforms, and got a huge kick out of having his picture taken with the Fruit of the Loom guys. The P. T. Barnum in him was already beginning to stir. He could picture it so vividly—a giant mobile home installed in the exhibition space down in the basement of Omaha’s new Qwest Convention Center at the 2004 shareholder meeting, next to the See’s Candies shop maybe, or over by the area where the Justin people were selling boots. The exhibition space kept getting bigger and more dramatic, with more vendors and more merchandise for sale every year. The thought of a whole house, right there in the middle of his shareholder meeting, with a lawn even, and shareholders lined up to get into the house, gaping in awe, delighted him. How many mobile homes could you sell at a shareholder meeting? he wondered. None of the guys at Sun Valley ever sold a mobile home at their shareholder meetings.

  Not only that, but Clayton was another company that married his business instincts with his urge to preach. He was going to give the bad actors of the mobile-home business hellfire and damnation. He was going to lead the mobile-home business to financial salvation.

  Buffett called in Ian Jacobs, his new project guy. They had a brief conversation: “Ian, here’s a file on Clayton. It gives you all kinds of dope on foreclosures and advances. Now, I’d like you to go out and see some retail dealers, and I’d like you to do a scuttlebutt approach to learning how this damned business works. The more you can learn about the sales practices, Ian, if there’s any real change going on from how it was done in the past, and who does it right, and who does it wrong, I would just soak up everything you can about what is going on and what is the logical way of conducting a business like this.”

  Like Marc Hamburg, Berkshire’s chief financial officer, and others before him, Ian’s ability to interpret and work off directions like this with virtually no further instructions or supervision would be crucial to his career at Berkshire Hathaway. For the right kind of person it was the learning opportunity of a lifetime. Ian flew off to scuttlebutt.

  By the end of the month shareholders jammed every flight into Omaha’s airport and filled every hotel room in town for the 2003 shareholders’ meeting, to see the man whom popular magazines had been proclaiming the “Comeback Crusader” and “The Oracle of Everything.” And there was some surprising news too. The Hong Kong Stock Exchange had disclosed that Berkshire had bought a stake in PetroChina, the giant, mostly state-owned Chinese oil company. It was Buffett’s first publicly acknowledged foreign investment in many years.18 He was notoriously cautious about investing outside the U.S. and had not owned a significant position in a foreign stock since Guinness PLC in 1993.19

  Reached by reporters hungry for an explanation of this radical departure from the past, Buffett said he knew nothing much about China and had bought it for the oil that was denominated in yuan, the Chinese currency. He was pessimistic about the dollar and optimistic about oil. Buffett had written an article for Fortune, “Why I’m Down On the Dollar,”20 in which he explained that he had made significant investments in foreign currencies out of a belief that the dollar would decline in value. The reason was something called the trade deficit: Americans were buying more from other countries than they were selling, and at a fast-accelerating rate. They were paying for the difference through borrowing; foreigners were buying Treasury bonds, an I.O.U. from the U.S. government. In short order, the country’s “net worth,” he said, “is being transferred abroad at an alarming rate.” He posited a hypothetical example of two countries called Thriftville and the deficit-spending Squanderville: Sooner or later, the Thriftville citizens who were buying Squanderville Treasury bonds started wondering if Squanderville was good for the money. When that happened, they still traded with Squanderville—but instead of bonds, they took less risky hard assets: land, businesses, office buildings. “And eventually,” wrote Buffett, “the Thrifts own all of Squanderville.”

  To ward off the United States becoming a version of Squanderville that was selling off pieces of itself to other countries, Buffett proposed a system in which United States companies that exported would be issued “Import Certificates”—in total about $80 billion a month. They could trade these (like the old warehouse certificates issued by Rockwood Chocolates could be traded). Anybody wanting to import into the United States would need an Import Certificate, and would have to buy from an exporter. Presto, companies would get paid a higher price to export than to sell domestically, automatically increasing exports. That, of course, would increase the importers’ (foreign companies’) costs. While this system could be viewed as unfriendly—a tariff, or tax on imports, which in the past had led to trade wars that depressed economies—Buffett felt that importers were going to suffer anyway as their goods became more expensive with the falling dollar. The Import Certificate idea at least used the market to allocate who was willing to suffer. Over time, demand for Import Certificates would gradually increase exports to rebalance trade and restore parity between Thriftville and Squanderville.

  The plan had many nuances, but its bottom line was hallmark Buffett in many ways. The article showcased Buffett’s thinking; it was a lesson on economics; it was a warning of potential catastrophe; it had a margin of safety (while it might not improve the trade balance as much as he hoped, the market mechanism meant it was unlikely to make things worse); it was a blend of a market and government solution; it was a complex, ingenious, comprehensive system—and, of course, a no-risk deal in which most parties would be at least somewhat better off than the alternative of doing nothing.

  Executing it would also require a wholesale change in thinking; a coalition of politicians would have to grasp the economics and care deeply enough about them to take the considerable political risk of pushing through Buffett’s idea. Moreover, the plan would attack a problem before it had turned into a crisis—always unlikely in Washington. The odds of anything remotely resembling a tariff being enacted into law with President Bush and free-marketeers controlling the White House were zero. Thus the Import Certificates were an elegant solution that was going absolutely nowhere. Buffett’s father, however, would have been extremely proud of him.

  And at least Buffett would have the honor of being the first prominent figure to go on record warning—loudly—about the risk of a falling dollar. To hedge that risk for Berkshire, he had been looking at Chinese stocks because of China’s burgeoning economic power. He had found PetroChina, studied it, and gotten comfortable enough to buy it. Although he was able to purchase only $488 million, he said he wished he could have bought more. His endorsement of PetroChina sent investors over the moon. Warren Buffett had bought a foreign stock! PetroChina soared. And so did attendance at the BRK shareholders’ meeting.

  That year, 15,000 people came to Omaha’s Woodstock for Capitalists. Buffett’s $36 billion fortune was once again exceeded only by Bill Gates’s. He had bounced back, almost to the top of the heap.

  “What is the ideal business?” a shareholder asked when the questions began. “The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine,” Buffett said. “So if you had your choice, if you could put a hundred mill
ion dollars into a business that earns twenty percent on that capital—twenty million—ideally, it would be able to earn twenty percent on a hundred twenty million the following year and on a hundred forty-four million the following year and so on. You could keep redeploying capital at [those] same returns over time. But there are very, very, very few businesses like that…we can move that money around from those businesses to buy more businesses.”21 This was about as clear a lesson on business and investing as he would ever give. It explained why Berkshire was structured as it was, although what it said about the stock market’s long history of disappointed investors was sobering. It explained why he was always looking for new businesses to buy, and what he was planning to do with Clayton Homes. He expected to invest part of Berkshire’s extra capital in Clayton so that it could survive to take market share away from its bankrupt competitors and to buy and service their portfolios of loans.22

  The fifty-some journalists from around the globe who had flown in to cover BRKfest were more interested in PetroChina and whether that investment signaled a new interest in foreign stocks. They got their chance to ask him and Munger about it at the press conference on Sunday. Many of them wanted to ask a version of a question that they knew would resonate with their home audiences: What stocks would you buy in Australia? Taiwan? Germany? Brazil? Russia? Buffett stressed that he was still buying mainly in the United States. Most foreign stocks, he said, were not in his circle of competence. The PetroChina stock didn’t change that.

  On Monday morning at the Berkshire board meeting, Buffett held a little seminar, explaining to the board the things he most wanted to teach them about this year, which consisted of the risk that the dollar would decline against foreign currencies and the problems involved in the financing of mobile homes.

  Tom Murphy and Don Keough had just been voted in as directors, joining Charlie Munger, Ron Olson, Walter Scott Jr., Howie, Big Susie, and Kim Chace, the lone representative of the old Hathaway textile family. There had been some grumbling about these appointments, with shareholders making noises about cronyism, and lack of balance and diversity. But the idea of a board of directors overseeing Warren Buffett was ludicrous. A board made up of Barbie dolls would do just as well. When the Berkshire board met, it was to listen to Buffett teach, just as every occasion—from a party to a luncheon to a sing-along with Jim Clayton—turned into an opportunity for Buffett to figuratively stand at the blackboard, fingers dusty with chalk.