The Snowball

by Alice Schroeder

  Chapter 46

  1. The Dow was sitting at 875 on the first day of 1982. It had hit that level for the first time back in September 1964.

  2. Corporate profits reached what would become the second-lowest point in a fifty-five-year period in 1983 (the lowest was 1992), according to Corporate Reports, Empirical Research Analysis Partners. Data 1952 through 2007.

  3. Banks lost their fear of bad credit through the combination of an emerging asset bubble, simple greed, the advent of securitization, and an eagerness to find toehold ways to fund equity transactions, a signal that the wall between commercial and investment banks erected by the Depression-era Glass-Steagall Act was beginning to break down.

  4. Eric J. Weiner, What Goes Up: The Uncensored History of Modern Wall Street as Told by the Bankers, Brokers, CEOs, and Scoundrels Who Made It Happen. New York: Little, Brown, 2005.

  5. They started out as investment-grade bonds, but when their issuers cratered, the bonds became so cheap that they paid a higher rate; e.g., a bond that yielded 7% would yield 10% if the price of the bond dropped to 70% of par.

  6. See Connie Bruck, The Predators’ Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders. New York: The American Lawyer: Simon & Schuster, 1988.

  7. Typically the deals worked either by giving shareholders who sold a higher price but leaving a much weakened company for those who didn’t, or by offering a premium that was only a fraction of the value the buyer would create through actions the former management should have taken themselves. Or both.

  8. Leonard Goldenson with Marvin J. Wolf, Beating the Odds. New York: Charles Scribner’s Sons, 1991.

  9. Everyone from Saul Steinberg to Larry Tisch had taken a stake in the company. Meanwhile, management’s first-choice buyer was IBM. In the end, Cap Cities proved a strong fit because of the complementary TV license and the minimum divestiture required.

  10. Interview with Tom Murphy.

  11. Ibid. Details are also recounted in Leonard Goldenson with Marvin J. Wolf, Beating the Odds.

  12. Buffett paid sixteen times earnings for Cap Cities, a 60% premium to its recent price, and, on banker Bruce Wasserstein’s insistence, threw in warrants that gave the seller a continuing equity stake in ABC. These terms, arguably, are the most lenient Buffett ever struck and suggest how badly he and Murphy wanted to buy ABC. Charlie Munger wrote to the Buffett Group on January 11, 1983, that Tom Murphy at Cap Cities had “compounded the value of his original 1958 investment at 23% per annum for 25 years.” Donaldson, Lufkin & Jenrette report February 26, 1980: “Earnings per share growth has compounded at 20% annually over the past decade and this rate has accelerated to 27% over the last five years.”

  13. Geraldine Fabrikant, “Not Ready for Prime Time?” New York Times, April 12, 1987.

  14. Murphy and his #2, Dan Burke, picked and chose to make divestitures required by the FCC. They kept eight TV, five AM radio, and five FM radio stations. Geraldine Fabrikant, Marc Frons, Mark N. Vamos, Elizabeth Ehrlich, John Wilke, Dave Griffiths, and Christopher S. Eklund, “A Star Is Born—the ABC/Cap Cities Merger Opens the Door to More Media Takeovers,” BusinessWeek, April 1, 1985; Richard Stevenson, “Merger Forcing Station Sales,” New York Times, April 1, 1985.

  15. With 1984 sales of $3.7 billion, ABC earned $195 million, whereas Cap Cities, one third its size, earned $135 million on sales of $940 million. The disparity in profitability was mainly due to the different economics of network affiliate stations versus the network itself but also to Murphy and Burke’s management skills.

  16. According to “Extortion Charge Thrown Out; Judge Cancels $75,000 Bond,” Omaha World-Herald, March 19, 1987, charges against Robert J. Cohen were dismissed after the case was referred to the Douglas County Board of Mental Health and Cohen was moved to the Douglas County Hospital from the Douglas County Corrections Center. Terry Hyland, in “Bail Set at $25,000 for Man in Omaha Extortion Case,” Omaha World-Herald, February 5, 1987, refers to the kidnapping plan.

  17. Interview with Gladys Kaiser.

  18. Ibid.

  19. Based on examples of actual letters received.

  20. Interview with Gladys Kaiser.

  21. Interviews with Howie Buffett, Peter Buffett, Susie Buffett Jr.

  22. Interview with Susie Buffett Jr.

  23. Alan Farnham, “The Children of the Rich and Famous,” Fortune, September 10, 1990.

  24. Interview with Howie Buffett.

  25. Interview with Peter Buffett.

  26. Billy Rogers letter to Warren Buffett, August 17, 1986.

  27. Warren Buffett letter to Billy Rogers, August 22, 1986.

  28. Billy Rogers letter to Warren Buffett, undated.

  29. Interviews with Tom Newman, Kathleen Cole.

  30. Richard I. Kirkland Jr., “Should You Leave It All to the Children?” Fortune, September 29, 1986.

  31. Interview with Kathleen Cole.

  32. Interview with Ron Parks.

  33. Interview with Peter Buffett. He was so shaken that he dialed “0” instead of “911,” as if taken back to childhood.

  34. “Billy Rogers Died of Drug Overdose,” Omaha World-Herald, April 2, 1987; “Cause Is Sought in Death of Jazz Guitarist Rogers,” Omaha World-Herald, February 21, 1987.

  35. Interview with Arjay Miller.

  36. Interviews with Verne McKenzie, Malcolm “Kim” Chace III, Don Wurster, Dick and Mary Holland.

  37. Interview with George Brumley.

  38. Louis Jean-Baptiste Alphonse Bachelier, Theory of Speculation, 1900. Bachelier applied the scientific theory of “Brownian motion” to the market, probably the first of many attempts to bring the rigor and prestige of hard science to the soft science of economics.

  39. Charles Ellis, Investment Policy: How to Win the Loser’s Game. Illinois: Dow-Jones-Irwin, 1985, which is based on his article “Winning the Loser’s Game” in the July/August 1975 issue of the Financial Analysts Journal.

  40. The modern-day equivalents of Tweedy Browne’s Jamaica Water warrants still exist, for example.

  41. Burton Malkiel, A Random Walk Down Wall Street. New York: W. W. Norton, 1973.

  42. Aside from the Superinvestors article, Buffett did not write about EMH directly until the Berkshire 1987 shareholders letter, but he had led up to it with related subjects such as excessive trading turnover since 1979.

  43. Transcript of Graham and Dodd 50th Anniversary Seminar. Jensen at the time was professor and director of the Managerial Economics Research Center of the University of Rochester Graduate School of Management. Within a year, he would be at Harvard, where he remains as professor of business administration emeritus.

  44. Stanley Perlmeter and the Washington Post pension fund. Although, as this book illustrates, Buffett shared ideas with some of these investors in the early days—for example, when he was short on capital—more often the use of similar rules led them to similar veins of ore.

  45. One subtle underpinning of EMH was a free-market, quasilibertarian philosophy that aligned with the spirit of deregulation and Reaganomics, under which investors could fend for themselves as free agents in an unfettered self-regulating market. Thus one side effect of EMH was to subtly build support for other types of market deregulation and for government and Federal Reserve actions that arguably contributed to later asset bubbles.

  46. Beta can be a godsend in helping manage an unmanageably large portfolio. Criticism of beta could also, therefore, be directed at the investors who put money into unmanageably large funds that are diversified this way, and then expect them to outperform the market every year, if not every quarter.

  47. Hedge funds in this form, pioneered by A. W. Jones, preceded popularization of the random-walk academic theory.

  48. In a worst-case scenario, both sides of an arbitrage go the wrong way—the short rises, the long falls. This is the “earthquake risk” of the arbitrageur.

  49. Buffett, speaking at the 1994 Berkshire annual shareholder meeting. Munger made the “twad
dle and bullshit” comment at the 2001 shareholder meeting.

  50. The model with junk bonds was based on average credit history, not the behavior of the stock or bond market. The two models are not only related, but have the same basic flaw, which is that “earthquake events” are never factored in correctly—because if they were, the model would reveal a prohibitively high cost of capital.

  51. With the introduction of equity index futures in 1982, Buffett started trading these instruments as a hedge. Nevertheless, he wrote Congressman John Dingell, chairman of the House Energy and Commerce Committee, warning about their risk, and likewise wrote to Don Graham, “So much for the many claims as to hedge and investment type utilization; in actual practice, virtually all contracts involve short-term highly leveraged gambling—with the brokers taking a bite out of every dollar of public participation.” Letter from Warren Buffett to Mr. and Mrs. Don Graham, January 18, 1983.

  52. Berkshire Hathaway annual letter, 1985. The deal was $320 million in cash and the rest in assumed debt and other costs. “Scott Fetzer Holders Clear Sale of Company,” Wall Street Journal, December 30, 1985. In Berkshire’s 2000 annual report, Buffett points out that BRK netted $1.03 billion from its net purchase price of $230 million.

  53. Interview with Jamie Dimon.

  54. Berkshire had $4.44 billion of assets on its books at the end of 1986, including $1.2 billion of unrealized gains on equities. Liquidating before the reform, Berkshire itself could have avoided paying any taxes, with the shareholders paying their 20% tax on the gain, or $244 million. If BRK liquidated after the Tax Reform Act took effect, Berkshire would be paying $414 million in corporate taxes (more than $185 million of which would have accrued to Buffett), before handing over the net proceeds to investors to pay a double tax, adding up to a maximum of a 52.5% tax on the $1.2 billion unrealized appreciation, or $640 million. Thus the total effect was $400 million. See also James D. Gwartney and Randall G. Holcombe, “Optimal Capital Gains Tax Policy: Lessons from the 1970s, 1980s, and 1990s,” A Joint Economic Committee Study, United States Congress, June 1997.

  55. Berkshire Hathaway annual report, 1986. Notably, Buffett phrases the statement in terms of the costly consequences if Berkshire liquidated after the act, not the huge benefits that would have resulted from liquidating before the act went into effect.

  56. This measuring stick has pros and cons, which are covered in investing books. Bottom line, it is a reasonable, conservative measure that can be distorted by acquisitions (something Buffett had discussed; see General Re).

  57. Interviews with Walter Scott Jr., Suzanne Scott; also Jonathan R. Laing, “The Other Man From Omaha,” Barron’s, June 17, 1995.

  58. Interview with Walter Scott Jr.

  59. Interview with Clyde Reighard.

  60. Jerry Bowyer, in National Review, August 11, 2006, wrote that Reagan’s “supply-side policies have helped Warren Buffet [sic] amass the world’s second-largest pile of wealth, which he routinely uses as a stage on which to stand and denounce the very supply-side measures that helped lift him to incredible prosperity.” It is true that like any investor, Buffett has benefited from the supply-side policies that reduce his personal taxes on investment income and capital gains. Notably, much of that benefit is effectively offset by Berkshire Hathaway’s taxes. Since the Reagan years, Citizens for Tax Justice and the Institute on Taxation and Economic Policy have been studying the annual reports of the top 250+ companies in the U.S., always coming to the conclusion that they are severely underpaying. See Robert S. McIntyre and T. D. Coo Nguyen, Corporate Taxes & Corporate Freeloaders (August 1985), Corporate Income Taxes in the 1990s (October 2000), Corporate Income Taxes in the Bush Years (September 2004). The top 250 companies in the U.S., while growing profits substantially, have consistently been shown to pay a fraction of the actual corporate tax rate throughout the 1980s, ’90s, and today, due to breaks for depreciation, stock options, research, etc. Berkshire, however, has averaged a 30% effective tax rate (net earnings before taxes, divided by the taxes paid currently) since 1986—offsetting Buffett’s personal tax benefits. Regardless, Buffett’s taxes are irrelevant to whether he is entitled to criticize supply-side policies.

  61. Robert Sobel, Salomon Brothers 1910–1985, Advancing to Leadership, Salomon Brothers, Inc., 1986.

  62. In other words, current partners were paid a premium above their invested capital by Phibro, in which retired partners who had already withdrawn their capital did not share.

  63. Anthony Bianco, “The King of Wall Street—How Salomon Brothers Rose to the Top—And How It Wields Its Power,” BusinessWeek, December 5, 1985.

  64. In the “Night of the Long Knives,” June 30–July 2, 1934, Hitler executed at least eighty-five perceived enemies of his regime and arrested a thousand others.

  65. James Sterngold, “Too Far, Too Fast: Salomon Brothers’ John Gutfreund,” New York Times, January 10, 1988.

  66. Paul Keers, “The Last Waltz: He had the power, she craved the position. Life was a ball until he had to resign in disgrace and an era ended,” Toronto Star, September 1, 1991.

  67. Roger Lowenstein, Buffett: The Making of an American Capitalist. New York: Doubleday, 1996, who did not identify the executive giving this description.

  68. Paul Keers, “The Last Waltz” Carol Vogel, “Susan Gutfreund: High Finances, High Living,” New York Times, January 10, 1988; David Michaels, “The Nutcracker Suit,” Manhattan, Inc., December 1984; John Taylor, “Hard to Be Rich: The Rise and Wobble of the Gutfreunds,” New York, January 11, 1988.

  69. As Mrs. Bavardage.

  70. Paul Keers, “The Last Waltz” Cathy Horyn, “The Rise and Fall of John Gutfreund; For the Salomon Bros. Ex-Head, a High Profile at Work & Play,” Washington Post, August 19, 1991.

  71. Robert Sobel, Salomon Brothers 1910–1985, Advancing to Leadership.

  72. The combative, powerful banker Bruce Wasserstein, a merger specialist, was supposedly going to run the firm. Gutfreund and his key lieutenants knew they would be instantly replaced by Wasserstein. And Perelman as the largest shareholder might scare clients away.

  73. Salomon bought the Minorco block itself at $38, a 19% premium to the stock’s $32 market price. It then offered Buffett the stock at the same price. The premium was typical for similar deals at the time (which were also criticized). The stock conveyed 12% voting power in the firm. Perelman offered $42 and said he might raise his stake to 25%.

  74. Salomon made a number of missteps. It took on a buyout of TVX Broadcast Group that ultimately failed, muffed a leveraged buyout of Southland Corporation, and wound up holding the bag on a problematic Grand Union buyout. After five unsuccessful years, Salomon exited the merchant-banking business in 1992.

  75. Sarah Bartlett, “Salomon’s Risky New Frontier,” New York Times, March 7, 1989.

  76. Buffett viewed his investment in Salomon as being like a bond. If he had wonderful stock ideas like GEICO or American Express, he would not be looking at bond equivalents and would not have done this deal.

  77. Interview with John Gutfreund.

  78. Interviews with John Gutfreund, Donald Feuerstein. Feuerstein’s son went to school with one of Perelman’s children. He knew Perelman was observant and parlayed for a critical delay past the holiday.

  79. According to Graham and Dodd, preferred stocks marry the least attractive features of equity and debt. “As a class,” they wrote, “preferred shares are distinctly more vulnerable to adverse developments than are bonds.” Benjamin Graham and David L. Dodd, Security Analysis, Principles and Teaching. New York: McGraw-Hill, 1934, Chapter 26. Preferreds are often described as “bonds with a kicker,” combining the safety of a bond with the upside of a stock. However, as Graham and Dodd note, this is not really correct. If a company gets in trouble, preferreds lack an enforceable claim to the interest and principal. When things go well, unlike a common stock, the investor has no right to the company’s profits. Speaking at the University of Florida in 1998, Buffett said, “The test
of a senior security is whether you are getting an above-average return, after tax, and feel certain of getting your principal back.” Here, the preference to the common was meaningless.

  80. Beginning October 31, 1995, in five installments over four years, it was mandatory to either convert into Salomon stock or “put” it back to the company for cash. Perelman offered to beat Buffett’s deal—and Gutfreund and several other managers told the board they would quit. He offered a conversion price of $42, much more attractive from Salomon’s point of view. He would have owned only 10.9% of Salomon, compared to Buffett’s 12%.

  81. If a potential buyer for his block of convertible preferred appeared, Buffett was obliged to offer Salomon first refusal. Even if it did not buy back the shares, he was prohibited from selling his entire block to any one purchaser. Berkshire also agreed to limit its investment in Salomon to no more than 20% for seven years.

  82. Michael Lewis, Liar’s Poker: Rising Through the Wreckage on Wall Street. New York: W. W. Norton, 1989.

  83. Interview with Paula Orlowski Blair.

  Chapter 47

  1. Berkshire Hathaway letter to shareholders, 1990; Michael Lewis, “The Temptation of St. Warren,” New Republic, February 17, 1992.

  2. At the University of Notre Dame, spring 1991. Cited in Linda Grant, “The $4-Billion Regular Guy: Junk Bonds, No. Greenmail, Never. Warren Buffett Invests Money the Old-Fashioned Way,” Los Angeles Times, April 7, 1991.

  3. In “How to Tame the Casino Economy,” Washington Post, December 7, 1986, Buffett advocated a 100% confiscatory tax on profits from the sale of stocks or derivative instruments that the holder has owned for less than a year.

  4. Linda Grant, “The $4-Billion Regular Guy.” Buffett hosannaed Gutfreund in his shareholder letters as well.

  5. The principal conflicts inherent in Salomon’s business were the undisclosed bid-ask spread that Buffett had objected to while working for his father’s firm in Omaha, the conflict between proprietary trades for the firm’s account alongside customer trades, the investment banking business built off equity research stock ratings, and the arbitrage department, which could trade on the firm’s merger deals. As a board member who made Berkshire’s investment decisions, Buffett says he either recused himself from discussions involving deals or did not invest on information he had, yet his board membership did create the appearance of a conflict of interest.