Case Study: Mid-Continent Tab Card Company (Excerpt)
This company was an outgrowth of IBM and, as you all know, Warren did not use computers in the 1950s but he was very aware of them. IBM was the only computer company of any size or importance at that time. And Warren’s Aunt Katie and her Uncle Fred had decided to invest in Control Data which was a startup company that was going to compete with IBM. Katie’s brother who was Bill Norris was founding Control Data because he wanted to create a business. He thought IBM was slow and bureaucratic. And Warren told Katie and Fred not to invest in Control Data. He said to them, “Don’t do it.” Who needs another computer company?
Those were his famous last words. They invested in Control Data anyway and they made a huge amount of money. And what was notable about this incident was that Warren told them not to invest because he actually knew a lot about IBM by studying IBM. He had been studying IBM since 1952 it had been in court embroiled in an anti-trust case for being a monopoly. Warren studied its financials and even though by then he had already declared IBM outside his circle of competence.
(It is interesting that he would study a company outside his circle of competence. Perhaps, he wished to be informed about an important company. Like studying Google today to understand its effect on the Media industry?)
He felt that even though IBM might have to be broken up one day, that its monopoly was so overwhelming–and, of course, he likes monopoly businesses–that to compete with it would be futile. So what happened was that IBM did actually settle with the Justice Department. And as part of that settlement it was required to divest of a business making tab cards.
What is a tab card? Before computer were digital, computers read off of punch cards. They were called Mark Sense Cards, and these were big decks of cards with holes punched in them and they would be stuck in the computer, and they would be read mechanically through the computer.
This company was formed because IBM had to divest of this business; it was an incredibly profitable business. In fact, because these cards were trivial because of the mainframe computers that IBM sold, it marked the cards up to earn a 50% profit margin. This was IBM’s most profitable business.
So when Wayne Ace and Warren Cleary who were two friends of Warren’s saw that IBM was going to have to divest in this business, and they thought we are going to buy a Carroll Press which was a press that makes these cards. And we are going to compete with IBM because we are based in the Mid-West, we can ship faster. We can provide better service. And they went to Warren and they said, “Should we invest in this company and would you come in with us? And Warren said, “No.”
Well, why did he say no? He didn’t say no because it was the technology company. He said no because he went through the first step in his investing process. This is where I think what he does is very automatic but it isn’t well understood. He acted like a horse handicapper. The first stop in Warren’s investing process is always to say, “What are the odds that this business could be subject to any type of catastrophe risk—that could make it (the business) fail? And if there is any chance that any significant part of his capital would be subject to catastrophe risk, he just stops thinking. NO. He just won’t go there.
It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a project and then at the end, the ask, “What could go wrong.”
Warren starts with what could go wrong and here he thought that a start-up business competing with IBM can fail. Nope, pass, sorry. And he didn’t think any more about it. But Wayne and Cleary went ahead anyway and within a year they were printing 35 million tab cards a month. At that point, they knew they had to buy more Carroll Presses so they came back to Warren and said, we need money—would you like to come in?
So now, Warren is interested because the catastrophe risk is gone. They are competing successfully against IBM. So he asks them the numbers, and they explain to him that they are turning their capital over 7 times a year. A Carroll Press costs $78,000 dollars and every time they run a set of cards through and turn their capital over, they are making over $11,000. So basically their gross profit on a press (7 x $11,000 = $77,000) is enough to buy another printing press. At this point Warren is very interested because their net profit margins are 40%. It is one of the most profitable businesses he has ever had the opportunity to invest in.
Notably people are now bringing Warren special deals to invest in—it is 1959. He has been in business for 2.5 years running the partnership. Why are they doing that? It is not because he is a great stock picker. They don’t know that. He hasn’t yet made that record. It is because he knows so much about business, and he started so early he has a lot of money. So this is something interesting about Warren Buffett—people were bringing him special deals like they are today with Goldman Sachs and GE.
He decided to come in and invest in the Mid-Continent Tab Company but, interestingly, he did not take Wayne and John’s word for it because the numbers they gave him were very enticing. But, again, he went through and he acted like a horse handicapper.
Now here is another point of departure. Everyone that I know or knew as an analyst would have created a model for this company and projected out its earnings or looked at its return on investment in the future.
Warren didn’t do that. In going through hundreds of his files, I never saw anything that looked like a model. What he did is he did what you would do with a horse….he figured out the one or two factors that determined the success of the investment. In this case, it was the cost advantage that had to continue for the investment to work. And then he took all the historical data, quarter by quarter for every single plant and he obtained similar information as best he could from every competitor they had, and he filled several pages with little hen scratches with all this information and then he studied that information.
Then he made a yes/no decision. He looked at—they were getting 36% margins, they were growing over 70% a year on a $1 million of sales—so those were the historical numbers. He looked them in great detail like a horse handicapper would studying the races and then he said to himself, “I want a 15% return on $2 million of sales and said, Yes, I can get that.” Then he came in as an investor.
OK, what he did was he incorporated his whole earnings model and compounding (discounted cash flow or DCF) into that one sentence. He wanted 15% on $2 million of sales (a doubling from $1 million current sales). Why does he choose 15%? Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that.
It is a very simple thing, nothing fancy about it. And that is another important lesson because he is a very simple guy. He doesn’t do any DCF models or anything like that. He has said for decades, “I want a 15% day one return on my capital and I want it to grow from there-ta da! The $2 million of sales was pretty simple too. It had a million in sales already and it was growing at 70% so there was a big margin of safety built into those numbers.
It had a 36% profit margin—he said I would take half that or 18%. And he ended up putting in $60,000 of his personal, non-partnership money which was 20% of his net worth at that time. He got 16% of the company’s stock plus some subordinated notes. And the way he thought about it was really simple. It was a one-step decision. He looked at historical data and he had this generic return that he wants on everything. It was a very easy decision for him. He relied totally on historical figures with no projections.
So what happened? Well? The company changed its name to Data Documents, and he owned it for 18 years. And he ended up putting another $1 million dollars into it over that time. It was bought out in 1979 by Dictograph, and he earned 33% compounded return over the time period he owned the investment (18 years CAGR—excluding additional capital $60,000 would compound to $1.18 million) so it was not too bad.
That was typical. I gave you this example because it was the other time besides GEICO that he got a Phil Fisher-type growth company at a Ben Graham like price. It was the most vivid example that I found, but it was a private investment and there is not a lot of public information about it available.
So, fast forwarding a little bit, why he thinks so much about catastrophe risk? Firestone’s law where he said, “Chicken Little only had to be right once.” And that is always the first thing that Warren thinks about. So why is Berkshire Hathaway today not dealing with some of the problems that other people are? It is because Warren passed on investing on a lot of things that he could have because the first question he always asks is, “What is the catastrophe risk?” And if the business or investment has catastrophe risk, he just says no.
You could probably get into an interesting discussion on stocks like AIG. That was a stock I was wrong on that for a long time until I finally turned around. He never invested in AIG because of the Catastrophe Risk. People brought him Bear Stearns or Lehman Brothers, and he turned them down. He saved himself a lot of trouble, time and energy this way. If you ask yourself the catastrophe risk question first before all the historical data, you will save yourself a lot of time and tears.
Because Warren is focused on efficiency, that is why he does that, and he is also very good at being realistic. And once he figures that something has the catastrophe (“Cat”) risk, he passes or never tries to change himself out of making that decision.
So today when you think about what is happening now (November 2008) like deals going on right now like Citigroup, Goldman Sachs people are still bringing him special deals that no one else can get, and he still is making sure that they do not have the cat risk as best he can. He is making a bet on management and his reputation as an investor—to some extent–can help these deals. They are giving him 10% guaranteed return—that is the minimum–on these deals. He still wants the 15%. At times, he has taken less and lowered his standards and he usually has been sorry when he has.
When it comes to the market as a whole, he uses somewhat the same technique. He recently said that he finds the stock market attractive now. In his 1999 Sun Valley speech he talked about investing in the market when the stock market’s value was between 70% and 80% of GDP. It is somewhat the same method because at that level, obviously the stock market is not going to zero and he has a huge margin of safety built into that, just as the 15% return and $2 million included a huge margin of safety given how fast Mid Continental Tab company was actually growing and the margins it was actually getting. And so he has put his margin of safety into return expectations.
He is using only historical data and he uses years and years of that data to arrive at the conclusion that, again, probabilities—he is handicapping—that it is the right price to buy. He doesn’t care if it (the market) goes up and down in price for the next two or three years. He just knows that at this price, he will do well over time.
I do think that it is really amazing that three weeks later there are pundits out there that the greatest living investor of our time and possibly ever is wrong for having made these investments and having predicted that the stock market is a buy right now. It is really ironic and interesting that somebody who has never been wrong in making a prediction and that the people who have been wrong in the past making predictions once again saying he is wrong.
Since we are talking about this handicapping concept, this is just a little quote from the Intelligent Investor that the margin of safety is always dependent upon the price paid. If, as we suggest, the average price level for most growth stocks is too high to provide a margin of safety for the buyer, then this simple technique of diversified buying may not work satisfactorily. That obviously applies to the market as a whole.
One thing that I think Warren Buffett should get a lot of credit for and a round of applause for is that he never, ever advocated dollar-cost averaging because it is wrong. The concept has led many people off a cliff. It is not right to buy the market at any price. And you have never heard him suggest that anyone should do it. I think he should get a lot of credit for that.
In the end, thank you for listening to this story, and I hope it gives you a little insight into how he thinks. It is also indefinable. There are certain things about him that will always be a mystery and never be explainable. And there is one thing you can emulate but only if it comes from the right place inside you. It has been said—and this came early to Warren—that the only person who is really qualified to advise you as to what you can do is yourself. He (Buffett) calls this your inner scorecard. You know yourself better than anyone. You and you alone know how determined you are to make something a success of any undertaking. And in the last analysis, 90% of being successful in business is that indefinable thing, which for lack of a better name we call GUTS. That quote is from a book called a 1000 ways to make a $1,000.