Tobias Carlisle: From Cigar-Butts to Unrecognized Jewels

GuruFocus.com

- By Robert Abbott

In previous chapters of Tobias Carlisle's book, "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," the author discussed the outstanding returns Warren Buffett (Trades, Portfolio) made while investing in "fair companies at wonderful prices," including Sanborn Map and Dempster Mill Manufacturing.


It was part of Carlisle's broader argument that deep-value investing -- buying "fair companies at wonderful prices" or cigar-butts -- remains a viable strategy for investors seeking above-average returns.

In chapter three, Carlisle introduced readers to Buffett's "bad" investment in Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), the company that became the guru's flagship enterprise. He was alerted to the textile maker by a friend, Dan Cowin, because the company was trading at just one-third of its liquidation value, i.e., if it was shut down and its tangible holdings sold for scrap.

The friend estimated the liquidation value at $19.46 per share, while the stock was available for $7.50 per share. Buffett agreed but wasn't sure how he could unlock the value, and in response Cowin said he could sell his stock back to the company, or Buffett could keep buying and liquidate it by selling the assets.

In December 1962, Buffett began buying into the company, and by 1963 had become the biggest shareholder. While he didn't reveal himself immediately, Buffett eventually became embroiled in an dispute with Seabury Stanton, the company's president. Then again, Stanton seemed to be fighting with everyone, including the chairman and the board of directors, and especially with the director who was his own brother, Otis.

Decades earlier, Seabury had saved the company by investing millions when others would not and apparently developed an entitled attitude. He also refused to heed the problems listed in a Harvard Business School thesis, written by his own nephew. In the document, the nephew argued that the textile industry in Massachusetts was doomed. Seabury responded by investing more millions, and about the same time allegedly began drinking heavily.

Buffett saw the situation as an opportunity and bought even more stock. Seabury responded by offering to buy out Buffett. Eventually this led to an agreement in which Seabury would pay $11.50 per share in a tender.

Seabury did follow through, offering to buy back stock from all shareholders including Buffett-- at $11.38 per share.

Buffett was furious about the 12-cent shortfall. In a rare show of emotion in his investing career, he decided he would take over the company rather than take the buyout. He bought enough new shares to become the controlling shareholder, at $15 per share. Next, he called a special meeting of shareholders and became an elected director. Seabury resigned a month later, and the board subsequently elected Buffett chairman in April 1965, a position he has held until the present day.

Concerned about being attacked by the local newspaper if he shut down the business, as he had been when he tried to shut down another business earlier, Buffett pledged to keep the business operating. At that time, textiles were the company's only business, so he slowly liquidated those assets, and reinvested the capital in new businesses. As Carlisle put it, "The textile business just wasted away. He finally shut it down in 1985."

In his annual letter to shareholders, Buffett explained his reasoning, in language that has since become part of his legend:

  • "Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

  • "In a difficult business, no sooner is one problem solved than another surfaces -- never is there just one cockroach in the kitchen."

  • "Time is the friend of the wonderful business, the enemy of the mediocre."



One of the investments that was likely made possible by the liquidation of Berkshire Hathaway assets, along with profits Buffett was making from his other hedge fund investments, was American Express (AXP).

Notably, the American Express investment was made under a different strategy than the one used to buy Berkshire Hathaway. In 1959, Buffett had met Charlie Munger (Trades, Portfolio) and the latter went on to have a profound influence on Buffett.

Before meeting Munger, Buffett had used only hard numbers to establish valuations. Munger, on the other hand, was also interested in the "softer qualities" of businesses. Munger also analyzed Buffett's business to the point that he concluded that Buffett usually liked bad businesses. Buffett agreed and, as the saying goes, "The rest is history."

The main businesses of American Express were traveler's checks and credit cards, but it also owned a smaller business that focused on "warehouse receipts." One of its clients had outwitted inspectors from the company and had committed a serious fraud based on the amount of soybean oil stored in a warehouse. The fraudster and his broker were both bankrupted, and creditors soon arrived at the doors of American Express, looking to be made whole again.

The creditors wanted ten times as much money as American Express earned in 1964. The share price was affected too and dropped by half. That plunge caught Buffett's attention, and he responded by researching the company. He concluded that the company's future depended on how its business customers would respond to the crisis, rather than how the fraud would affect it.

If customers stopped using their traveler's checks and AmEx cards, the company would go under, along with many restaurants and hotels that accepted the cards. Buffett asked his broker to find out how the restaurants and hotels were reacting, and even went to restaurants in Omaha himself to see if they were still accepting the card.

All the research indicated they were still taking the cards, and it seemed likely the company would survive, despite the hit to its finances and its reputation. Buffett made a "bet the company" investment, using 40% of the Buffett Partnership funds to buy 5% of American Express stock. When he sold his shares in 1969, while closing his hedge fund, share prices were up 500%.

That experience helped convince Buffett that Munger's approach was valuable, that there was a real business in American Express and not just a set of assets. What's more, by purchasing a sound business at a bargain price, the returns would keep coming in every year, and not just once. As Buffett wrote, "Charlie shoved me in the direction of not just buying bargains, as Ben Graham had taught me. This was the real impact he had on me. It took a powerful force to move me on from Graham's limiting view. It was the power of Charlie's mind."

Notes:

In purchasing Berkshire Hathaway, Buffett found that bargain investments could lead to serious headaches for a one-time gain. On the other hand, investments like American Express could deliver returns continually if they were "wonderful companies at fair prices."

American Express marked the transition from the young Buffett, who believed in "fair companies at wonderful prices," to the mature Buffett who came to believe in "wonderful companies at fair prices." It also marked a transition from short-term to long-term thinking.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

This article first appeared on GuruFocus.


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