Why Did Warren Buffett Buy Berkshire Hathaway in 1965?
Why did Warren Buffett Buy Berkshire Hathaway in 1965?
On May 10, 1965 Warren Buffett, through his investment partnership, famously took over the management and control of Berkshire Hathaway Inc., a then large but struggling New England textile maker. His investment partnership had accumulated about 49% of the shares starting in 1962 and culminating with heavy purchases in early 1965.
In explaining why he bought it, Buffett was quoted at the time as saying “we bought Berkshire Hathaway at a good price”. My research has uncovered that this “good price” did not involve a low price to trailing earnings multiple. Instead, it refers to a good price in relation to the value of the assets. It may also have referred to a good price to expected forward earnings but that is not clear.
In later and in recent years Buffett has said that buying Berkshire was a mistake because back then it was only involved in the textile business. Textiles were a declining industry in 1965. It tied up a lot of his money in a poor business.
In his 1989 annual letter, Buffett said, under the topic “Mistakes of the First Twenty-Five years”:
“My first mistake, of course, was in buying control of Berkshire. Though I knew its business -textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.
If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. …”
Even if it was a mistake, Buffett had his reasons to buy Berkshire and those reasons, including exactly in what way “the price looked cheap” seem worthy of further exploration. This article will review some of the previously published reasons for this historic purchase and will add a more detailed exploration of Berkshire’s 1964 and 1965 financial statements which provide insight into Buffett’s probable reasons for the purchase and why it appeared to be under-valued in the market as Buffett was buying it.
Buffett’s policy was to keep his investments secret until the buying was completed. Accordingly, his limited partners did not even know about the purchase of a controlling interest in Berkshire Hathaway until some time after it was completed. In his July, 1965 letter to his investment partners, Buffett noted that the partnership had gained a control position in one of its investments. Only later was it revealed that this was Berkshire Hathaway.
In his January 1966 letter, further details were provided. Buffett described how the partnership had been accumulating shares in Berkshire Hathaway since 1962 on the basis that it was trading significantly below the value to a private owner. The first buys were at a price of $7.60. The discounted price reflected the large losses Berkshire had recently incurred.
The Buffett partnership’s average share purchase price was $14.86 reflecting very heavy purchases in early 1965 as Buffett took control of the company in the Spring of 1965. Buffett reported to his partners that at the end of calendar year 1965, Berkshire had a net working capital (without placing any value on plant and equipment) of about $19 per share.
Warren Buffett had begun accumulating shares in Berkshire Hathaway on the basis that it was trading at a significantly lower price than the value to a controlling private owner. Buffett had earlier made a number of investments on this basis and the usual outcome was to later sell the block of accumulated shares in the market or to another single buyer. In this case however Buffett ended up taking control of the company.
During this period one of the three categories of investments that the Buffett partnership was making was called a control situation, where Buffett would take control or become active in the management of the company. In a 1963 letter he said: Because results can take years, “in controls we look for wide margins of profit — if it looks at all close, we pass.” He also said he would only become active in the management when it was warranted.
On at least one previous occasion Buffett had taken full control of a public company. The Buffett partnership had purchased 70% of Dempster Mills Manufacturing in 1961. Buffett brought in a new manager at Dempster and had the manager reduce inventory and Buffett then had Dempster invest in marketable securities. If Buffett had not sold Dempster in 1963 it seems quite possible that it would have been Dempster that became his corporate investment vehicle rather than Berkshire.
Buffett noted that back in 1948 Berkshire had had 11 mills and 11,000 workers but by the time Buffett took control it had only 2 mills and 2,300 employees. Buffett also noted that in “a very pleasant surprise” existing management employees were found to be excellent. Ken Chace, he said, was now running the business in a first-class manner and it also had several of the best sales people in the business. Before taking control, Buffett knew that Ken Chace was available to manage it.
Buffett indicated that Berkshire was not going to be as profitable as the likes of Xerox but that “it was a very comfortable sort of thing to own” and “a delight to own”.
Berkshire Hathaway’s 1964 Balance Sheet
A recently published book put together by Max Olson has compiled all of Buffett’s letters to Berkshire Shareholders and it includes previously hard to obtain information on Berkshire Hathaway’s 1964 balance sheet as follows:
|Assets||$ millions||Liabilities||$ millions|
|Accounts Receivables and Inventories||19.1||Accounts Payable and Accrued Expenses||3.2|
|Net Property, Plant and Equipment||7.6||Total Liabilities $5.7|
|Other Assets||0.3||Shareholders’ Equity 1.138 million shares book value
$19.46 per share
Buffett had therefore taken control of Berkshire Hathaway for the partnership at an average price that was 76% ($14.86 / $19.46) of book value. The cash, accounts receivables, and inventories of $20.8 million were, after deducting total liabilities of $5.7 million, worth $15.1 million or $13.30 per share. In effect one could argue that Buffett had purchased the company at approximately the value of its current assets minus all liabilities
He was therefore paying almost nothing for the property, plant and equipment and any going concern value of the business. There was at least some market value in the property plant and equipment. And there was some value as a going concern.
The book value of $19.46 per share, at the end of fiscal 1964, can be broken down, on a percentage basis, as follows:
Accounts Receivable and Inventory 69%
Net Property, Plant and Equipment 27%
Other Assets 1%
This indicates that the assets which were purchased for 76% of book value were relatively high quality assets. Most of the assets were relatively liquid (assuming that the inventory could be sold for cash at close to its stated value). It is possible that there was land that was worth more than its balance sheet value. However it is also possible that the plant and equipment was worth far less than book value. However, the $7.6 million net value of the property plant and equipment had already been reduced on the 1964 balance sheet to reflect an expected $4.2 million loss on a property expected to be sold.
The Balance Sheet reveals that Berkshire Hathaway was ostensibly attractive given the price of 76% of book value. And it turns out that the 1964 balance sheet was in effect missing an important hidden financial asset in terms of available past losses that could be used to eliminate substantial future income taxes. Subsequently, Berkshire did make substantial profits in 1965 and 1966 that benefited greatly from a lack of income taxes. The extent to which Buffett valued the potential use of the past tax losses is unknown.
In his 1979 letter to Berkshire shareholders Buffett said “It probably also is fair to say that the quoted book value in 1964 somewhat overstated the intrinsic value of the enterprise, since the assets owned at that time on either a going concern basis or a liquidating value basis were not worth 100 cents on the dollar.” Even though, as we calculated just above, Buffett paid an average of 76 cents on the dollar this 1979 statement arguably contradicts the notion that the price looked cheap in 1965. (Paying 76 cents on the dollar for assets worth somewhat less than a dollar might not fit Buffett’s definition of being cheap.)
Berkshire Hathaway’s Earnings at the Time of Buffett’s Purchase
Next we will look at Berkshire’s earnings at the time of Buffett’s purchase.
There was certainly no strong history of profits to make Berkshire Hathaway attractive or “cheap”. In fact it had lost a total of $10.1 million in the nine years prior to the 1964 balance sheet depicted above. The company was shrinking rapidly as its assets fell from $55.5 million in 1955 to $28.9 million in 1964. Despite the $10.1 million in losses it had paid out $6.9 million in dividends and paid out $13.1 million to repurchase shares. This was funded, in part through asset sales and also through non-cash depreciation expenses since investments in new and replacement equipment were likely less than the depreciation amount. Selling textile mills as they were closed down generated cash even if the mills were sold at a loss.
The company had earned only $0.126 million in 1964. This was approximately 11 cents per share. This suggests that Buffett’s $14.86 average purchase price represented a P/E ratio of 135 times trailing earnings! On a cash flow basis the ratio may have looked better since capital spending was apparently lower than the depreciation expense.
However, the company earned $2.279 million in the year ended October 2, 1965. This was $2.11 per share. This suggests that the purchase at $14.86 represented an attractive P/E ratio of 7.0. The company’s equity at the end of 1965 was $24.5 million or $24.10 per share. Before an apparently discretionary charge equivalent to income taxes, the actual net income for 1965 was $4.319 million and earnings per share were about $4.00. Buffett apparently did not consider the $4.319 million in earnings to be representative since it reflected zero income taxes due to temporary deductions available. Still, it is a fact that the P/E ratio based on the $14.86 price paid and this $4.00 per share earnings was only about 3.7! The fact that the actual earnings of Berkshire in 1965 were about $4.00 per share is consistent with a figure of $4.08 pre-tax indicated for 1965 in Buffett’s 1995 letter to shareholders given that the GAAP income tax was apparently zero in 1965.
Berkshire’s profit (before the discretionary allowance for income taxes that were not actually payable due to past tax losses) in 1965 at $4.3 million was considerably higher than it had made in recent years. It’s not clear to what extent this was due to strong profit margins in the industry that year, a reduction in overhead costs, the closing and sale of an unprofitable textile mill, or what. Possibly Buffett became aware that 1965 was going to be an exceptionally profitable year. He had undoubtedly studied the industry and would have been aware if this cyclic industry was entering a period of higher profitability. Or, possibly it was his actions in controlling the company in the last five months of fiscal 1965, including any influence before taking control, that led to the sudden profit. The 1965 letter to shareholders does not shed much light on the reasons for the increased profits but does say that the company made substantial reductions in overhead costs during 1965. It seems likely that while the reduction in overhead costs was partly or fully due to Buffett, 1965 was probably going to be at least a reasonably profitable year in any event.
The surge in earnings in fiscal 1965 was not due to investments in stocks. It does not appear that Buffett had already started to accumulate any significant stock market gains for Berkshire in its first few months under his control – the vast majority of the marketable securities at the end of 1965 were in short-term certificates of deposit.
It is certainly not clear what earnings Buffett might have expected Berkshire to earn going forward. In his 1985 letter, Buffett stated that at the time of the purchase he had expected Berkshire’s textile operations to be much better ran under Buffett’s chosen manager than had been the case in the past. And we know that it ended up earning an impressive $4.89 per share in 1966. Recall that Buffett paid an average of $14.86 per share to take control of Berkshire. These 1966 earnings would have been lower but still reasonably strong at $2.71 per share if not for past tax losses that were available to eliminate income taxes.
Other Reasons for the Purchase
Alice Schroeder’s book (The Snowball) indicates that Buffett was initially attracted to Berkshire simply due to the fact that he could buy about $19 worth of book value for $7.50. A friend of Buffett’s at that time suggested that the whole company could be purchased and liquidated. Buffett later met with Berkshire management and offered to let the company buy back his shares for $11.50. Apparently, management promised to do so but then formally offered only $11.375. Apparently, Buffett was incensed and decided to buy control of the company and oust the current management. By the time Buffett bought the company he had picked one of the employees to run it and he had toured its operations and become familiar with it. He promised that he had no intention of liquidating the business.
The then 34 year old Buffett may also have been attracted to the idea of gaining control of a company with 2300 employees. There was, presumably, a certain amount of “psychic income” in that. It is also likely that he wanted to “show” the outgoing management and everyone else that he could run the company far more profitably than they had. Keep in mind that Buffett is an extremely competitive man.
Advantages of Controlling Ownership of a Corporation
In this section, we explore certain advantages of owning Berkshire apart from its book value and its earnings. These advantages may have also factored into Buffett’s decision to purchase Berkshire.
There are certain advantages that are associated with purchasing a controlling but not full ownership of any corporation. And these advantages are magnified by purchasing a controlling interest at less than book value. These advantages are not unique to Berkshire.
It is therefore important to note that Buffett did not buy 100% of Berkshire. He got control of Berkshire by purchasing about 49% of the shares. As controlling owner he controlled 100% of Berkshire’s book value and assets. He had paid about $8.3 million (49% of 1.138 million shares at an average purchase price of $14.86). But Buffett now controlled all of Berkshire’s $22.1 million in equity capital. And he controlled all of its $27.9 million in assets. In effect this was a way of getting an extra $13.8 million ($22.1 – $8.3) in investor capital under his management without actually having to raise that capital from investors.
Furthermore, and perhaps very importantly, this was investor capital that the public shareholders of Berkshire had no ability to extract. Shareholders could sell their shares to others but the capital would remain with Berkshire. In contrast, in Buffett’s partnership operation, investors were free to withdraw their capital at the end of any calendar year which would have required Buffett to maintain a significant cash balance rather than investing all of the partnership’s assets.
In his 1964 letter, written four months before the takeover of Berkshire, Buffett noted that his limited partners had complained about their income tax liabilities. These would have arisen mostly as the partnership sold securities it had invested in at large capital gains. Buffett may have considered the fact that if the investments were made through a corporation in which his “partners” owned shares then all capital gains and other income would be taxed only in the hands of the corporation. As long as there were no dividends to the shareholders, and as long as they did not sell their shares, his investees would not face personal tax liabilities.
In the ten years prior to 1964, Berkshire had raised substantial cash by selling off property (textile mills). Much of this cash had gone to paying dividends and buying back stock. Just prior to Buffett taking control in May 1965, Berkshire was in the process of or had recently sold another mill. While it was sold at a loss it nevertheless generated some cash. Buffett may have planned to divert any cash previously used for dividends and buybacks to investing in marketable securities.
Buffett apparently stopped Berkshire’s long-standing practice of buying back shares. That practice had been draining capital (money) from the company. Buffett apparently felt that he could find better uses for that money than repurchasing shares. No shares were repurchased in fiscal 1966, the first full year under Buffett’s control..
There was also additional leverage associated with Berkshire’s $5.7 million of debt and accounts payable. In total Buffett now had control over Berkshire’s $27.9 million of assets by investing $8.3 million.
The purchase of of 49% of Berkshire Hathaway also brought in the owners of the remaining 51% as new participants and “audience” members for Buffett’s wealth building and for his investment writings. He might also have considered that ownership of a publicly traded company would bring him more public notice. It seems likely that even at this time Buffett immensely enjoyed the process of making his partners (including minority shareholders) rich and he enjoyed the public notice that came along with that. Purchasing Berkshire therefore added to his enjoyment.
Buffett also likes history and was interested in and intrigued by Berkshire’s long history. Roger Lowenstein in his book about Buffett recounts how Buffett was excited to find that copies of Berkshire’s financials going back to the 1920’s were were available.
Disadvantages of Investing in a Corporation
Offsetting the advantages of investing in corporate form which are described above, there is an income tax disadvantage. Buffett has explained that investing in a corporate form has certain disadvantages for the owners as opposed to investing directly or through a partnership. Those who invest through a corporation are subject to a certain amount of double taxation. The corporation pays income taxes and then its owners pay income taxes on dividends and, if they sell their shares, capital gains. Buffett limited this disadvantage in several ways. Berkshire itself often holds shares for decades which defers capital gains taxes. And Berkshire does not pay any dividend which eliminates the personal tax on dividends. A shareholder who buys and holds Berkshire for decades does not incur any personal tax until the shares are sold.
In the end, it appears that there were several reasons that contributed to Buffett wanting take control of Berkshire Hathaway. The initial purchases were based on the fact that the shares were selling well below the value to a controlling owner. It appears that taking full control later became the best way to realize value on the initial investments.
The purchase, below book value, of about 50% of this publicly traded company provided leverage and allowed Buffett to control an additional $28 million of assets for an investment of $8 million. It also brought the public shareholders into his “tent” enlarging his audience and helped to bring Buffett to the attention of the wider public. Buffett was likely excited to be taking control of a company with 2300 employees. And, it appears that he thought that it would make at least a reasonable profit as an operating business. He likely knew that Berkshire had entered a cyclic period of higher profitability. And he would have been aware of the value of past tax losses in reducing income taxes payable on any anticipated profits.
It’s not clear to what extent he had immediate plans to attempt to extract cash from Berkshire by some combination of increasing profits, reducing inventory, and continuing to harvest depreciation cash flows and plans to then invest that cash in more profitable businesses and in stocks and bonds. Buffett’s 1995 letter to shareholders does indicate that he and Charlie Munger “knew in a general way what we hoped to accomplish” in regards to growing both marketable securities and operating earnings.
In part, the controlling purchase was motivated by a conflict with the existing management that led to his conclusion that management needed to be changed. Like most investments it was probably based partly on emotion and partly on numerical analysis. Knowing Buffett, it seems likely that the purchase was fully justifiable on the numbers alone.
In part, the purchase is explained by Buffett’s longstanding habit of being a man of action. In Berkshire he saw the opportunity to improve his return by taking control and changing management. As is his habit, he acted swiftly. Having decided that the best course of action was to take control, he did so. Despite Buffett’s decades later comment that the purchase of Berkshire was a mistake it certainly ended up working out rather well, most especially for the remaining public shareholders of Berkshire Hathaway.
Shawn Allen, CFA. CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
January 4, 2014 (With minor edits to December 1, 2017)
Prologue and lessons learned:
Despite Buffett’s comments that purchasing Berkshire was a mistake, it’s hard to agree with that assessment.
Everything that Berkshire has grown into today came from the very wise way in which Buffett reinvested the profits and cash flows of the original textile operation in highly profitable ways.
Berkshire’s book value at the end 2012 was a staggering 8,654 times higher than it had been just prior to Buffett’s purchase. That’s an increase of 865,400%. Meanwhile the share count had increased by only 44%. The shares that existed at the end of 1964 still accounted for 69% of the ownership in 2012 and these shares had increased in book value by 586,817%. The only new capital that has come into Berkshire occurred when Berkshire very occasionally issued shares in making acquisitions. Fully 69% ($132,196 million) of Berkshire’s equity capital at the end of 2012 of $191,588 million can be traced solely to the growth of the initial equity of $22 million that Buffett started with.
Buffett’s first major move in re-deploying Berkshire’s equity came within two years of assuming control of Berkshire. In early 1967 Berkshire Hathaway purchased a pair of property insurance companies for $8.6 million million. A key characteristic of insurance companies is that the insurance premiums which are ultimately ear-marked to pay claims can meanwhile be invested.
The cash for this purchase came mostly from Berkshire’s unusually high profits in 1965 and 1966, which totaled $9.3 million. The cash did not come primarily from reducing inventories, receivables or assets of the textile operation, although as indicated in Buffett’s 1985 letter that was partly the source of the cash for the purchase. Buffett was careful not to pour much additional capital, including profits from the textile business, into the textile business. Instead, he extracted much of its profits for other purposes. But it is not the case that he materially reduced the capital in the textile business. Berkshire Hathaway’s textile business remained operational under Buffett’s control for 20 years until 1985.
Reviewing Buffett’s 1965 purchase of Berkshire Hathaway is interesting enough just for its historical significance. But it also may offer some important lessons for today’s investors and investment managers.
What might today’s investment managers learn from Buffett’s purchase?
They might learn to look for investments that could work out in several ways. Buffett’s purchase price was cheap in relation to book equity and also in relation to the profitability that occurred in the years immediately after the purchase. In the case of the earliest purchases, Buffett also knew that the company itself might repurchase his shares at a substantial gain.
Buffett’s Berkshire purchase illustrates how a large investor can gain complete control of a company by purchasing a controlling but not full interest.
Most importantly, Buffett’s purchase of Berkshire and its subsequent operation provides valuable lessons in how the profits and cash flows of a sub-par business can be redeployed into much more lucrative investments.