Capital Allocation: The Financials of a New England Textile Mill
A fascinating look back at Berkshire Hathaway from 1955 to 1985
“Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”
— Warren Buffett, 2014 Letter to Shareholders
On a spring day in 1964, Warren Buffett received a letter from Seabury Stanton offering to purchase the Buffett Partnership’s seven percent stake in Berkshire Hathaway. Stanton, the seventy-one year old President of Berkshire, had been closing unprofitable textile plants for several years and decided to use much of the savings to repurchase Berkshire stock. Buffett started buying Berkshire shares in 1962 at a cost of $7.51/share after recognizing that the stock was trading not only below book value but below net current asset value.1 Earlier that spring, Buffett negotiated a deal with Stanton in which the Buffett Partnership would sell its stock back to the company.
Buffett and Stanton agreed to a price of $11.50 per share. But Stanton’s letter offered an eighth of a point less, or $11.375 per share. This annoyed the thirty-three year old Buffett and he declined to tender his shares. Instead, he started aggressively buying more shares of Berkshire in the open market and, by the spring of 1965, Buffett had enough shares to take control of Berkshire and oust Stanton. Stanton’s attempt to undercut Buffett by less than $14,000 caused Buffett to make what he characterized as a “monumentally stupid decision” when he recounted the story five decades later.2
Berkshire Hathaway was one of many undervalued companies that Buffett invested in during his years of running the Buffett Partnership. Buffett’s letters to partners during those years reveals a great deal about the strategies he employed and it is quite obvious that there was no master plan to acquire Berkshire and turn it into his main investment vehicle. Berkshire evolved from an undervalued portfolio holding into a control position because of Stanton’s failure to honor his verbal agreement with Buffett which turned him into an “activist” investor. Under Buffett’s management, Berkshire evolved into his main investment vehicle over the subsequent decade because Berkshire had excess capital to deploy in a very tax-efficient manner.
Warren Buffett labored in relative obscurity for years before he first appeared on the front page of the Wall Street Journal in 1977 and he did not really become a household name for nearly another two decades until Roger Lowenstein’s Buffett biography was published in 1995. In recent years, numerous books have been written that cover Buffett’s early years running his partnership and his later years at Berkshire. However, until now, there has not been an attempt to tell the Berkshire Hathaway story as the company was transformed from a failing textile manufacturer into a massive conglomerate. Jacob McDonough’s book, Capital Allocation: The Financials of a New England Textile Mill attempts to analyze Berkshire from 1955 to 1985 through the eyes of an investor who was examining financial statements during those years.
As McDonough states at the outset, he wrote the book for practitioners who are interested in analyzing the financial statements of Berkshire Hathaway during its early years in an attempt to study what Buffett saw at the time and how he transformed the business. The book emphasizes the numbers from Berkshire’s financial statements along with McDonough’s analysis of the sources and uses of cash flow. The extensive notes demonstrate that McDonough obtained and studied all of Berkshire’s early financial statements. These documents pre-date the SEC’s Edgar system and are not widely available on the internet.
For many Berkshire shareholders, this might be the first time that they have had the opportunity to examine Berkshire’s early financial statements. McDonough starts in 1955 with a presentation of Berkshire’s balance sheet along with a table showing the company’s sales and net income over the subsequent seven years. More importantly, he analyzes Berkshire’s shareholders’ equity accounts over this period to demonstrate how management was returning significant cash to shareholders. This is what Warren Buffett would have seen sitting in his office in Omaha in 1962 when he made the decision to purchase his first shares.
During the late 1950s and early 1960s, Stanton was closing unprofitable textile plants and returning significant capital to shareholders. Berkshire had total equity of $51.4 million at the beginning of 1955 and returned $16.8 million to shareholders over the next seven years despite posting a cumulative net loss of $1.5 million. During that time, the company had to spend $15.1 million on capital expenditures which exceeded depreciation charges, meaning that true economic earnings were even worse than the $1.5 million net loss.
Stanton obviously saw the writing on the wall and was actively shrinking the business by returning capital. Nearly half of the capital return over those seven years was in the form of share repurchases. Why? Stanton saw that Berkshire shares were trading far below book value during much of the period — indeed, often far below liquidation value. Every share that he repurchased at such bargain basement prices enriched continuing shareholders. Between 1955 and 1961, shares outstanding were reduced by 30 percent.
Buffett clearly saw a “cigar butt” when he started buying shares in 1962. At Buffett’s purchase price of $7.51 per share, he was buying part ownership in a business with $16.5 million in net current assets and book value of $32.5 million at a bargain basement valuation of only $12.1 million. If Buffett had overcome his anger over Stanton’s lowball offer and accepted $11.375 per share in the spring of 1964, that would have represented a nice 51.5 percent gain over a couple of years. But he was angry and he started buying shares aggressively.
Let’s take a look at the evolution of the Buffett Partnership’s (BPL) ownership between the rejection of Stanton’s offer and early 1966:
May 6, 1964: BPL owned 110,858 of Berkshire’s 1,583,680 shares outstanding.3
Early April 1965: BPL owned 392,633 of Berkshire’s 1,017,547 shares outstanding.4
Early 1966: BPL owned 552,528 shares, or 54.3 percent of the company.5
As Buffett said fifty years later, he “became the dog who caught the car.” Berkshire now represented 25 percent of BPL’s total assets and the business was a terrible one in an industry destined to continue shrinking in the future. Berkshire did not have excess capital immediately following Buffett taking control of the company and also carried a small amount of debt. If conditions had not temporarily improved in 1965 and 1966, providing Buffett with $9.4 million of free cash flow over those two years, the history of Berkshire might have been very different.
Buffett attributes these two good years to “luck”, and perhaps the improvement in operating conditions was luck, but Buffett’s skill with respect to redeploying the cash flow was not luck. Most managers of a textile company would have taken that cash and reinvested it into the business, probably buying new equipment that, at best, would provide only a fleeting competitive advantage. The long-term future of textiles was still dim, regardless of a couple of years of profits. Buffett recognized this and began to allocate capital away from textiles.
In March 1967, Berkshire paid $8.6 million to purchase National Indemnity, an insurance company run by Jack Ringwalt, a longtime friend of Buffett’s. This was the beginning of a multi-decade period of diversification away from textiles into other lines of business. Textiles withered away in importance and the business was shut down in 1985. Meanwhile, Buffett’s empire grew into banking, candy, newspapers, and marketable securities.
McDonough takes the reader through Berkshire’s expansion throughout the 1970s and into the early 1980s. Importantly, he also examines the history of Diversified Retailing, a company formed in 1966 by Buffett, Charlie Munger, and Sandy Gottesman, as well as Blue Chip Stamps, a trading stamp company that Munger eventually controlled. Berkshire held stakes in these companies and they were eventually merged into Berkshire. During the 1970s, Blue Chip Stamps was used as a vehicle for acquiring several important businesses including See’s Candies and the Buffalo News. Understanding the history of Diversified Retailing and Blue Chip Stamps is required to fully understand Berkshire during this timeframe, but the links between the three companies have long been somewhat obscure and confusing. McDonough does a good job of untangling the story and presenting it in a clear and concise manner.
I have been a Berkshire shareholder for over two decades and have written hundreds of articles covering the company on The Rational Walk over the past eleven years as well as In Search of the Buffett Premium, a detailed report published in 2011. I make it a point to read whatever I can find regarding Berkshire Hathaway and I can say that much of the information contained in McDonough’s book will be new to even the most informed Berkshire Hathaway shareholder. The book will be most relevant to investors who seek to study and emulate Buffett’s approach as well as to shareholders of Berkshire who are interested in the company’s early history.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.
Net current asset value is the total of all current assets on the balance sheet minus all liabilities. An article explaining the concept in more detail was published in 2009.
The Buffett Partnership owned ~7% of the 1,583,680 shares of Berkshire outstanding in May 1964, or ~110,858 shares. The 1/8 point difference amounts to 110,858 x 0.125 = $13,857