Warren Buffett: Liquidator to Operator

Dempster Mills

Dempster Mills Case Study:

Dempster_Mills_Manufacturing_Case_Study_BPLs  Note the difference in strategy between Buffett and Graham in this type of investment.

As previously discussed, we have read the Preface and Chapter 2, Contrarians at the Gate in Deep Value where we learned about Graham and liquidations and the great mean-reverting mystery of value investment. Klarman’s writings were also read (Margin of Safety) to learn about his approach to liquidation and valuation. Valuation is an imprecise art where value is no one precise number.  Finally, Mr. Market is there to serve us not guide us. Therefore, think of all the pundits, experts, and CNBC commentators we can ignore for the rest of our investing careers.

If readers have questions or comments, do not hesitate to write. I try not to look at my emails but once a week. I neither have a cell phone nor a TV, but time is scarce so I can respond faster (or another student can to your questions) here in the comments section.

Now we transition into reading Chapter 3 of Deep Value, “Warren Buffett: Liquidator to Operator.”  Buffett was Graham’s prized student who forged his own way.   There are about ten books written on Buffett every year. We will now focus on his early career by going through his Complete_Buffett_partnership_letters-1957-70_in Sections

After Dempster, we will study Sanborn Map and then See’s Candies. Put on your thinking caps.   Go the extra mile and find out more about these companies if you have the interest.   Focus on how Buffett estimated the intrinsic value of Dempster Mills AND how he managed the investment over time.   What made up his margin of safety BESIDES the price discount?

Reader Question:   Do I know Toby Carlisle, and do I think his approach works?

Yes, I have had the pleasure of meeting Toby. A nice guy who seems like a Renaissance man similar to Graham but with a darker sense of humor. Toby taught me how to speak Australian English.   You don’t thank your host for a delicious meal by saying, “That was excellent.!”   You say, “What a belly-bust!”   You don’t go out to drink beers, you go out to “rip down a frosty.”  I am indebted for those tips.  I learned during my working days in Cairns, Australia that fly-crawling was the national sport.  If you could choose which fly could crawl the furthest along a wall or ceiling, you were the champ.  The game had a huge element of randomness. I digress…

Since we haven’t finished our course of study on Deep Value Investing, I am no expert to comment upon his approach. But Deep Value investing can work since it does the opposite of a naive strategy. Hard-core contrarian-investing is difficult because buying what has been losing or is obscure, despised, and loathed goes against human nature.  Are you more attracted to go into a full restaurant than one with cobwebs across the window?   So far in our readings, net/nets seem more likely to be small, illiquid securities, so the investing approach may be more suited for individuals with a limited amount of capital who can go anywhere to find bargains.

Even the great Walter Schloss managed small amounts of money using his deep value approach. As his accounts grew, he would return capital to his partners, thus keeping the amounts of money he managed appropriate for the illiquidity of the names he bought and sold.  He would also buy and sell scale down and up, I heard.

Why don’t you call him at his firm, Eyquem Investment Management LLC or visit www.greenbackd.com and find his email address. Ask for his record so far in managing accounts.  What happens when there are only six or seven net/nets–does he concentrate into those?

Are my instructions clear?

Addendum: Does Intuition Have a Role in Quantitative Investing?


25 responses to “Warren Buffett: Liquidator to Operator

  1. Hi John,

    Is it true that Ben Graham kept contradicting himself with each new publication and eventually: in the 1970s Graham stopped advocating a careful use of the techniques described in his text for security analysts in selecting individual stock investments, citing that

    “in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.”

    This statement was made by Graham under the belief, that the “average manager” of an investment trust cannot consistently beat the average return of the market because

    “In effect that would mean that the stock market experts as a whole could beat themselves—a logical contradiction” and that for most investors in general “to achieve satisfactory investment results is easier than most people realise; to achieve superior results is harder than it looks.”

    If this is true, why does everyone (including Columbia) still consider learning value investing from his books?

    • Well, Graham had unflinching honesty and realism. He taught the right ATTITUDE in being bottom-up, fact based when analyzing investments. He also respected the market but knew the market cannot claim infallibility. He also taught the art of valuation.

      There is no definite value for a given bond or stock. Instead of defining with precision he comes up with a range of values.

      Despite 100 million CFAs and massive computer power, there is so much info that people just ignore most of it. Look at Enron. Look at the examples in Greenblatt’s book on spin-offs–You can be a Genius.

      If you know where to look for mispricings and you pick your spots, then you have a chance. But is it easy to beat the market by a wide mile? No.

      Do you think investors would have destroyed themselves in Internet stocks in 1999 – 2000 or housing stocks in 2004-06, if they understood Graham. Just the concept of reversion to the mean and normalizing earnings should keep you out of a lot of trouble.

  2. What’s the alternative? In my opinion that would be a trader.

    Market efficiency theory can’t/shouldn’t be applied when investing in stocks.

    Not all participants in the market are experts as in they are not well informed- due diligence, proper research and among other factors. Thus value investing tries to scrutinize the true value of the business, which is subjective and relies on qualitative as well as quantitative factors.

    As Keynes said ” I would rather be vaguely right than precisely wrong”

    Market efficiency theory tends to be, in this situation, more on the opposite side of the quote, to some degree.

    A trader on the other hand thrives on the daily volatility of the stock. That volatility is a consequence of myriad factors that are relevant and not relevant to the stock value.

  3. A couple of differences between Buffett and Graham on Dempster. In short

    1. Dempster was not a net net so Graham would not have had bought the stock. Buffett calculated the ‘liquidation sale’ value of the PP&E and included it in his intrinsic value.

    2. Buffett invested a substantial part of his portfolio in Dempster. Graham (if he had bought it) would have made it one of many stocks in a diversified portfolio to protect against losses.

    3. Graham would wait for the net net to turn around, either by changes in economic cycle, or new management or new company strategy. The net net giving a margin of safety whilst waiting. Buffett on the other hand bought enough Dempster stock to become CEO and catalysed the change himself. Although it seems he needed Harry Bottle to make the necessary changes for him.

    • ValueFactors,

      I’m not so sure about what you say in item 3 about Mr Graham.

      In fact, he sometimes did take on the role of an activist or took control of a company so as to liquidate it. If you take a look at his autobiography and some of the things that WJS wrote about him, you will find a few examples of what I mean (such as the famous Northern Pipeline case). Also, take a look at the Schroeder biography of WEB in which she describes how Mr Graham caused the Reading Corp to diversify and had his partner’s son appointed as an executive of that company (presumably, he had taken control by then).

      The problem is that, these days, Mr Graham is largely known for his so-called “net net” approach, as an academic and an author. However, people forget that, at the height of his career, Mr Graham was a leading player on Wall St, doing all sorts of things from convertibles arbitrages to special situations. As to the latter, take a look at one of the appendices to Security Analysis in which he summarises what opportunities can be found in that area – he practically pioneered this stuff, but he gets no credit for it.

      As you may have guessed by now, I’ve spent a ton of time reading in this area (since 1987 in fact)! These days, I try to spend more time doing, rather than just reading. So please forgive me if I don’t have the time to give you all the correct references/citations. Believe me, if you spend some time reading about Mr Graham, you will find it as rewarding as it is instructive.


  4. Another comment. It’s interesting (for me at least) how at the start, from ’62 to ’63 the book value per share of Dempster was decreased whilst the intrinsic value (liquidation of assets – liabilities) actually went up.
    This is counter intuitive for me and an important learning point!

    • There was a study – sorry, I don’t know the original source – that showed that companies that increased their book value for share rapidly actually did badly in the market-place. So, surprisingly, it all fits together.

  5. Thee seems to be many tie-here here between Buffett, Icahn, Deep Value, and Greenblatt restructurings.

    Here’s what I think are the key points about Dempster Mill:
    * it was generating low returns on capital
    * Take Current Assets (5491k), take off all liabilities (2318k), and divide by number of shares (60146) to arrive at a NCAV of $52.75. Buffett bought at $28.
    * liquidate underperforming assets

    Buffett basically got to the idea of Deep Value. Buffett had the advantage that he had a control situation, so he could force liquidation. This seemed to be a similar strategy to Icahn. Icahn sometimes held shares for a long time, and instead of obtraining control, he used other means to “out” the value.

    I’m going to make a general proposition: investing in assets that produce returns greater than the cost of capital adds value to the company, whilst investing in assets that produce returns less than the cost of capital destroys values.

    There is a corollary to this: if you dispose of assets that earn less than their cost of capital, then you adding value to the company.

    This, as I see it, is the essence of restructuring that Greenblatt is talking about.Greenblatt has this to say, on page 184 and 185: “There are basically two ways to take advantage of a corporate restructuring. On eway is to invest in a situation after a major restructuring has already been announced. … The other way to profit is from investing in a company that is ripe for restructuring”.

    There are probably two key issues here: look for new management or activists; look for “hatchet-men”, men who will cut out the dead wood so that the healthy branches may thrive, rather than those who will take a sows ear and try to make a silk purse out of it. You want men that know that when they are in a hole, it’s time to stop digging.

  6. Toby does not have good performance. Maybe his strategy doesn’t work, or he is busy pitching his book, but its worth explaining why that has been the case for your readers who are reading his book…

    • Mike: Can you point me/us to the performance numbers? Where are they available.

      That said, whether he is doing well or poorly, unless his record is ten years plus, performance can be random. Also, we don’t really care about his performance but the logic, quality and efficacy of the book’s principles. Do they make sense? Do they work? and Do they work for US/You?

  7. John, Toby is from Queensland and they all talk a bit funny up there. Not just a distinctive accent, but they use some interesting expressions too – as you have discovered. Don’t judge all Aussies by what you heard from Toby!

    mcturra2000, I think you’re absolutely right. I saw a quote once from CTM to the effect that all sorts of interesting possibilities can arise when you can find a company which is able to cut out loss-making business. I can’t find the quote just now, but I suspect CTM was probably talking about GEICO, which is a good example of the principle you referred to.

    Also it can work in reverse too. Sometimes opportunities arise when a conglomerate sells a good business. Let me give you an example: I’m currently looking at a situation in which a company has recently sold-off a thriving property services business for a good price. The company has used the net sale proceeds to pay down some debt and return capital to shareholders. The company continues to operate its remaining division, a long-established engineering business, which probably has mediocre growth prospects at present (and, indeed, there is some ‘bad news’ in the press relating to some of the projects in the company’s orders book). However, you would not believe the metrics of the company now – eg, EV/EBIT of approx 2.9x with a ROIC of approx 32%, based on LTM figures adjusted to exclude the sale of the property services business, capital return, etc. (I’m still checking out these numbers and trying to estimate what the normalised earnings of the remaining division may be, etc.)


  8. Disliked the fact that it didn’t get into more detail about his early investments. Nothing about Western Insurance. Nothing about how he bought Geico. Nothing about how he bought Genesse Valley, or Union Street Railway.

    Nothing about Marshall Wells, Grief Brothers Cooperage, Philadelphia Reading & Coal, Cleveland Worsted Mills, National American Fire Insurance, and Rockwood.

    All investments bought at insanely cheap prices (with the exception of Geico.) No mention of them. Really disappointed with chapter 3 of the DEEP VALUE book. You could gain more insight on early Buffett if these early investments were mentioned.

    • Dear Wapo:

      excellent points. Can you pull those other investment case studies. If not, I will try to dig them out. We should try to find out about those investments.

  9. mcturra2000: Very true. Buffett looks just like Icahn on this particular case. I can’t remember if this was the case where the whole city raised hell against him and he promissed himself we would not get involved in this situation any longer. Buffett is more of a PR guy while Icahn is a “go for the throat” kind of guy not caring much for anything but the results. I’m not judging though! : )

  10. Wouldn’t this kind of valuation require some kind of liabilities adjustment for firing employees like Klarman mentions in his book? Buffett just seems to simplify things by being conservative on the asset value and tackling the liabilities as is (full value).

  11. I think the key point on Dempster Mills,as was noted in an earlier comment, was Buffett’s preparedness to move from shareholder to activist. In so doing he as then able to chart a course for the business that may never have happened. The ability for the installed CEO to turn inventory into cash probably happened in the nick of time as obsolescence would have eventually kicked in. It is the beauty of the activist model… most of us have only two shots at a winning investment, when to purchase a security and when to sell it. The activist gets these two + a very important third shot, which is influence the operational/strategic direction of the company, and per Icahn possibly invite a 3rd party buyer at a favourable price.

  12. Let me just add something to the excellent comments made by others above.

    If you go through WEB’s partnership letters carefully, you will find a passage in which he refers to how he selected his “generals” investments (as he called them).

    Essentially, he was looking for what are now called “net nets” (like what Mr Graham did) but his approach was slightly different. That is, WEB tended to focus on situations in which there was “ferment” as he called it – something was going on in relation to the company which suggested that things would probably change.

    I suspect (but can’t prove) that he would often follow situations in which someone was trying to shake up the company, which according to the Schroeder book, WEB referred to as “coat-tail riding”.

    Also, I believe that WEB tended to be less diversified in his approach, as compared to what he learned at Graham-Newman. It might have been in the Lowenstein biography where it was said that WEB would prepare a short-list of say 15 possible candidates and then he would try to pick the best one from that list.

    There is, however, something that has always bothered me about WEB’s early approach. The deeply undervalued “net nets” are typically very small companies with little liquidity. In my experience with such companies on our local stock exchange, the prices tend to jump around quite a bit depending on happenstance – eg a new sell order at market can drive the price down very quickly, because of the large buy/sell spread or inadequate buyer support Against this background, I note that, in one of his letters, WEB mentioned that if a company remained cheap, he would continue buying until something happened. The troubling aspect with this is that WEB’s own purchases might have flattered the returns that he reported to his investors annually. I’m not suggesting that he was manipulating the market in any way. It’s just that, if WEB wasn’t one of the few who was buying the stock offered on the market, the share prices may have tended to oscillate more erratically and perhaps WEB’s performance in his early partnership years may not have been so consistent. Also, in a sense he was forced to continue buying because he had such success with his marketing that money was coming in all the time and, depended on market conditions, other opportunities sometimes disappeared.

    • I think the idea of riding coat-tails is what non-activist investors should aim for. Activism may be able to produce larger profits, but requires a greater concentration of capital. If an error of judgement is made, it could sink you. It seems that Icahn was “winging it” to a large extent in his early career, and he may have been wiped out if things had gone a slightly different way.

      The good news is that I think investors can do OK out of coat-tail investing.The place to start would be to look for companies that trade substantially below book, which is likely due to either a poor trading record or adverse sentiment in a sector. Net-nets are likely to be extraordinarily rare, and I think in the UK at least, the bulk of those will be Chinese companies and likely frauds.

      The things to look out for are large director purchases, which may indicate that we’re reaching the bottom. Also, a change in directors may be a positive sign, especially if they’re regarded as turnaround specialists. Another area to look at is where directors have a meaningful stake. They are likely to act in a way that protects their interest.

      Finally, Greenblatt’s chapter on restructurings is worth taking on board. I’m re-reading Greenblatt’s “Genius” book, and it probably warrants a re-read every year.

      Looking back on the Ackman/JCP episode, it perhaps shows a wrong strategy. It was hoped that by bringing in Ron Johnson, he could effectively make a silk purse out of a sow’s ear. Unfortunately, that didn’t happen. He would have been better off going through the books, and look to cull underperforming assets. It’s not fancy or classy, but it should work.

      Fate has a fickle hand, though. I find the ANF (Abercrombie & Fitch) story quite interesting. Founded in 1892. In the late 1980’s it became an ailing sports clothing retailer. In 1992, Michael Jeffries took over as president in 1992. He switched it to a teen apprarel merchandiser. At the time, I don’t think anyone believed it would work, and that ANF was doomed. Of course, we all now know what a huge success the strategy was

        • Interesting, John.I’m not sure how he’s coming out with EBITDA of $200m. JCP has operating losses of $772m over TTM, and depreciation/amortisation of $625m. Anyone agree/disagree with this?

          I see that he notes an equity offering last year ($786m). He is probably right in the sense that there’s no imminent danger of bankruptcy. Unfortunately, the company seems to be consuming cash at a worrying rate, so it still looks like it’s throwing good money after bad.

          I don’t think it’s an archytypal Carlisle “Deep Value” share, and it’s not the sort of company that an early Buffett would have poured his money in due to its negative NCAV.

          I would be interested in hearing other’s views.

  13. Pingback: Q&A: Case Study on Dempster Mill Manufacturing Company | Hurricane Capital

  14. Hi!

    Here comes my answers to the case study questions.

    Q: How did Buffett find this investment and what ways did he reach an intrinsic value?
    A: Buffett found Dempster since the “figures were extremely attractive.” In other words, a low price compared to book value.

    Q: How many margins of safety did he have?
    A: When Buffett first acquired stock in Dempster the most important margin of safety was most likely in the great discount between price and book value.

    Later on when Buffett realized that current management didn’t succeed he had Harry Bottle to take over as CEO. This provided sort of a second margin of safety, a great manager or management team is never a negative. And in Harry Bottle Buffett found himself a great CEO able to run the business in a way Buffett himself thought was most likely to create the most value. I put Harry as second, because I think that he was more important than any potential future improvement in earning power. The earning power was more likely to be an outcome of great operating management.

    Third, possible improvement in earning power.

    Q: What “type” of investment is this—is earning power below Asset Value?

    A: The investment in Dempster started out as a net asset value investment, this due to the great discount between price and book value. Buffett also wrote that “the figures were extremely attractive.” It wasn’t the qualitative aspects of Dempster that was the main reason why Buffett started acquiring stock, it was all based on the great discount to book value per share.

    When Buffett started purchasing Dempster stock the earning power value was a lot lower than the value of the assets, even compared to net current asset value and Buffett’s valuation applying different discounts to each balance sheet item.

    Buffett wrote that Dempster had “…earned good money in the past but was only breaking even currently.” Earning power value clearly had taken a hit, and was probably a big reason for the stock price trading at such a big discount to book value. As Graham & Dodd wrote in Security Analysis when discussing Westinghouse Electric and Manufacturing Company position; “…the stock sold for much less than the net current assets alone, presumably indicating widespread doubt as to its ability to earn any profit in the future.”

    Buffett may have had some expectations for the earning power to come back and help support a higher stock price, even if this was far from a sure thing. The margin of safety was in the low price compared to book value. If earning power would be restored, that would serve as a bonus I think.

    Q: Is this a franchise? Why or why not is this occurring?

    A: Dempster was not a franchise. Buffet wrote that “The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.” Not the characteristics to be expected from a franchise. Buffett also wrote that Dempster was in a “fairly tough industry,” and it also had “unimpressive management.”

    If earning power was to be restored it would probably, even in the best case, only support the net asset value, thus no excess returns and no earning power value greater than the asset value. This would indicate a business without any franchise value, i.e., no sustainable competitive advantage—or moat.

    Q: Was Buffett lucky in this investment? Why or why not?

    A: I think luck always plays some part. But Buffett started to purchase stock due to the margin of safety he deemed to be present. So even if Harry Bottle had not come along, Buffett might have been able to sell out without making a loss. When already invested and taking control he used his skill as a business owner in a pretty good way I think, mostly through Harry Bottle taking care of the daily operating activities.

    Q: How would Graham approach an investment like this?

    A: Not really sure about this one. Graham also invested in businesses situations that could be compared to Dempster. But even if Graham did so, maybe the most likely way he would look at Dempster would be purely quantitative. From what I can see, Dempster never was a pure net-net during the time Buffett was an owner. So maybe Graham would have stayed away from it.

    Q: What would have been the big difference between Graham and Buffett concerning Dempster Mills?

    A: That Graham never would have bought because the stock wasn’t cheap enough to provide a margin of safety to an estimated liquidation value (current asset minus total liabilities). But I’m not really sure about this one. Will be interesting to see the comments to this question.

    So, now I shall start reading the comments to see what all other participants have to say about these questions. Even though the case study was posted a few days ago I have not read any comments that’s been posted, since this would sort of “anchor” my own answers.

  15. I have not read the other partnership letters yet, but was the fair value method used by Warren B the same as he uses in others or even later? Seemed a mixture of book value and the net asset value.

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