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Notes – The Snowball, By Alice Schroeder: Part V, Chap. 43-52

The following are reading notes for The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder (buy on Amazon.com). This post covers Part V: The King of Wall Street, Chap. 43-52

[These notes were never published on time. They may be incomplete as posted now.]

The modern Buffett

In Part V of the Snowball, we see Buffett’s transformation from the early, cigar butt-picking, Grahamian value-minded Buffett, through the filter of his Fisherite partner, Charlie Munger, into the mega cap conglomerator and franchise-buyer Buffett who is popularly known to investors and the public the world round.

It is in this part that we also see Buffett make one of his biggest missteps, a stumble which almost turns into a fall and which either way appears to shock and humble the maturing Buffett. It is in this era of his investing life that we see Buffett make some of his biggest rationalizations, become entangled in numerous scandals he never would’ve tolerated in his past and dive ever deeper into the world of “elephant bumping” and gross philanthropy, partly under the tutelage of his new best friend and Microsoft-founder, Bill Gates.

The lesson

Buffett made a series of poor investments but ultimately survived them all because of MoS. There will be challenges, struggles, and stress. But after the storm, comes the calm.

The keys to the fortress

From the late seventies until the late nineties, despite numerous economic and financial cycles Buffett’s fortune grew relentlessly under a seemingly unstoppable torrent of new capital:

Much of the money used for Buffett’s late seventies spending spree came from a bonanza of float from insurance and trading stamps

This “float” (negative working capital which was paid to Buffett’s companies in advance of services rendered, which he was able to invest at a profit in the meantime) was market agnostic, meaning that its volume was not much affected by the financial market booming or crashing. For example, if you owe premiums on your homeowner’s insurance, you don’t get to suspend payment on your coverage just because the Dow Jones has sold off or the economy is officially in a recession.

The growth in Buffett’s fortune, the wilting of his family

Between 1978 and the end of 1983, the Buffetts’ net worth had increased by a stunning amount, from $89 million to $680 million

Meanwhile Buffett proves he’s ever the worthless parent:

he handed the kids their Berkshire stock without stressing how important it might be to them someday, explaining compounding, or mentioning that they could borrow against the stock without selling it

Buffett had once written to a friend when his children were toddlers that he wanted to see “what the tree has produced” before deciding what to do about giving them money

(he didn’t actively parent though)

Buffett’s private equity shop

Another tool in Buffett’s investment arsenal was to purchase small private companies with dominant franchises and little need for capital reinvestment whose excess earnings could be siphoned off and used to make other investments in the public financial markets.

Continuing on with his success in acquiring the See’s Candy company, Buffett’s next private equity-style buyout involved the Nebraska Furniture Mart, run by a devoted Russian immigrant named Rose Blumkin and her family. And, much like the department store chain he once bought for a song from an emotionally-motivated seller, Buffett beat out a German group offering Rose Blumkin over $90M for her company, instead settling with Buffett on $55M for 90% of the company, quite a discount for a “fair valuation” of practically an entire business in the private market, especially considering the competing bid.

An audit of the company after purchase showed that the store was worth $85M. According to Rose Blumkin, the store earned $15M a year, meaning Buffett got it for 4x earnings. But Rose had buyers remorse and she eventually opened up a competing shop across the street from the one she had sold, waging war on the NFM until Buffett offered to buy her out for $5M, including the use of her name and her lease.

One secret to Buffett’s success in the private equity field? Personality:

“She really liked and trusted me. She would make up her mind about people and that was that.”

Buffett’s special priveleges

On hiding Rose Blumkin’s financial privacy: Buffet had no worries about getting a waiver from the SEC

Buffett got special dispensation from the SEC to not disclose his trades until the end of the year “to avoid moving markets”

The gorilla escapes its cage

Another theme of Buffett’s investing in the late 1980s and 1990s was his continual role as a “gorilla” investor who could protect potential LBO-targets from hostile takeover bids. The first of these was his $517M investment for 15% of Tom Murphy-controlled Cap Cities/ABC, a media conglomerate. Buffett left the board of the Washington Post to join the board of his latest investment.

Another white knight scenario involved Buffett’s investment in Ohio conglomerate Scott Fetzer, which Berkshire purchased for $410M.

Then Buffett got into Salomon Brothers, a Wall Street arbitrage shop that was being hunted by private equity boss Ron Perelman. Buffett bought $700M of preferred stock w/ a 9% coupon that was convertible into common stock at $38/share, for a total return potential of about 15%. It even came with a put option to return it to Salomon and get his money back.

But Buffett had stepped outside of his circle of competence:

He seemed to understand little of the details of how the business was run, and adjusting to a business that wasn’t literally made of bricks-and-mortar or run like an assembly line was not easy for him… he had made the investment in Salomon purely because of Gutfreund

Buffett’s disgusting ignorance and hypocrisy


I would force you to give back a huge chunk to society, so that hospitals get built and kids get educated too

Buffett decides to sell the assets of Berkshire’s textile mills– on the books for $50M, he gets $163,122 at the auction. He refused to face his workers and then had the gall to say

“The market isn’t perfect. You can’t rely on the market to give every single person a decent living.”

Buffett on John Gutfreund:

an outstanding, honorable man of integrity

Assorted quotes

Peter Kiewit, a wealthy businessman from Omaha, on reputation:

A reputation is like fine china: expensive to acquire, and easily broken… If you’re not sure if something is right or wrong, consider whether you’d want it reported in the morning paper

Buffett on Wall St:

Wall Street is the only place people ride to in a Rolls-Royce to get advice from people who take the subway

Book Blog – The Great Deformation – Part I, The Blackberry Panic Of 2008

Book Blogs are notes about books I’m reading, as I read them. They may or may not be followed up by wholesale reviews in traditional format.

The Great Deformation, by David A. Stockman published 2013 (buy on Amazon.com)

I received a copy of David Stockman’s 2013 analysis of the mechanics of the 2008 financial crisis and its aftermath as a gift from a friend and sat down to read the first 50 pages, Part I.

I think Stockman attempts to make several key points as a set up to the remainder of this lengthy tome:
-the mainstream/regime narrative of an incipient economic crisis catalyzed by a financial collapse originating in Wall Street credit markets controlled by major Wall Street institutions (such as Morgan Stanley and Goldman Sachs) is one part baseless lie and one part clueless ignorance of facts on the ground at the time
-there was a crisis, for these particular institutions, which was a result of years of non-value adding financial and accounting chicanery enabled by Fed Chairman Greenspan’s infamous “put” and the crisis would’ve resulted in the liquidation of these firms assets (and the termination of their managers) into abler hands which would’ve been a good thing for competitive financial markets and the capitalist economy as a whole
-this crisis was not only averted by the frantic lobbying of connected officials in Congress, the Treasury and other regulatory agencies by crony executives in the affected firms, but these same executives and officials worked in concert to turn the bailout moment into a massive payday/profit opportunity; most of the people making decisions about this in the government, particularly in the Treasury and the Fed, were inexperienced, miseducated or otherwise rankish amateurs with little understanding of the context of their decisions or their consequences beyond the immediate moment
-the scale of the bailouts in terms of pure dollars was completely without precedent or connection to actual costs and risks present in the system at the time
-memoirs of officials and executives involves in the bailout discussions published extemporaneously do not make a substantial case for their decisions based off of data available about the period years later
-much of the decision-making at the time, by concerned executives as well as captured officials, seems to be dominated by the twin desire to avoid taking responsibility for mistakes made in the past (thereby looking foolish) and to continue the illusion of the viability of the system based on these mistakes going forward

“All the rest,” as it has been said, “is illustration.”

There were parts of the narrative I found confusing to follow at times. Its possible I didn’t read clearly, but in several instances it seemed like on one page or at the beginning of a chapter Stockman would be arguing that the potential capital losses of a particular company were small enough relative to their total balance sheet that they could easily sweat the loss from a survival standpoint and then on the next page or at the end of the chapter, he seemed to suggest the same loss was so sizeable that it would threaten the viability of the enterprise itself.

I think there was a lot of question-begging in the narrative as well. Stockman builds a decent logical case for why there was no “contagion” that could spread from Wall Street (the financial markets) to Main Street (the rest of the economy) that would result in a general economic depression. But his argument always rests on the costs being shifted to various government backstop agencies and funding sources which could make things like commercial lending and payroll finance markets “money good”. It isn’t explained where these institutions would come by the required funds necessary to remain in operation without a bout of money printing (bailouts) and how this is different than the bailouts Wall Street received.

That leads to another concern I have with the overall thesis, which is that somehow, what happens on Wall Street is arbitrary and doesn’t affect greater economic outcomes. While I agree with the notion that purging the financial system of bad debts and bad business models during periods of crisis is a process of economic health rather than economic illness, I so far fail to see how the repricing and reorganization of economic capital taking place in these markets would not result in similar repricings and reorganizations of capital investment throughout the economy as a whole. Stockman details several multi billion dollar examples of ” predatory financial practices” in which members of Main Street America were able to finance lifestyles they couldn’t prudently afford the costs of and it seems like these are prime (or subprime, as it were) examples of assets that would need to be repriced and reorganized into abler hands. The gutters of both Streets would be filled with the purged excess, and it would eventually drain.

Annoyingly, Stockman repeatedly exalts “our political democracy” and even conflates its goodness and functioning with free market capitalism. For me, this is a fundamental flaw in reasoning and defining terms that throws his entire analysis into suspicion, at least from the standpoint of his analytical framework operant and his own agenda in terms of desired social outcomes. I don’t think Stockman and I are on the same page, in other words.

So far, Stockman’s book expects a lot of prior knowledge on behalf of the reader. He doesn’t begin the book outlining his economic or financial theories, nor his concept of the purpose of government. We intuit bits and pieces of it as he proclaims this bad, that person good, this event horrid, etc. But he never really says “I’m from the School of X” or gives a summary of the key principles necessary to follow his analysis. Therefore, it comes off as strenuously assertive rather than rigorously logical. And I think part of Stockman’s goal is to spread blame in a bipartisan fashion, while building bridges and giving accolades in an “independent” manner. So far, though, it seems arbitrary due to this lack of explanation about his framework.

Notes – Reading Popper: “The Open Society And Its Enemies”, Introduction (#philosophy, #criticism)

Notes from a shared reading of Karl Popper’s “The Open Society and Its Enemies” (available at Amazon.com), to be updated as read and discussed. An introduction to Popper, his life and his ideas can be found at the Stanford Encyclopedia of Philosophy

Popper sets up a dichotomy– the Closed Society of tribal authoritarianism, and the Open Society of individual reason and critical rationalism. He claims that there are potent intellectual forces trying to always return civilization to the Closed Society and that the Open Society is relatively new as a cultural phenomenon and still in its infancy (implying it requires special protection and pleading).

He advocates “piecemeal social reform” through a democractic social structure as opposed to “Utopian social engineering” which is an ancient, totalitarian project most recently (as of his writing) guided by historicist philosophy. It’s interesting he felt the need to attack historicism as you would think the end of the two world wars effectively destroyed the power structure of the Prussian monarchy built upon that intellectual foundation.

Popper says he will concern himself with the method of science. Specifically he says that in the social realm the methodology of predicting and knowing the future is flawed and impossible and implies a determinist metaphysics he can’t abide by. He stands against predictivism and it seems he is also going to make an argument that the predictive methodology of physics and other natural sciences has been transferred, uncritically, to the social realm where it does not apply due to human will. However, curiously he does not say he is offering a scientific refutation but only a personal one intent on showing the “harm” of historicist thinking. What an odd position for a scientific philosopher to take!

Popper wants to show the barrenness of following Great Men unquestioningly. He wants to turn people away from philosophies built on the disappointment with reality not reflecting their wishes. Ultimately, it is about personal responsibility and many of these popular philosophies wish to deny it to everyone but the Great Men.

I may be putting the cart before the horse here but I think it’s interesting that Popper offers democracy as a salve for totalitarianism because it offers a “peaceful way to share power”. But democracy isn’t peaceful. It’s built on the gun. Popper only knew a little about economics in his own time, despite being so physically and intellectually close to many great economists (such as Mises!) I think that replacing democracy with the market would greatly improve his thesis in terms of both consistency and explanatory power.

Notes – Original Issue Discount (OID) Tax Implications, Lessons Learned (#taxes, #investing)

In the process of carrying out the KV Pharmaceuticals capital structure arbitrage trade of 2012, I got caught with my pants down a bit as I didn’t think to sell the convertible notes before they stopped trading. As a result, I missed an opportunity to lock in a capital loss for tax purposes at the time, which would’ve helped shield some of the income I made on the puts and thus made the trade as a whole more tax efficient.

Instead, I got a double-whammy of tax inefficiency for my ignorance, a chicken that finally came home to roost in tax FY2013 as the CPA assisting me with my tax preparation informed me that I ended up owing an additional sum beyond amounts withheld in prior periods due to Original Issue Discount (OID) interest income related to my defunct KV Pharmaceuticals play!

At first I was shocked and dismayed– the company went into bankruptcy and the securities were eventually removed from my account entirely earlier this year. How could I owe taxes when I never earned any cash interest and will never get back even a penny from the securities I stupidly held onto?

I talked about it with my CPA (who double-checked with his partner) and then spoke to a rep at TD Ameritrade and the matter is decisively not going to turn out in my favor. I learned that when a bond goes into default it often switches from cash interest basis to accrual interest basis in the eyes of the IRS, and like any good group of thugs they want their blood now, not later. In other words, I owe federal income tax on “accrued interest” I not only never received but never will receive. Because the securities were removed from my account in 2014 and not 2013, it looks like I accrued interest income due to me even though we clearly know right now that I’ll never get it.

Instead, I get a stepped up cost basis on the securities (in the amount equal to the accrued interest not received) so when I finally report the loss for FY2014 taxes, it’ll be a total loss of X + Y instead of just X. I get to shield additional future income with the X + Y amount but I paid real cash up front for the privilege.

If I had known better, I would’ve executed this trade such that the gains and losses all occurred in the same period in 2012. I also probably wouldn’t have gotten into a trade in the first place whose money-making mechanics I generally understood but about whose technical execution and tax implications I was grossly ignorant.

Another expensive lesson learned!

Notes – Stanford Graduate School of Business Search Fund Primer (#searchfund, #business, #investing)

Notes on “A Primer On Search Funds” produced by the Stanford Graduate School of Business

“The Search Fund”

  • Greater than 20% of search funds have not acquired a company
  • Stages of the Search Fund model:
  • Raise initial capital (2-6mos)
  • Search for acquisition (1-30mos)
  • Raise acquisition capital and close transaction (6mos)
  • Operation and value creation (4-7+ years)
  • Exit (6mos)
  • SFs target industries not subject to rapid tech change, easy to understand, fragmented geographic or product markets, growing
  • Highest quality deals are found outside broker network/open market due to lack of auction dynamics
  • Research shows that partnerships are more likely to complete an acquisition and have a successful outcome than solo searchers (71% yielded positive return, 15 of top 20 performing funds were partnerships)
  • Principals budget a salary of $80,000-120,000 per year w/ median amount raised per principal $300,000~
  • Majority of the economic benefit of SF comes through principal’s earned equity; entrepreneur/partners receive 15-30% equity stake in acquired company in three tranches
  • Investors typically receive preference over the SFer, ensuring investment is repaid, with return attached, before SFer receives equity value
  • Individual IRR from 2003-2011 median was not meaningful, heavily skewed toward 75th percentile where median was 26% in 2011; 57% of individual IRRs were not meaningful in 2011; the median fund destroyed capital in 2009 (0.5x) and 2011 (0.8x); 58% in 2011 broke even or lost money
  • Half of the funds that represent a total or partial loss were funds that did not acquire a company; biggest risk is in not acquiring a company at all
  • Median acquisition multiples: 1.1x revenues; 5.1x EBITDA
  • Median deal size, $8.5M

“Raising a Fund”

  • Search fund capital should come from investors with the ability and willingness to participate in the acquisition round of capital raising

“Search Fund Economics”

  • Search fund investors often participate at a stepped up rate of 150% of original investment in acquired company securities

“Setting Criteria and Evaluating Industries”

  • Desirable characteristics for a target industry: fragmented, growing, sizable in terms of revenues and number of companies, straightforward operations, early in industry lifecycle, high number of companies in target size range
  • Desirable characteristics for a target company: healthy and sustainable profit margins (>15% EBIT), competitive advantage, recurring revenue model, history of cash flow generation, motivated seller for non-business reasons, fits financial criteria ($10-30M in revs, >$1.5M EBITDA), multiple avenues for growth, solid middle management, available financing, reasonable valuation, realistic liquidity options in 3-6 years
  • Key challenge is “know when to take the train” lest a SF never leaves the station waiting for the perfect opportunity
  • Ideally, seller is ready to transition out of the business for retirement or personal circumstances or has something else they’d like to do professionally
  • Experience shows it is better to pay full price for a good company than a “bargain” for a bad one
  • Idea generation: SIC and NAICS codes, Yahoo! Finance, Thomson Financial industry listings, Inc. 5000 companies, public stock OTC and NASDAQ lists and even the Yellow Pages; generate a list of 75 potential industries to start
  • Target industries buoyed by a mega-trend
  • Can also target an industry in which the SFer has worked and possesses an established knowledge base and network
  • Some focus on 2-3 “super priority” industry criteria (eg, recurring revenues, ability to scale, min # of potential targets, etc.)
  • Objective is to pare down the industry target list to 5-10 most promising
  • Basic industry analysis (Porter’s five forces, etc.) is then used to narrow from 10 to 3; SFers use public equity research and annual reports for market size, growth, margin benchmarks; also Capital IQ, Hoover’s, Dun & Bradstreet and One Source
  • Industry insiders (business owners, trade association members, sales or business development professionals) and industry trade associations or affiliated ibanks and advisory firms are primary methods of research and often have general industry research or white papers available
  • Next step is to create a thesis to codify accumulated knowledge and compare opportunities across common metric set in order to make go/no-go decision
  • In order to become an industry insider, SFers typically attend tradeshows, meet with business owners, interview customers and suppliers and develop “River Guides”

“The Search”

  • Median # of months spent searching, 19
  • 54% spend less than 20 months searching, 25% spend 21-30 months, 21% spend 30+ months
  • Track acquisition targets with CRM software such as Salesforce, Zoho, Sugar CRM
  • Bring up financial criteria and valuation ranges as early as possible when speaking to potential acquisition targets to save everyone time
  • A company that is too large or too small as an acquisition target may still be worth talking to for information
  • You must immediately sound useful, credible or relevant to the owner; deep industry analysis should already have been performed at this stage
  • Tradeshows can be a critical source of dealflow
  • If a particular owner is not willing to sell, ask if he knows others who are
  • “River Guides” are typically compensated with a deal success fee, usually .5-1% of total deal size
  • Boutique investment banks, accounting firms and legal practices specializing in the industry in question are also a good source of deals
  • The business broker community itself is extremely large and fragmented; could be a good rollup target?
  • Often, brokered deals are only shown if a private equity investor with committed capital has already passed on the deal, presenting an adverse selection problem
  • Involve your financing sources (such as lenders and investors) early in the deal process to ensure their commitment and familiarity

“Evaluating Target Businesses”

  • Principles of time management: clarify goals of each stage of evaluation and structure work to meet those goals; recognize that perfect information is an unrealistic goal; keep a list of prioritized items impacting the go/no-go decision
  • Stages: first pass, valuation/LOI, comprehensive due diligence
  • It is in the best interest of the SFer to tackle core business issues personally during due diligence as it is the best way to learn the details of the business being taken over
  • Adding back the expenses of a failed product launch rewards the seller for a bad business decision; adding back growth expenses gives the seller the double benefit of capturing the growth without reflecting its true cost
  • Due diligence may also uncover deductions to EBITDA or unrealized expenses that reduce the “normalized” level of earnings (undermarket rents, inadequate insurance coverage, costs to upgrade existing systems, etc.)

“Transitioning Ownership and Management”

  • Create a detailed “Transition Services Agreement” with the seller, a legal contract where specific roles, responsibilities, defined time commitments and compensation are agreed prior to the transaction close
  • The first 100 days should be dedicated to learning the business
  • Businesses consist of people, and people need communication; great leaders are always great communicators
  • “Don’t listen to complaints about your predecessor, this can lead to a swamp and you don’t want to be mired there.”
  • The goal is to learn, not to make immediate changes
  • Outwork everyone; be the first person in and the last to leave
  • Many SFers insert themselves into the cash management process during the transition period by reviewing daily sales, invoices and receipts and signing every check/payment made by the company
  • The company’s board should be a mix of deep operational experience, specific industry or business model experience and financial expertise
  • The seeds of destruction for new senior leaders are often sown in the first 100 days