Berkshire Hathaway’s Great Transformation

“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 per share after recognizing that the stock was trading not only below book value but below net current asset value.1 Earlier that spring, Buffett had 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.3
  • Early 1966: BPL owned 552,528 shares, or 54.3 percent of the company.4

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.3 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.


Purchase Capital Allocation: The Financials of a New England Textile Mill on Amazon.com


  1. 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 on this website in 2009. []
  2. The Buffett Partnership owned ~7% of the 1,583,680 shares of Berkshire outstanding in May 1964, or ~110,858 shares. The eighth of a point difference amounts to 110,858 x 0.125 = $13,857 []
  3. Warren Buffett’s 2014 letter to shareholders [] [] []
  4. Capital Allocation, p. 26 []

Lighthouse: Women Leading the Way in Finance

“It’s one of the things that makes me optimistic about America because when I look at what we have accomplished using half our talent for a couple of centuries, and now I think of doubling the talent that is effectively employed — or at least has the chance to be — it makes me very optimistic about this country.”

Warren Buffett

Navigating through life can be a dangerous and intimidating journey without the guidance of those who have already traveled on the same path. The world is a complex place and trying to learn everything through direct experience is simply not possible. Much can be learned vicariously through a study of the lives of those who have succeeded in the areas we are interested in pursuing. Very few successful people have enjoyed lives free of adversity and trouble. It would be crazy to not leverage the lessons they have learned.

The finance industry has traditionally been dominated by men for a variety of reasons and women have often found it difficult to break into the field. Lighthouse: Women Leading the Way in Finance is an engaging compilation of the life stories of nineteen women who have found their path and are determined to help others follow in their footsteps. Maya Peterson wrote the book to inspire and empower women to study “female lighthouses in the world of finance.” While these women have navigated different paths, what they have in common is the shared experience of being women in a male-dominated field and how they found ways to overcome challenges. Although young women embarking on their careers will find the stories highly relevant, all readers should be able to draw lessons from the book. Those who are established in their careers might be inspired to give a helping hand to younger colleagues who could benefit from some guidance.

Writing this book review from the perspective of a man, it is obviously not possible to directly relate to several examples of obstacles that the women describe. However, the challenges of balancing a career in finance with having a family is one that has been highlighted over many years as being particularly problematic. The traditional career trajectory in finance involves taking an entry level job after college graduation to gain experience and to return to school to pursue an MBA, usually in your mid to late 20s. This is followed by an intense period of work into your early 30s, necessitated by a need to pay off heavy student loan debt and to prove worthy of greater responsibilities.

Of course, these career demands coincide with the age when most people want to get married and start having children. A failure to account for these challenges creates an environment in which a company can lose promising female talent to competitors. Being cognizant of these family challenges is not only a matter of ethics but also can be a competitive advantage if talented female employees can be retained.

Although navigating family challenges is a common thread in many of the profiles presented in the book, there are also other examples of obstacles that I have seen in office environments. In particular, as Lauren Templeton describes, many women are not assertive enough in business environments:

“I think women are bad at raising money because few of us have the confidence to go ask for it. I am not good at raising capital. Do you know why? Because I have never asked for any of it. I don’t ever ask. Our business has grown organically. That is a wonderful way to grow a business — by referral — but the business could be a lot better if I did what men do. Men slide a presentation across the table and say, ‘I want you to invest with me.’ Women are more like, ‘How can I help you?'”

Lighthouse, p. 21

Lauren Templeton is an accomplished investor who was mentored by her uncle, the famous Sir John Templeton, but still has trouble asking for business. Part of this has to do with cultural expectations with men who aggressively seek business being viewed as “go getters” while women might be perceived as “difficult.” Templeton recounts a situation in which she had to call out her prime broker for overcharging her and their tone was immediately aggressive. She believes that labels are often thrown at assertive women such as “Gosh, she’s a bitch to work with”, whereas men who assert themselves would be held in greater respect.

Many of the women who are profiled did not set out to build a career in finance. For example, Lisa Shalett was inspired to learn Japanese and major in East Asian studies after visiting Japan during high school. However, when she eventually developed an interest in business and earned a Harvard MBA, her background in Japanese and her years of working in Japan proved to be a differentiating factor that qualified her for a Wall Street position focusing on Japanese equities. An understanding of Japanese culture, language, and business practices was more important than an understanding of markets, which she was able to learn on the job. Eventually, Shalett became a partner at Goldman Sachs and, at one point, she was the only woman partner in the equities division.

Shalett’s insight regarding leveraging all of her skills in different contexts is particularly valuable:

“I suddenly got this insight that people tend to define themselves and their skills by the context in which they have used them to date. They don’t stop and think. The skills that have made me successful in the current [role] could also be useful in this new, totally different role. I had to learn to separate the skills I had from the way I had used them to that point … ”

Lighthouse, p. 72

Some of the profiles involve women who were clearly interested in finance from an early age. Erin Lash bought her first shares of stock at the age of ten and learned a valuable lesson when her pick, Blockbuster Video, fell victim to the rise of Netflix. Her first-hand experience with industry disruption led her to value sustainable competitive advantages, otherwise known as “moats”, which served her well when she joined Morningstar as an equity analyst focusing on consumer staples. Morningstar is well known for their focus on deep research to assess the quality of a company’s moat. Lash eventually moved into a director role and was the only female director in the company’s North American sector.

I have purposely not mentioned the fact that Maya Peterson is only seventeen years old until now because the quality of her work far surpasses what one would expect from a teenager and should be viewed on its merits. Peterson previously published Early Bird: The Power of Investing Young, which I reviewed a couple of years ago, and has inspired many young people to start investing.

In January 2019, Peterson gave a talk at Markel Corporation and a transcript is provided at the end of Lighthouse. There’s a great deal of wisdom in the transcript, but what stands out to me is her understanding of humility, making mistakes, and learning vicariously from the errors of others:

“Investing has also taught me to work hard on analysis. I like to call it nerdiness. Making mistakes is part of the process, it happens to everyone. But not everyone learns from their mistakes. Wouldn’t you rather learn how I lost money on Mattel and know not to make that same mistake yourself? Nerdiness allows you to keep your mind open to new information and have an ongoing desire to learn from others.

lighthouse, p. 142

Peterson has made important contributions to the cause of financial literacy and helping women achieve their professional goals in the field of finance. Both of her books deserve to be widely read by young people interested in finance and investing. Lighthouse also deserves to be read by older professionals, both men and women, who want to better understand the challenges facing young women as they navigate the industry. As Warren Buffett has said, women are key to America’s prosperity so we all have a stake in the outcome.

Disclosure: The Rational Walk LLC received a review copy of the book.

Buffett’s SEC Filing Implies Repurchases

Warren Buffett has often applauded share repurchase programs instituted by companies in which Berkshire holds significant equity positions, but his attitude toward Berkshire Hathaway repurchasing its own shares has always been more complicated. In early 2000, at a time when Berkshire shares were severely depressed, Buffett expressed an interest in repurchases below $45,000 per Class A share but noted that he was not doing so merely in order to “support” the stock. At the time, he admitted that he had made errors prior to that point by not repurchasing shares.

Over a decade later, Buffett expressed mixed emotions regarding the repurchase program announced in September 2011 noting that he doesn’t enjoy cashing out selling partners at a discount even though doing so somewhat enriches continuing shareholders. A watershed change in Berkshire’s repurchase policy took place in 2018 when an explicit price-to-book limit was removed in favor of allowing discretionary repurchases whenever management considered shares to be undervalued. Readers who are interested in a comprehensive review of Berkshire’s repurchase activity since 2011 can refer to Buffett Loosens the Purse Strings for Repurchases, an article posted on this site in February 2020.

During the Berkshire Hathaway annual meeting held on May 2, 2020, which was covered in the Rational Reflections newsletter, Warren Buffett seemed very worried about the COVID-19 pandemic and general economic conditions. During the meeting, he disclosed that Berkshire halted all repurchase activity after March 10 despite the stock price plunging well below the level of Berkshire’s recent repurchase activity. The transcript of the meeting is worth reviewing in order to understand the level of Buffett’s caution in early May. He clearly stated that the range of possible economic outcomes resulting from shutting down large segments of the economy remained “extraordinarily wide”. The fact that Buffett was repurchasing shares as late as March 10 before halting activity reveals that a change in his thinking might have taken place at that point. Perhaps it was related to his discussions with Bill Gates and Dr. Anthony Fauci around that time.

In light of Buffett’s comments only ten weeks ago, it was surprising to learn that Berkshire Hathaway almost certainly repurchased a significant amount of stock at some point between the annual meeting and July 8 when Buffett submitted a regulatory filing to the Securities and Exchange Commission documenting his annual charitable donations of Berkshire Hathaway stock. Sharp-eyed investors and journalists picked up on the implications of the filing which disclosed Buffett’s holdings as a percentage of shares outstanding. Here are the facts that were included in the filing:

  • Buffett owned 248,734 Class A shares and 10,188 Class B shares as of July 8.
  • Each Class B share has 1/1500 of the economic rights of a Class A share.
  • We can calculate that Buffett owned 248,740.8 Class A equivalents as of July 8.
  • Buffett’s ownership of Berkshire was 15.54% of the economic interest of the company.
  • Dividing 248,740.8 by 0.1554, we calculate that there were 1,600,649 Class A equivalents as of July 8.
  • The 10-Q report reveals that there were 1,620,023 Class A equivalents outstanding as of March 31.
  • This shows that 19,374 fewer Class A equivalents were outstanding on July 8 than on March 31.

The average closing price of the more liquid Class B shares between May 4 and July 7 was approximately $180, which is equivalent to $270,000 per Class A share. If we assume that repurchases were made at around that average price of $270,000, this would imply that Berkshire allocated approximately $5.2 billion to repurchases over that two month span. It is very doubtful that these repurchases started immediately after the annual meeting given Buffett’s clear indication that he was very concerned at that time and not eager to allocate capital. Given Buffett’s reputation for integrity, it’s inconceivable that he “talked down” the stock on Saturday, May 2 only to repurchase shares on Monday, May 4. But he might have changed his mind a couple of weeks later. We will not know the exact amount allocated to repurchases until Berkshire’s second quarter 10-Q report is filed in early August, but the repurchase amount is likely to be in the $5 – $5.5 billion ballpark.

Reading the tea leaves regarding repurchase activity at Berkshire is hazardous business. In Berkshire Hathaway and the Coronavirus Crash, published on March 22, I noted that Berkshire was trading at a price-to-book level significantly below the old 1.2x limit and that it was possible that Buffett could find shares attractive. The key question of how much of Berkshire’s large cash balance was truly deployable was the subject of another article, Thoughts on Berkshire’s Deployable Cash, published on April 21. Along with many Berkshire shareholders, I was surprised by Buffett’s cautious tone at the annual meeting and by the lack of repurchase activity even as shares fell far below valuation levels that had previously prompted repurchase activity. However, as Buffett said, his view of the range of possible outcomes of the COVID pandemic were very wide and clearly he wanted to reduce risk to the business by maintaining significant cash.

Based on commentary in the financial media and on Twitter, it seems like many Berkshire shareholders were disappointed with the lack of repurchase activity and the stock declined immediately after the annual meeting. Although the stock price has recovered since then, Berkshire has badly lagged the S&P 500 this year and remains far below its record high level of $344,970 reached on January 17, 2020. Although the explicit price-to-book limit of 1.2x was eliminated in mid-2018, many shareholders still erroneously viewed that level as a “floor”, a mentality that I criticized in 2016 in Berkshire’s Repurchase Level is not a “Floor”. Buffett has made it abundantly clear that he will never “support” the stock and initiate repurchases merely because it is falling and he wishes to stop a further decline.

So what can we infer based on the apparent ~$5 billion of repurchases that likely took place over the past two months?

It seems likely that Buffett’s views of the range of possible economic outcomes related to COVID have narrowed somewhat, and that he might view the very worst outcomes as less likely than he did when he spoke at the annual meeting on May 2. To be more precise, his views were likely more positive at the time the repurchases were made, and we do not know the exact timing. At the time of this article, published on July 13, the level of COVID infections, the rate of tests turning up positive, and other metrics have again taken a turn for the worse and several states have implemented new social restrictions and business closures.

Many commentators have noted that Berkshire’s equity portfolio, as reported on Form 13-F, appreciated strongly during the second quarter and into the first half of July. This appreciation has been driven by the extraordinary move in Apple shares which are close to breaching the $400 level. Berkshire owned 245,155,566 shares of Apple as of March 31, a position that is now valued at nearly $97 billion, up from $62.3 billion on March 31. Due to recent changes in accounting rules, the tens of billions of dollars of market appreciation in Berkshire’s equity portfolio will show up as tens of billions of dollars of “net income” when second quarter earnings are released.

It is not likely that the appreciation of Berkshire’s equity portfolio alone prompted Buffett to repurchase Berkshire stock. Although it is true that Berkshire’s book value is now far greater than the $229,358 per A share reported as of March 31, Buffett almost certainly has his own assessment of the intrinsic value of Berkshire’s equity portfolio. His own assessment of the intrinsic value of the portfolio, as well as the intrinsic value of Berkshire’s operating companies, is what will inform his thinking when it comes to calculating Berkshire’s intrinsic value. If shares can be purchased at a sufficient discount to that value, and if he views the range of overall economic outcomes as being acceptable from a risk standpoint, it is likely that he will repurchase shares. If the discount is not wide enough, or if he views the range of outcomes as too wide or skewed to the negative side, he will hoard cash.

Although Buffett does give periodic interviews, he has been notably quiet over the past ten weeks since the annual meeting. Few businessmen in America have a collection of companies in as many diverse sectors of the economy and Buffett is well positioned to personally observe the impact of COVID. He also has direct access to Bill Gates, Anthony Fauci, and other expects regarding pandemics. The repurchase activity implied by the recent SEC filing is good news in the sense that Buffett must have been more optimistic when he initiated those repurchases than he was on May 2. However, shareholders should not make too many assumptions beyond that until the second quarter report is released in early August. The COVID pandemic is by no means over and Buffett has demonstrated that he will change his mind as the facts change.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

The Irrational Tax Trap

“Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”

— Benjamin Franklin

Oliver Wendall Holmes famously said that “taxes are what we pay for a civilized society.” As a widely admired Supreme Court Justice, such words carried a great deal of weight for many citizens and his statement is frequently quoted to this day. Holmes was not a mere virtue signaler when it came to the necessity of funding the government. He voluntarily paid a very high “tax rate” when he left his estate to the United States upon his death in 1935. There is no doubt that Holmes was correct regarding the fact that some level of taxation is required for government to function and that some level of government is required for any large and complex civilization to flourish.

But the devil is in the details.

It might be possible to get over ninety percent of the people to agree that some level of taxation is necessary. But it is difficult to get even a bare majority to agree on the overall level of taxation that is appropriate to say nothing of which level of government — federal, state, or local — should be levying the tax. Even if you can achieve a consensus regarding the overall level of taxation and at what level to levy the tax, the question of who should pay the bulk of the taxes will be controversial.

Taxes are inherently emotional for many people and it is very easy to make serious errors in a state of mind that is not grounded in facts and reason. Those who generally disapprove of the size and scope of government are more likely to view taxes negatively and to seek ways to minimize their personal tax burden. However, even people who approve of a strong and forceful government rarely enjoy paying taxes themselves and will usually not pass up opportunities to reduce their payments. It is important to note that I am referring to legal methods of tax planning here rather than tax evasion.

Regardless of your views regarding the role of government, the level of taxation, or who should bear the brunt of the tax burden, it seems clear that viewing the subject of taxation in a rational manner is desirable. When it comes to making investment decisions, it is critical to keep the issue of taxes in mind but to not allow taxes to be the primary driver of decisions. The old Wall Street quip that one should not let the “tax tail wag the investment dog” is worth keeping in mind because it is all too common for tax driven decision making to lead to serious errors in the long run. Taxes should be viewed as just one of many factors feeding into a coherent decision making process.

The Proof is in the Pudding

As an investor, are you making rational decisions when it comes to taxes?

Everyone obviously likes to think that they are rational, but it is quite likely that tax considerations have hurt your results over time. However, hindsight bias and a human tendency to remember triumphs while relegating errors to the deep recesses of memory makes it likely that we have forgotten cases where tax considerations hurt us.

So, forget about theory and take a look at your results.

If you are like many investors based in the United States, you probably have accounts that enjoy tax free or tax deferred status along with accounts that are fully subject to current income taxes. In my case, I have both traditional and Roth IRA accounts as well as my taxable investment account. Both the traditional and Roth IRA do not incur any current-year tax based on decisions to buy or sell securities, or decisions to invest in securities that pay dividends. The Roth IRA has the additional benefit of offering tax free distributions for people over the age of 59 1/2. My regular investment account has no such tax benefit. Dividends, interest, and capital gains taxes are due on an annual basis.

If my decision making is rational with respect to taxes, then it would follow that the pre-tax results of my IRA accounts and my regular taxable account should not be very different. However, to my surprise, a few years ago when I examined my returns based on the tax status of the account, I found that my IRA accounts had significantly outperformed my taxable account on a pre-tax basis! The difference was not insignificant and because my taxable account is significantly larger than my IRAs, the aggregate lag in dollar terms was very large.

A thorough examination of my transaction activity revealed that I was more likely to sell securities in my IRA accounts than in my taxable account. Although turnover in the IRA accounts was not particularly high, it was materially higher than in my taxable account. I was far more willing to take capital gains in my IRA accounts knowing that I could reinvest the full proceeds of the sale in a new investment without facing the prospect of paying the capital gains tax. As a result, when securities held within my IRA accounts approached my assessment of intrinsic value, I was more likely to at least trim back on the position or sell it entirely when more attractive opportunities existed for reinvestment.

In contrast, a review of my taxable account revealed that I would tend to hold securities in that account even as they approached or exceeded my assessment of intrinsic value. Make no mistake about it, a buy-and-hold approach is usually a good one provided that the companies in a portfolio are steadily growing intrinsic value over time. Owning a security that trades at intrinsic value, or even slightly above it, can be perfectly fine if the intrinsic value of the security is also growing at a nice clip. But the fact is that not all companies fall into this category and usually there are opportunities to reinvest capital in undervalued opportunities. The requirement to take advantage of such opportunities, when fully invested, is to sell a security that is trading at or above intrinsic value. But you have to be willing to do it even if it involves paying taxes.

The Lure of Tax Deferred Compounding

Let us step back for a minute to consider the power of tax deferred compounding and why the prospect of it lures so many investors into making poor decisions.

In a taxable account, a legitimate goal should be to hold securities that will successfully compound intrinsic value over long periods of time, preferably without paying out much in the way of taxable dividends. If you can find a company that can compound capital internally at an attractive rate, your results will be superior to what you would get if you had to identify a different company offering the same rate of return every year. In addition to not having to pay capital gains taxes until you eventually sell, holding a stock for a long period of time relieves the investor of making multiple decisions and the work required to do so successfully.

A simple example should illustrate this point. Investing in a company that can compound intrinsic value at 8 percent per year for twenty years will result in turning a $100,000 investment into over $466,000 prior to paying taxes. If the capital gains tax is 20 percent at the end of this period, the investor will be left with nearly $373,000 after paying the tax.

In contrast, if an investor must change companies every year to earn a 8 percent return, paying a 20 percent capital gains tax along the way, the effective rate of compounding is reduced from 8 percent to 6.4 percent. This investor’s initial $100,000 investment will turn into just under $346,000 at the end of twenty years. In this example, we assume that each of the twenty investments were held for at least one year to qualify for long term capital gains tax treatment. If the holding period was under a year, the lag would be worse.

So, identifying a “compounding machine” that allows for a twenty year holding period produces a difference in the ending balance of $27,000 which is not an insignificant sum relative to the initial $100,000 investment. However, the key caveat is that the single stock must be able to deliver performance over a long period of time. Additionally, the investor would have to forego opportunities to sell and reinvest in better opportunities along the way.

Have I Learned Anything?

In my case, the reason my IRA accounts outperformed my taxable accounts is because I stubbornly refused to sell securities in my taxable account that would incur current year capital gains taxes. I often held the same securities in my IRAs and did sell those shares in order to reinvest in more attractive opportunities. My refusal to pay capital gains taxes resulted in long term underperformance of my taxable account relative to what I know my investment skill was capable of producing, as shown in the results of my IRAs. I would have been far better off making identical decisions in my taxable account and my IRAs, paying the taxes, and reinvesting.

I conducted this analysis of my accounts a few years ago. Have I learned anything from my mistakes?

Apparently I have not learned much given my behavior early this year.

I had held shares of a company in both my IRA and taxable accounts since 2018 that appreciated sharply during the course of 2019. By February 2020, the shares traded materially above my assessment of intrinsic value. I sold the shares that were held in my IRA accounts and redeployed the funds. But in my taxable account, I stubbornly refused to sell more than a token number of shares because doing so would have resulted in a very steep capital gains tax and the loss of other tax benefits.

Fast forward to April 2020. The COVID-19 crisis not only brought the shares of the company in question down to earth, but the fundamental business conditions facing that company had deteriorated to the point where my intrinsic value estimate had declined significantly and the level of risk involved had increased. The range of potential outcomes for the business widened to the point where I was no longer comfortable that a reasonable margin of safety existed. I sold the shares in my taxable account. I still realized a gain on my sale but the large amount of outperformance relative to the S&P 500 that I would have locked in back in February was almost entirely given up. My IRA again outperformed my taxable account due to aversion to realizing taxable income.

Combatting Psychological Pitfalls

It is not possible to change the past and self-recriminations serve no useful purpose. However, we should always try to learn from past mistakes and avoid repeating these errors in the future. The irrational aversion to taxes is a problem facing many investors but perhaps there are ways to frame the problem in a way that is likely to lead to better decisions.

One approach is to reframe how we think about taxes. Those of us who believe that the government wastes a great deal of money are prone to dislike paying taxes because we believe that our money will be wasted. Rather than thinking about our tax money as going into a large void, however, we can reframe the situation. Let’s say that you have realized a $100,000 capital gain and now face a $20,000 federal tax as a result. Rather than framing that $20,000 as going into the government’s general fund, there is no reason that we cannot think of it as funding a specific relative’s social security or Medicare benefits for the year. Alternatively, you can pick any other program and think of your money as funding that program.

If that idea sounds naive, and it might be a stretch for many people to think of taxes in that way, consider a change to how you track your net worth. The reality is that when we refuse to sell an appreciated security to avoid paying current-year taxes, we are not avoiding the eventual tax on the gain. We are only deferring it. If a company, such as Berkshire Hathaway, holds appreciated securities, accounting statements are required to account for a deferred tax liability that recognizes the amount of tax that would be due on the security if the gain was realized immediately.

Individuals should be doing the same for their holdings and recognizing deferred tax liabilities. If you purchased a security years ago for $100,000 and today it is worth $1 million, I am sorry to tell you that you have a silent partner and that entire $1 million is not yours. You have a $900,000 capital gain. And your “partner”, Uncle Sam, “owns” about $180,000 of that $1 million position. You should be carrying a $180,000 deferred tax liability against that $1 million position.

From a mental accounting perspective, if you are carrying a deferred tax liability and thinking of your net worth net of that liability, you are far more likely to be willing to recognize the capital gain and actually pay the tax than if you pretend that the liability does not exist. It is easier from a psychological perspective and leads to more rational decision making outcomes.

Conclusion

Investors should attempt to find companies that are capable of compounding intrinsic value at satisfactory rates for long periods of time without paying taxable distributions to shareholders. Finding such companies, however, is difficult because it is rare for a company to be able to redeploy capital at a high incremental return on equity unless they have and maintain significant moats. Every investor is looking for companies with moats that will protect attractive returns from being competed away. So the valuation of companies that have obvious reinvestment opportunities tends to be high.

If we take Warren Buffett’s approach to heart and view owning shares of a company as owning an interest in the underlying business, we should not have a hair trigger when it comes to selling. The instinct to buy and hold securities of great companies is a good one, but we need to face up to the fact that holding even a great business through periods of significant overvaluation can result in unsatisfactory returns.

When a company gets significantly overvalued, it makes sense to take profits if there are other opportunities that offer brighter prospects going forward. Even Warren Buffett expressed regret in his 2004 letter to shareholders regarding his decision to not sell shares of stock he considered overvalued during the bubble years of the late 1990s.

Those of us who have made serious errors related to irrational tax aversion can take some comfort in knowing that the greatest investor of the past seventy years has grappled with the same problem.

The Buffalo News: From Butler to Buffett

“News, to put it simply, is what people don’t know that they want to know. And people will seek their news – what’s important to them – from whatever sources provide the best combination of immediacy, ease of access, reliability, comprehensiveness and low cost.”

— Warren Buffett, 2012 Annual Letter to Berkshire Hathaway Shareholders

Human beings have an innate curiosity and desire to know what is happening in the wider world beyond their immediate circle of family, friends, neighbors, and co-workers. In peaceful and prosperous societies, the type of information most people seek might be mundane details about a vote in the city council, the fortunes of the local high school football team, job openings at the new factory, what’s on sale at the supermarket, or the weather forecast for their picnic on Saturday. In times of crisis, we have a desperate need to know the current state of affairs in order to take action ourselves or just to understand what is happening around us.

From the end of the Second World War until almost the end of the twentieth century, almost all Americans got this type of information from one of three sources: television, radio, and the local newspaper. Events of the day were curated by professional journalists who, for the most part, attempted to report the news accurately. The news was disseminated by large organizations that, while not without occasional controversy, were mostly trusted by the majority of people. Some of my earliest memories as a child include the evening ritual of my parents turning on the television to watch Walter Cronkite provide his summary of the news. In the morning, I would hear the familiar CBS Radio chime and know it was the top of the hour. As a teenager, I delivered the local newspaper starting with the afternoon edition and later moving to a larger morning route. Serious people took the news very seriously.

Then the internet changed everything.

Suddenly, in the final years of the twentieth century, anyone with a computer and an internet connection had an unlimited supply of news provided first by hundreds and soon by thousands of publishers. Not only did we have access to newspapers from around the world but we gained access to less formal sources of information written by ordinary people. For the most part, this information was not only abundant but was also free. Within the span of a few years, the comfortable culture of journalism was completely upended, never to be the same again.

The massive upside of diversity of sources, freedom of speech, and lower economic costs were initially all that we focused on but it slowly became apparent that something has been lost as well. Whereas society previously relied on journalists to decide what constituted information as opposed to mere noise, we now must take much more responsibility for differentiating between the signal and noise for ourselves. Journalism became too insular and comfortable and did not react quickly enough to make the case for its crucial role in a free society. With few exceptions, newspapers have been unable to charge customers for content online and total circulation (print and digital) has fallen precipitously to levels not seen since before 1940 when the U.S. population was less than half of today’s level.

Source: Trends and Facts on Newspapers via Pew Research Center

Not surprisingly, the drop in circulation has been accompanied by a precipitous decline in advertising revenue for almost all newspaper publishers. According to the Pew Research Center, U.S. newspaper advertising revenue peaked at $49.4 billion in 2005 and dropped to $14.3 billion by 2018. The decline in circulation revenue has been less severe, peaking at $11.2 billion in 2003 and coming in at just under $11 billion in 2018. In inflation adjusted terms, of course, the circulation revenue decline has been more significant.

Newspapers face a vicious cycle: As circulation declines, they must increase the price of papers to customers to maintain circulation revenue, but the subsequent decline in readership dissuades more advertisers who gain access to fewer and fewer eyeballs every year.

Not surprisingly, newspapers have made major cuts to newsroom staff over the past twenty years.

Source: Trends and Facts on Newspapers via Pew Research Center

Cutting investment in staffing inevitably results in degradation of the content needed to attract readers. Newspapers then must decide whether to attempt to maintain circulation revenue by raising prices for die-hard readers, who might be on the older side and continue subscribing simply by force of habit, but at the cost of losing less committed readers. Then as circulation counts drop again, advertisers will cut their orders since fewer eyeballs will see their promotions, and the vicious cycle continues.


A Man of Unlimited Confidence

The cacophony of views prevalent on the internet today has no equal in human history, but there was a time when traditional print newspapers were far more numerous and competitive. From Butler to Buffett: The Story Behind the Buffalo News provides a great example of the evolution of newspapers from the late nineteenth century up through the consolidation of the industry that was largely complete a hundred years later. Murray B. Light, who worked for the Buffalo News for a half century starting in 1949, provides a fascinating account of how the paper transformed from a scrappy startup founded by Edward Butler in 1873 into the only surviving newspaper in the city 110 years later. Light, who passed away in 2011, was asked to write a history of the newspaper by Warren Buffett who had purchased the Buffalo News in 1977. The book is both a history of the newspaper as well as the personal memoir of a longtime veteran of twentieth century journalism.

When Edward H. Butler arrived in Buffalo in 1873, he saw an opportunity. Although the city had ten newspapers, none of them published a Sunday edition. This might seem odd in light of the much expanded Sunday newspapers that seemed to grow larger and larger during the twentieth century. Obviously, people would have more time to read on weekends. But 1870s Buffalo was a weird mix of vice — there were nearly a hundred saloons, numerous gambling parlors, and plentiful houses of ill repute — and virtue, with religious ministers united in saying that any commercial activity, including newspaper publication, on Sundays would degrade the sanctity of the Sabbath.

Butler, who was only 23 years old at the time of his arrival in the city, plowed ahead anyway. He firmly believed that any enterprise would succeed under his leadership. He was a man of unlimited confidence. So on December 7, 1873, the first issue of the Buffalo Sunday News was published despite the vociferous opposition. Unlike most the newspapers of his era, Butler took a non-partisan position. He was determined to not serve as a political party organ and he wanted to provide information relevant to everyone in the family. Butler’s strategy was immediately successful with rapid gains in circulation which brought about a virtuous cycle that would attract more advertisers, and in turn even more readers. Although Butler did not take an overtly political posture, his affiliation with the progressive politics of the era caused the paper to pay special attention to the plight of the poor at a time when few labor protections were enshrined into law.

By 1880, several competing newspapers had started Sunday editions and Butler decided to aggressively move into the market for daily newspapers. Employing a bold strategy, Butler rolled out his daily evening newspaper, named The Buffalo Evening News, at a bargain price of one cent per copy at a time when competitors were charging five cents. This highly promotional pricing attracted readers and the readers attracted advertisers — the classic economic model for newspapers that would last for another century. Butler was a man of seemingly unlimited energy who was involved in every facet of the enterprise until his death in 1914. By 1897, his paper claimed to have a larger circulation than the combined circulation of all competing Buffalo daily papers. Although this claim was somewhat dubious, Butler did have nearly twice as much circulation as his nearest competitor and dominated the field.

During the final decade of his life, Butler became more involved in politics and, in 1912, he turned over management of the paper to his son, Edward H. Butler Jr., who would run the newspaper until his death in 1956. The Buffalo News would remain in the hands of family members until Warren Buffett and Charlie Munger purchased the paper in 1977. Murray Light entered the scene in 1949 as a young copyeditor and, from that point forward in the chronology, the story benefits from his own eyewitness account of major developments within the company and the city of Buffalo.

Although the early history of Butler’s founding of the newspaper is fascinating and should hold any reader’s interest, Light’s later description of the many characters who shaped the paper from the 1950s into the 1990s is likely to be of more interest to a reader who is specifically interested in the individuals involved. Much of the narrative involves what could be thought of as “inside baseball” — stories of newspapermen who were “characters”, politics within the organization, and the many promotions and controversies that exist within any large organization.

Enter Buffett and Munger

After remaining in family control for over a hundred years, the estate tax finally compelled the Butlers to put the newspaper on the market following the death of Kate Butler in August 1974. Kate Butler had taken over management of the newspaper in 1956 when her husband, Edward H. Butler Jr., passed away and she stubbornly refused to transfer control of her interest in the paper prior to her death. Warren Buffett and Charlie Munger enter the narrative almost exactly halfway into the book where Light provides a summary of the steps the family took to sell the paper and how it came to be purchased by Blue Chip Stamps on April 15, 1977 for $35,509,000.

Blue Chip Stamps was one of the corporate entities that was partially owned by Berkshire Hathaway during its early years. Charlie Munger served as Chairman of Blue Chip Stamps, but both he and Buffett were actively involved in the decision to purchase The Buffalo News and had a role in dealing with the difficult early years of their ownership. Although Light does tell the familiar story of Berkshire’s troubles with the newspaper during the early years, a reader who is more interested in the specifics of the story would be well served to read Charlie Munger’s letters to Blue Chip shareholders that have been helpfully compiled by Max Olson.

Although Butler started out in Buffalo with a Sunday only publication and only later moved to daily publication, his successor decided to eliminate the Sunday issue in 1915. By the time Buffett and Munger took control, The Buffalo News had lacked a Sunday offering for over sixty years. Instead of a Sunday edition, The Buffalo News published an expanded Saturday “weekend” edition but this was a poor substitute for readers with leisure time available on Sunday mornings who did not want to read stale news. By 1977, Buffalo was a city with two newspapers — The Buffalo News which published in the afternoons from Monday to Friday as well as its Saturday weekend edition and The Buffalo Courier-Express which published a morning edition seven days a week. Buffett and Munger were convinced that to remain relevant, their newspaper had to publish seven days per week.

Warren Buffett is well known for his love of newspapers and he obviously took great pleasure in helping craft the advertising and circulation pricing strategy prior to the rollout of the Sunday paper. At the same time, Light says that Buffett took an entirely hands-off approach when it came to setting newspaper editorial policy. As Buffett wrote to a friend at the time, he was “having so much fun with this it is sinful.”

Publication of the first Sunday issue was set for November 13, 1977, but two weeks before launch, the Courier-Express filed an anti-trust lawsuit alleging that The Buffalo News was using its strong position during the week to subsidize a loss making paper on Sunday, with the intent of eventually driving The Courier-Express out of business. The Courier-Express was fortunate to find a friendly judge who imposed onerous conditions on the rollout of Sunday paper and this caused several years of struggles for The Buffalo News before an appeals court rejected the lower court’s findings. However, the troubled early years were not over for Buffett and Munger. They faced a strike in 1980 and an additional three years of heavy losses until The Courier-Express finally ceased publication in the fall of 1982. At that point, The Buffalo News started a morning edition and Buffalo became a one newspaper town.

It is doubtful that Buffett and Munger in any way expected the kind of turmoil they faced immediately after purchasing the newspaper. For several years, Charlie Munger warned Blue Chip shareholders that The Buffalo News could be forced to cease publication and liquidate if the legal situation did not improve and labor relations worsened. Even in his valedictory letter to shareholders in early 1983, on the eve of Berkshire acquiring full ownership of Blue Chip, Munger characteristically refuses to brag about the turnaround that was already underway and states that he and Buffett might just have been lucky:

Finally, our shareholders should recognize that if our 1977 purchase of the News has now worked out acceptably from their viewpoint, which contrary to our prediction last year may now be true even after taking into account time delays, the conclusion does not follow that we made a sound managerial decision buying the News when we did for the price we paid. In retrospect, we were strongly influenced because we liked the newspaper, its people and the city, and we may simply have gambled shareholders’ money against the odds and won. Our stewardship may have been, at best, dubious in this instance. We know that the financial outcome we now report could with slightly different breaks just as well have been either (1) a large loss on closure of the News or (2) the expectation of much more money-losing in continued operation, as part of the only defensive strategy with reasonable prospects.

Charlie Munger’s 1982 Letter to Blue Chip Stamps Shareholders

Charlie Munger was being modest. From 1983 through the end of the century, when Berkshire stopped breaking out reporting for the newspaper in its annual reports, the business provided consistently excellent results when viewed in light of the initial acquisition cost:


Nothing Lasts Forever

Berkshire continued to own The Buffalo News for another two decades after the newspaper became too small for the growing conglomerate to break down its results in a granular manner. Buffett and Munger, although fully aware of the internet and the changing competitive landscape, never ceased to love the newspaper business, perhaps due to the wonderful economics that The Buffalo News eventually produced along with Berkshire’s experience owning shares of The Washington Post. During the early 2010s, Berkshire began purchasing additional newspapers at distressed prices, as Buffett discussed at length in his 2012 annual letter. His hope was that the acquisitions were made at prices that fully reflected the inevitable continued decline that he regarded as inevitable.

From 2012 to 2017, Berkshire reported circulation figures for its newspaper properties, and the tabulation of this data confirms the decline. During this period, The Buffalo News saw its daily circulation drop by nearly 27 percent. The table below is a compilation of circulation data taken from Berkshire’s annual reports before the presentation was discontinued in the 2018 annual report (click on the image for a larger view):

Finally, in January 2020, Berkshire announced that its newspaper holdings would be sold to Lee Enterprises for $140 million, marking a rare instance where Warren Buffett has sold businesses within the Berkshire conglomerate. Lee had previously taken over management of Berkshire’s newspapers in 2018 with the exception of The Buffalo News. However, The Buffalo News was included in the sale to Lee which closed in March. Berkshire continues to have an interest in the success of the newspapers having extended Lee $576 million of long-term financing at an interest rate of 9 percent.

Taking the long view, it is clear that Berkshire Hathaway is far better off because Buffett and Munger saw the enviable economics of the newspaper industry back in the 1970s and decided to get involved in a big way, both directly via The Buffalo News and indirectly as a longtime shareholder of The Washington Post. This early positive experience clearly influenced Buffett’s decision to purchase his collection of papers in the 2010s, but these purchases were made at distressed prices that discounted continued decline. However, the decline obviously proceeded faster than Buffett anticipated and the media group might have become a distraction. Berkshire has not so much exited the newspaper industry as exchanged its equity ownership position for high yielding debt in the form of financing to Lee. Time will tell whether this commitment works out for Berkshire shareholders in the long run.

Murray Light clearly loved The Buffalo News and spent his entire professional career at the newspaper. The rough and tumble of the internet in the 21st century makes the world Light inhabited seem almost foreign in comparison. We should not necessarily wish for a return to those times. The concentrated nature of news delivery in the twentieth century provided the impression of greater stability, but only because fewer voices were being heard.

The chaos of the internet in the 2020s produces tremendous noise but also an unlimited variety of perspectives. However, it is our jobs as consumers of the news to separate the wheat from the chaff. And lately, it seems like there has been an abundance of chaff and little wheat when it comes to feeding our daily need for information.


Buffett and Munger, circa 1977

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

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