How Warren Buffett Made His Fortune

A genius for spotting opportunity and growth potential spark wealth

Most investors are familiar with Warren Buffet, who is the man in command at Berkshire Hathaway (BRK.A,BRK.B). Buffett is one of the most successful investors of all time, with a net worth placing him somewhere in the top three richest people in the world. His partner in crime was Charlie Munger, who has worked with him for the past 50 years. While most investors are familiar with the story of Berkshire Hathaway, few seem to know how exactly Buffett made his first millions, that catapulted him to Berkshire Hathaway and the companies and stocks he owns through it.

Buffett started several investment partnerships in 1956 with approximately $105,000 in investor money, after his former employe, Graham-Newmann investment partnership, was liquidated. Buffett had put an initial $700 of his own money, which ballooned to a stake worth $20 million by the time he liquidated his investment partnership in 1969. The assets under management had grown to $100 million by that time. The Berkshire Hathaway annual letters to investors have been inspired by Buffett’s annual and semi-annual letters to his limited partners.

Per the Buffett Partners agreement, Buffett as the General Partner received a cut of the profits. For every percentage point gain above 6% in a given year, Buffett collected 25% of the gains. The Buffett Partnership Limited (BPL) was essentially a hedge fund, which pooled investor’s money and invested them at the discretion of the fund manager. Buffett never had a losing year during the thirteen years he ran the partnership, and he also managed to add new investors along the way. In addition, he reinvested any gains he made as a general partner back into the partnership.

Buffett invested in the following types of companies at the partnership: generally undervalued securities, work-outs and control situations. Work-outs included stocks whose financial results depend on corporate actions rather than supply and demand factors created by buyers and sellers. Control situations include occasions where BPL either controlled the company or took a sufficiently large position that allowed it to influence policies of the company.

After the BPL was liquidated, Buffett received shares in Berkshire Hathaway, as well as shares in companies which ultimately merged in Berkshire. And the rest is history.

The lesson to be learned from this exercise is that in order to become rich, Warren Buffett had a scalable business model, with a substantial amount of leverage. Unfortunately, BPL was mostly a one-man operation, although the turnaround expert he employed with Dempster Mill Manufacturing company is a rare situation where he employed others. He did exchange ideas with several of his value investing friends however.

Warren Buffett's $50 Billion Decision

This article, by Warren Buffett, as told to Randall Lane, appears in the upcoming April issue of ForbesLife magazine, as part of its “When I Was 25″ series.

By Warren Buffett

Benjamin Graham had been my idol ever since I read his book The Intelligent Investor. I had wanted to go to Columbia Business School because he was a professor there, and after I got out of Columbia, returned to Omaha, and started selling securities, I didn’t forget about him. Between 1951 and 1954, I made a pest of myself, sending him frequent securities ideas. Then I got a letter back: “Next time you’re in New York, come and see me.”

So there I went, and he offered me a job at Graham-Newman Corp., which he ran with Jerry Newman. Everyone says that A.W. Jones started the hedge fund industry, but Graham-Newman’s sister partnership, Newman and Graham, was actually an earlier fund. I moved to White Plains, New York, with my wife, Susie, who was four months pregnant, and my daughter. Every morning, I got on a train to Grand Central and went to work.

It was a short-lived position: The next year, when I was 25, Mr. Graham—that’s what I called him then—gave me a heads-up that he was going to retire. Actually, he did more than that: He offered me the chance to replace him, with Jerry’s son Mickey as the new senior partner and me as the new junior partner. It was a very tiny fund—$6 million or $7 million—but it was a famous fund.

This was a traumatic decision. Here was my chance to step into the shoes of my hero—I even named my first son Howard Graham Buffett. (Howard was for my father.) But I also wanted to come back to Omaha. I probably went to work for a month thinking every morning that I would tell Mr. Graham I was going to leave. But it was hard to do.

The thing is, when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I’ll go back to Omaha, take some college classes, and read a lot—I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, “Compound interest guarantees I’m going to get rich.”

My wife and kids went back to Omaha just ahead of me. I got in the car, and on my way west checked out companies I was interested in investing in. It was due diligence. I stopped in Hazleton, Pennsylvania, to visit the Jeddo-Highland Coal Company. I visited the Kalamazoo Stove & Furnace Company in Michigan, which was being liquidated. I went to see what the building looked like, what they had for sale. I went to Delaware, Ohio, to check out Greif Bros. Cooperage. (Who knows anything about cooperage anymore?) Its chairman met with me. I didn’t have appointments; I would just drop in. I found that people always talked to me. All these people helped me.

In Omaha, I rented a house at 5202 Underwood for $175 a month. I told my wife, “I’d be glad to buy a house, but that’s like a carpenter selling his toolkit.” I didn’t want to use up my capital.

I had no plans to start a partnership, or even have a job. I had no worries as long as I could operate on my own. I certainly did not want to sell securities to other people again. But by pure accident, seven people, including a few of my relatives, said to me, “You used to sell stocks, and we want you to tell us what to do with our money.” I replied, “I’m not going to do that again, but I’ll form a partnership like Ben and Jerry had, and if you want to join me, you can.” My father-in-law, my college roommate, his mother, my aunt Alice, my sister, my brother-in-law, and my lawyer all signed on. I also had my hundred dollars. That was the beginning—totally accidental.

When I formed that partnership, we had dinner, the seven of them plus me—I’m 99 percent sure it was at the Omaha Club. I bought a ledger for 49 cents, and they brought their checks. Before I took their money, I gave them a half sheet of paper that I had made carbons of—something I called the ground rules. I said, “There are two or four pages of partnership legal documents. Don’t worry about that. I’ll tell you what’s in it, and you won’t get any surprises.

“But these ground rules are the philosophy. If you are in tune with me, then let’s go. If you aren’t, I understand. I’m not going to tell you what we own or anything like that. I want to get bouquets when I deserve bouquets, and I want to get soft fruit thrown at me when I deserve it. But I don’t want fruit thrown at me if I’m down 5 percent, and the market’s down 15 percent—I’m going to think I deserve a bouquet for that.” We made everything clear, and they gave me their checks.

I did no solicitation, but more checks began coming from people I didn’t know. Back in New York, Graham-Newman was being liquidated. There was a college president up in Vermont, Homer Dodge, who had been invested with Graham, and he asked, “Ben, what should I do with my money?” Ben said, “Well, there’s this kid who used to work for me.…” So Dodge drove out to Omaha, to this rented house I lived in. I was 25, looked about 17, and acted like 12. He said, “What are you doing?” I said, “Here’s what I’m doing with my family, and I’ll do it with you.”

Although I had no idea, age 25 was a turning point. I was changing my life, setting up something that would turn into a fairly good-size partnership called Berkshire Hathaway. I wasn’t scared. I was doing something I liked, and I’m still doing it.

From forbes.com

Related Books

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)

The Warren Buffett Stock Portfolio: Warren Buffett Stock Picks: Why and When He Is Investing in Them

Creating a Portfolio like Warren Buffett: A High Return Investment Strategy

Berkshire Hathaway 2012 Shareholder Meeting Notes (part 2)

Written by Greg Speicher

Hedges
Some hedging required in operating businesses.

Buffett thinks about worse case scenarios all the time – more than most. They won’t take risks that threaten the business.

Valuations
Valuing GEICO is different than valuing Gen Re.

GEICO’s intrinsic value is greater than net worth and float. This is not true for all insurance businesses. GEICO will have growth plus underwriting profits.

Buffett would love to buy operating businesses at 9-10x pre-tax earnings if they had similar characteristics to Berkshire’s operating businesses. He would pay even more for Berkshrie’s businesses since they know the businesses.

Gold
Buffett would not buy gold. He prefers productive assets.

JP MorganBuffett bought JP Morgan for his personal account. He could not buy Wells Fargo in is personal account so he bought JP Morgan. His best ideas are in Berkshire.

Munger likes focused, long-term investing. Munger thinks investors should be thinking about the 98 1/2 percent of things that drive results, not the 1 1/2 percent.

If Buffett was not running Berkshire, he would own a lot of WFC in his personal account.