The Long History of Shareholder Activism

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”  — Upton Sinclair

On the commute home from work, a man suddenly has a brilliant flash of insight and comes up with a unique business idea.  Having long ago achieved financial freedom, he is no longer compelled to work for his employer and has sufficient capital to pursue the idea.  A month later, a small office is set up and, before long, there are a dozen employees at work turning the idea into reality.  Through ownership of 100 percent of the equity of the business, there is no conflict between the owner and the manager because he is the same person.  Three years later, a major expansion opportunity requires additional capital.  The owner’s father-in-law, being a successful businessman himself, provides capital (and, in due course, unsolicited advice) in exchange for 40 percent of the equity.  Although the business is still “all in the family”, Thanksgiving dinner becomes a little more awkward that year.

Dear ChairmanSome element of an agency problem exists the moment a business transforms from a pure owner-operator model to one that involves outside shareholders.  Obviously, the degree to which an agency problem exists depends on the individuals involved, the separation between owners and managers, and the amount of equity that management continues to own.  The character of management counts a great deal, but few managers treat non-management owners as true “partners” in the business.  In Dear Chairman:  Boardroom Battles and the Rise of Shareholder Activism, Jeff Gramm provides an entertaining history showing that the agency problem and shareholder activism is nothing new.  The media often portrays shareholder activists as rapacious and amoral individuals with no social conscience.  While this is sometimes true, more often the interests of owners are advanced by activists.  Through eight chapters presenting interesting case studies, the book offers insights into how activism has evolved over nearly a century.  Social mores have changed dramatically but the inherent tension between managers and owners has been a constant.

The case studies range from Benjamin Graham’s campaign against Northern Pipeline in the late 1920s to campaigns by Dan Loeb and Carlo Cannell in recent years, and it is likely that readers will find different chapters more or less compelling based on their interests and period of personal involvement in the stock market.

Benjamin Graham: Activist Pioneer?

For students of Benjamin Graham, reading about his activist campaign against Northern Pipeline shows a side of the father of value investing that has not been widely known previously.  In an exceedingly polite but firm letter, Mr. Graham asserts the right of owners of a company to claim excess capital that is not remotely necessary for the operations of the business.  Northern Pipeline’s management had hoarded excess capital over a long period of time which eventually resulted in an inefficient structure for shareholders who owned an operating business along with a tax-inefficient securities portfolio.  The following quote from the letter is just as applicable today:

“The determination of whether capital not needed in the business is to remain there or to be withdrawn, should be made in the first instance by the owners of the capital rather than by those administering it.”

Not only were Northern Pipeline’s managers behaving in a manner similar to many corporations today, they apparently pioneered one of the annoying tactics management often uses to discourage shareholder involvement.  The annual meeting was held in Oil City, Pennsylvania even though the company’s executive offices were conveniently located in New York City.  The remote location did not stop Benjamin Graham from going to a meeting to make a presentation on how to distribute the excess capital.  However, due to a procedural motion, he was not even permitted to speak at the meeting.  Northern Pipeline’s management also tried to obfuscate the issue by claiming that investors with no operational knowledge of the business were trying to exert operational control when the question was entirely one of capital allocation.  Sound familiar?

Graham’s Activism Influences Buffett

We can be sure that Warren Buffett knew about the Northern Pipeline story when he began investing in Sanborn Map Company three decades later.  As we discussed in a review of Warren Buffett’s Ground Rules, the Sanborn Map situation involved a very similar scenario of an operating company being coupled with a large securities portfolio representing capital that was completely unnecessary for the business with management stubbornly clinging to that capital.  Sanborn Map is also briefly discussed in Dear Chairman.  Mr. Buffett no doubt was inspired by the Northern Pipeline example as he launched his own activist campaign against Sanborn.

One chapter in Dear Chairman stands out as a bit different from the rest.  In the early 1960s, American Express faced a dangerous situation in which much of its economic goodwill could have been eliminated due to the salad oil scandal.  The book provides details regarding the background of the scandal and how management initially reacted to it.  However, Mr. Buffett did not launch an activist campaign against American Express management.  To the contrary, he sent a letter to management supporting its decision to cover the losses of customers even though doing so was not strictly required from a legal perspective.  Other investors were not pleased with American Express absorbing losses that the company was not contractually required to cover but Mr. Buffett understood that the savings in hard cash would be far outweighed by the loss of reputation and associated economic goodwill.

Here we have a wonderful example of a young Warren Buffett explicitly advocating for the reduction of tangible book value of a company in exchange for economic goodwill that was nowhere to be found on the balance sheet but nevertheless a very real asset.  Many investors believe that Warren Buffett shifted from a “pure value” approach to “paying a fair price for a great business” with Berkshire’s acquisition of See’s Candies in 1973 but the salad oil scandal at American Express shows that his appreciation for economic goodwill was already well developed a decade before the See’s purchase.

“And Then What?”

The book does not present shareholder activism in a one-sided manner.  Critics of activism often complain about short term oriented activists motivated by greed rather than the long term health of a business.  At times, misguided activism can destroy tremendous value for shareholders.

In the BKF Capital chapter, we are presented with a case study of failed activism that destroyed an asset management company.  BKF Capital was criticized by the activists for having high expenses that transferred most of the benefits of assets-under-management growth from shareholders to employees.   Asset management companies are notorious for high compensation costs and BKF Capital had higher costs than several firms that the activists claimed were comparable.  Management argued that the comparisons were not valid for a small and rapidly growing firm and that cutting compensation would result in an exodus of talent and destruction of the company.  In the end, that is precisely what happened when the activists got their way.

The activists were not necessarily incorrect in their criticism of BKF Capital.  The Chairman and CEO had made some questionable decisions that suggested nepotism and the compensation levels were certainly high.  The problem is that the activists apparently failed to ask an important question:  “And then what”?  What are the second and third order effects of cutting compensation when it comes to asset growth?  Is the flight of talent a realistic risk that must be taken into account?  It appears that not enough second-level thinking took place.

Losing by Winning

Sometimes in the heat of battle, there can be an excessive focus on “winning” and not enough focus on what happens after the “victory”.  Even Warren Buffett was not immune to making decisions in the midst of a boardroom battle that he would later regret.  On May 6, 1964 Seabury Stanton offered to purchase the Buffett Partnership’s interest in Berkshire Hathaway for $11.375 per share.  Mr. Buffett was not pleased.  He had previously offered to sell its holdings for $11.50 per share and Mr. Stanton had said “Fine, we have a deal.”  In response to insulting tender offer, Mr. Buffett instead began accumulating more Berkshire shares and eventually took control of the company in 1965.

In his 2014 letter to Berkshire Hathaway shareholders, Mr. Buffett referred to his behavior as “a monumentally stupid decision”. Berkshire Hathaway became Mr. Buffett’s main investment vehicle.  In 1967, he entered the insurance business through Berkshire rather than through the partnership (BPL):

If BPL had been the purchaser, my partners and I would have owned 100% of a fine business, destined to form the base for building the company Berkshire has become. Moreover, our growth would not have been impeded for nearly two decades by the unproductive funds imprisoned in the textile operation. Finally, our subsequent acquisitions would have been owned in their entirety by my partners and me rather than being 39%-owned by the legacy shareholders of Berkshire, to whom we had no obligation. Despite these facts staring me in the face, I opted to marry 100% of an excellent business (NICO) to a 61%-owned terrible business (Berkshire Hathaway), a decision that eventually diverted $100 billion or so from BPL partners to a collection of strangers.

Although Berkshire has worked out remarkably well, the outcome would have been far better had Warren Buffett resisted the urge to “win” in his battle with Seabury Stanton.  Any aspiring activist has to be humbled by this story.  Whether the reader aspires to be an activist or simply wants greater insight into activism and the impact on target companies, Dear Chairman contains insights and lessons that are worth careful consideration.

Purchase Dear Chairman:  Boardroom Battles and the Rise of Shareholder Activism from Amazon.com

Book Review: Warren Buffett’s Ground Rules

“So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” 

— Warren Buffett, letter to partners, October 9, 1967

As Warren Buffett wrote these words to his partners in late 1967, he was writing from the perspective of a 37 year old man who was about to wrap up the eleventh year of his partnership having achieved gross returns of 1606.9%, which represents annualized returns in excess of 29 percent.  For a number of years, Mr. Buffett had been warning his partners that future results would not come close to his past track record.  However, in 1968, the partnership posted its highest ever gross return of 58.8 percent which exceeded the return of the Dow Jones Industrial Average by an amazing 45.6 percent.  Then in May 1969, with assets under management exceeding $100 million ($~650 million in 2016 dollars), Mr. Buffett announced plans to close the partnership and retire.

Warren Buffett's Ground RulesThe idea of closing up shop with an unparalleled thirteen year track record and assets under management growing at a tremendous clip probably seems crazy to most modern-day investment managers.  Although Mr. Buffett did not charge a fixed annual management fee like most other funds, he was entitled to 25 percent of all profits over a six percent hurdle rate.  Even if his performance was destined to fall to 10 percent, on average, he would have generated fees of at least $1 million per year in 1970s dollars.  However, by the late 1960s, he was securely rich and did not want to be “totally occupied with out-pacing an investment rabbit all my life.”  The only way to slow down, in his view, was to stop.  Jeremy Miller’s new book, Warren Buffett’s Ground Rules, does an excellent job of putting the Buffett Partnership letters into context.  Perhaps more significantly, Mr. Miller draws a number of lessons from the letters that are potentially just as actionable for investors today as they were for Mr. Buffett five decades ago.

The Buffett Partnership letters have been available for a number of years and many investors understandably pored over the details chronologically in an attempt to replay the amazing track record and come up with applicable lessons.  However, just as Lawrence Cunningham added significant value putting the Berkshire Hathaway annual letters into context, Mr. Miller’s efforts with the partnership letters have revealed valuable insights that a chronological reading might miss.

For practicing investors today, the most valuable section of the book is Part II where Mr. Miller goes through the three main categories of Buffett Partnership investments:  The Generals, Workouts, and Controls. All three represent fields where modern-day investors can look for bargains with an individual’s area of focus depending mostly on temperament, circle of competence, and assets under management.

The Generals

The Generals were companies that made up a concentrated portfolio of undervalued securities that represented the majority of overall partnership gains.  With only one exception, Mr. Buffett never discussed any of the Generals with his partners or even disclosed the names of the companies.  This strict secrecy might appear eccentric to investors today.  After all, we see famous hedge fund managers on television describing their favorite investments all the time.  Mr. Buffett’s desire for secrecy, even when he was relatively unknown, stemmed from his lack of interest in seeking out fame as well as his desire to continue accumulating shares of his favorite investments at low prices.  There was no incentive for him to reveal his portfolio and invite “coat-tailing”.  According to the book, the partnership would typically have 5-10 percent positions in five or six generals with a number of smaller positions adding another 10-15 percent in aggregate.

How did Warren Buffett go about selecting the Generals?

He was constantly appraising the value of as many stocks as he could find, looking for the ones where he felt he had a reasonable ability to understand the business and come up with and estimate for its worth.  With a prodigious memory and many years of intense study, he built up an expansive memory bank full of these appraisals and opinions on a huge number of  companies.  Then, when Mr. Market offered one at a sufficiently attractive discount to its appraised value, he bought it; he often concentrated heavily in a handful of the most attractive ones.

Imagine for a moment Warren Buffett sitting in his office in the late 1950s with The Wall Street Journal, a Moody’s Manual, a pile of printed annual reports, a notepad, and a pencil.  These were the tools of his trade at the time when he was coming up with these lists of investment candidates.  There was no SEC website, no access to spreadsheets like Microsoft Excel, no way to research companies except to send out for information, and he didn’t even have an HP-12C.  The idea of coming up with a list of hundreds of investment candidates and then keeping up with them and gauging their relative attractiveness is hardly an easy task with modern resources but it is certainly possible for diligent investors.  In the 1950s and 1960s, raw memory, intellect, and work ethic were probably greater competitive advantages than they are today, but the right temperament, which is timeless, is even more critical.

Workouts

Merger arbitrage was a major source of investment ideas and profit for the Buffett Partnership throughout its history.  As Mr. Buffett was wrapping up the partnership in 1969, he lamented that his performance in workouts that year had been “atrocious”.  Indeed, merger arbitrage was a hazardous activity in the 1960s and remains so today, except now there is far more information and efficiency which could make this field more challenging.

For the partnership, the overall experience in workouts was positive due to Mr. Buffett’s skill and insight into which deals to bet on.  When an acquisition is announced, the spread between the price the target company’s stock trades at and the offer price represents potential profit to an investor purchasing the stock.  The degree to which the investor can profit depends on the size of the spread, the amount of leverage used, the amount of time between buying the target’s stock and the transaction closing, and whether the deal actually does close or falls apart.  The situation becomes much more complex when an offer involves the acquiring company’s stock rather than cash.

Despite the risks, workouts represented an attractive field for the partnership both because of the profits they generated and due to the fact that these returns were uncorrelated to the overall stock market.  In most years, workouts made up 30-40 percent of partnership assets.  When the overall level of the stock market was rising, Mr. Buffett would tilt the partnership away from Generals and toward Workouts.  When the stock market was falling, he would allocate more capital toward Generals and less toward Workouts.

In contrast to the secrecy surrounding Generals, Mr. Buffett was more willing to discuss Workouts once they were fully … worked out.  Mr. Miller presents one such case study regarding Texas National Petroleum from the 1963 letter.  In considerable detail, Mr. Buffett describes how he came up with the idea, researched the matter in great detail, and profited from the spread that emerged.  One interesting item to note is that the company’s management was often available to comment on how the process was going.  While perfectly legal, ethical, and appropriate based on the rules in existence at the time, it isn’t clear whether managers today would be willing to discuss the progress of a transaction with an outside shareholder.

Modern-day investors can pursue workouts today but have to use a great deal of caution.  One potential field for consideration might involve looking at deals that involve Berkshire Hathaway.  For example, when Berkshire announced the Precision Castparts acquisition in August 2015, Precision Castparts shares did not trade up to the $235 offer price.  Shares jumped from around $193 on the day before the announcement to slightly over $230 on the day of the announcement.  One could purchase shares at $230 in mid-November and at a little over $231 just days before the acquisition closed in January 2016:

PCP August 2015-January 2016

Obviously buying shares during this period was not entirely risk free.  If the transaction fell through for any reason, shares would probably have fallen back to August levels or perhaps even further given the overall market environment in early 2016.  However, Berkshire is known for never backing out on acquisitions once announced.  The risk seemed quite low.  An investor who added leverage and waited until the transaction was about to close could have earned substantial returns.

Is this field risk free or for the faint of heart?  Not at all, but this was an important category for the Buffett Partnership and worth examining for those who believe that they have a suitable temperament.

Controls

Berkshire Hathaway’s policy is to never pursue hostile acquisitions and the company does not typically seek to influence the managers of investees.  Warren Buffett is not known as an “activist” investor today but that is precisely what he was at times during the 1960s.  The most famous example is Berkshire Hathaway itself where Mr. Buffett built up a stake in the company over several years before assuming control and forcing out management.  Berkshire started out as a General and morphed into a Control.

Although Berkshire Hathaway might be the most famous example of a Control, Mr. Miller’s coverage of the Sanborn Map Company is a classic that modern-day investors might find it easier to relate to.  Sanborn Map made up 35 percent of the partnership in 1959 and concluded successfully in 1960.

Sanborn was a successful publisher of very detailed maps used by insurance companies to assess various risks.  The company was a cash cow and management built up a large securities portfolio over a number of years.  By the late 1950s, the map business was in decline.  The market quotation of Sanborn implied that the map business had negative value, as Mr. Buffett described:

In the tremendously more vigorous climate of 1958 [in comparison to the late 1930s] the same map business was evaluated at a minus $20 [per share] with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.

The size of the investment portfolio had also made managers and directors complacent and there was a lack of urgency in rejuvenating the map business, which Mr. Buffett believed still had positive value.  Mr. Buffett joined the board but found that most of the other directors had nominal holdings of the stock and did not share his urgency.  In late 1958, an opportunity arose when several unhappy large shareholders decided to sell.  However, even in combination with unhappy continuing shareholders, Mr. Buffett lacked an outright majority.  Seeking to avoid a proxy fight, a solution was devised to take out all shareholders who wanted to exit:

About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value.  The map business was left with over $1.25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated.  The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.

In this example, we see an investor who was not yet thirty years old take effective control of a company founded in the late 1800s and devise a solution that not only resulted in significant gains for the partnership but also a positive outcome for continuing shareholders of Sanborn.  So, while Warren Buffett was an “activist” in his early years, the basic elements of fair dealing that he is known for today were already present.

George Risk Industries – A Modern Day Potential Control?

Are there still situations like Sanborn Map?  The situation at George Risk Industries in early 2010 was not identical to Sanborn Map but it “rhymed” in certain ways.  George Risk, founded in 1965, had an operating business but was massively overcapitalized with a large securities portfolio.  The son of the company’s founder served as CEO and had a controlling interest.  With a market capitalization of just over $20 million at the time, the company also traded below net current assets.

Fast forward to 2016 and not much has changed.  The founder’s son passed away and his daughter took over as CEO.  The family still has a majority interest in the company.  The valuation of the company has nearly doubled to around $37 million and shareholders have received meaningful dividends throughout the period.  The company is still massively overcapitalized.  Returns from owning George Risk have not equaled the return from S&P 500 or Berkshire Hathaway.

Would Warren Buffett, if he had been operating with very little capital in 2010, have attempted to purchase shares of this thinly traded stock?  Would he have taken an active role trying to persuade the Risk family to distribute securities to shareholders?  We cannot know the answer to these questions but would note that this field of endeavor is still very much open to small investors who have the appropriate temperament, and perhaps more importantly, a great deal of patience and ability to underperform for a long period of time while waiting for the investment thesis to play out.

Anyone who is interested in George Risk has the luxury of access to the SEC database covering almost 20 years of company history, something an investor operating in the 1950s could only dream about.

Closing the Partnership

As one reads the final chapters of the book, we know how the arc of Mr. Buffett’s life will proceed and view the story from that perspective.  However, in the late 1960s, it really did appear that Mr. Buffett wanted to slow down.  It was clear that he did not want to fully “retire” and intended to take at least an advisory role at Diversified Retailing and Berkshire Hathaway.

Some of you are going to ask, “What do you plan to do?”  I don’t have an answer to that question.  I do know that when I am 60, I should be attempting to achieve different personal goals than those which had priority at age 20.  Therefore, unless I now divorce myself from the activity that has consumed virtually all of my time and energies during the first eighteen years of my adult life, I am unlikely to develop activities that will be appropriate to new circumstances in subsequent years.

It is hard to not observe that Mr. Buffett closed the partnership shortly before reaching 40 years of age.  Was this part of a mid-life crisis?  Those of us on the far side of the big 4 – 0 might relate to the need to make some sort of reassessment upon the realization that we will soon be closer to receiving Social Security than to our college years.  It is obviously true that the environment of the late 1960s, described in detail in the book, was the main factor and Mr. Buffett really did feel like he was out of good ideas that could be implemented within the constructs of a $100 million portfolio.  However, it is interesting to get somewhat of a personal window into what went into the decision at this point in his life.

Regardless of intentions, we know that any “slow down” did not last for long.  As Chairman and CEO of Berkshire Hathaway, Mr. Buffett took the underlying ground rules of his partnership into a corporate form.  As the Berkshire Owner’s Manual makes clear, the corporate form has not erased the partnership culture.

Most value investors are familiar with the history of Berkshire Hathaway and with the broad outlines of the Buffett Partnership as documented in excellent biographies such as The Snowball and The Making of an American Capitalist.
Thanks to Mr. Miller’s efforts, we now have the ability, in a concise and efficient format, to explore Warren Buffett’s early years as a professional investor.  Whether reading the book for actionable approaches to investing or just out of biographical curiosity, it is definitely time well spent.

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

The Remarkable Iscar Story

“Follow your heart and invest your time and resources in a product that you love.  If you are excited about what you are making, it will hold your interest and you will be well equipped to interest your customers in it.”  — Stef Wertheimer

Contemporary business success stories often focus on entrepreneurs who come up with an idea, obtain funding, and score quickly by selling the business at an attractive valuation either via acquisition or through an offering of stock to the public.  There can be no doubt that a sub-set of these entrepreneurs have made real and lasting contributions to society in astonishingly short periods of time, but often we are left scratching our heads wondering about the valuations obtained by companies with no compelling business model or pathway to profitability.  In contrast, individuals who spend a lifetime building up a business do not typically receive the same attention.  Perhaps this is because the value of their creation is not recognized dramatically in a few years but snowballs over many decades.  However, if one seeks insight into how real and lasting value is created, reading the biographies and memoirs of entrepreneurs who have spent decades perfecting their craft is usually worthwhile.

The Habit of Labor:  Lessons from a Life of Struggle and Success

Habit of LaborStef Wertheimer’s formative years were spent in his native village of Kippenheim, Germany during the turbulent years leading up to the second world war.  Mr. Wertheimer’s prosperous family was deeply impacted by the Nazi persecution of Jews during the early-mid 1930s and the family decided to emigrate to British-controlled Palestine in 1937.  At the age of ten, Mr. Wertheimer found himself in an unfamiliar culture and had to grow up quickly as his family’s economic security deteriorated after his father’s business began to fail.  An early entrepreneurial aptitude coupled with a rebellious streak led Mr. Wertheimer to make important contributions to Israel’s early industrialization.  Iscar was founded in 1952 in a shack next to Mr. Wertheimer’s home.  It was valued at $5 billion 54 years later when Berkshire Hathaway acquired a majority interest.  The story of this extraordinary up-from-the-bootstraps business success is the main subject of Mr. Wertheimer’s book, The Habit of Labor:  Lessons from a Life of Struggle and Success.

Mr. Wertheimer did not complete his formal education and learned various crafts through experimentation, independent study, and apprenticeships as a young adult.  His subsequent experiences in the Palmach in the mid-late 1940s, particularly working in urgent situations requiring quick development of military supplies, clearly contributed to his leadership skills and aptitude for innovation under extreme pressure.  Nevertheless, in post-independence Israel, Iscar did not immediately prosper and the company faced five lean years with little monetary reserves.  Government policy did not recognize the importance of industrialization, offered little support, and there was very limited credit available for expansion.

Through the course of the narrative, Mr. Wertheimer provides many details regarding the rise of Iscar from these modest beginnings to the export powerhouse it became prior to Berkshire’s acquisition in 2006.  Additionally, readers who are interested in the economic development of Israel will find many aspects of the book interesting, particularly those related to Mr. Wertheimer’s lifelong focus on industrialization and the impediments that he faced.  There is much to learn regarding the benefits of vocational training coupled with attractive industrial parks focused on integrating education, manufacturing, arts, culture, and a high quality of life in communities that were previously agrarian, isolated, and undeveloped.

Berkshire’s Acquisition of Iscar

In late 2005, Eitan Wertheimer, who had taken over management of Iscar from his father, sent a brief letter to Warren Buffett describing Iscar and concluding that Berkshire Hathaway would be an ideal home for the company.  At the time, Mr. Buffett had never heard of Iscar and had never purchased a subsidiary outside the United States.  However, Mr. Buffett found Iscar’s primary business of developing consumable cutting tools attractive and was impressed with management, as he wrote in Berkshire’s 2006 annual letter to shareholders (pdf):

ISCAR’s products are small, consumable cutting tools that are used in conjunction with large and expensive machine tools. It’s a business without magic except for that imparted by the people who run it. But Eitan, Jacob and their associates are true managerial magicians who constantly develop tools that make their customers’ machines more productive. The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.

Stef Wertheimer provides an account of the deal in his book and states that the $4 billion price tag was not the primary factor that led his family to pursue the deal with Berkshire.  Mr. Wertheimer was primarily concerned with “the continued Israeli production, in the Galilee, by Israeli hands and with an Israeli brain, within an advanced and competitive world.” Obviously the Wertheimer family wanted a fair deal for the product of sixty years of effort but non-economic factors clearly played an enormous role.  We are reminded of the factors that led Bill Child to sell R.C. Willey to Berkshire Hathaway a decade earlier.  History doesn’t always repeat but it often rhymes.

As we noted recently, Berkshire was a very large company in 2006 but still relatively small compared to what it has become today.  With shareholders’ equity of $91 billion at the end of 2005, Berkshire’s purchase of 80 percent of Iscar for $4 billion represented a significant allocation of capital.  It is interesting to note that approximately half of the purchase transaction was accounted for by goodwill, representing the consideration paid in excess of identifiable assets:

Iscar

The Wertheimer family retained a 20 percent interest in the business until 2013 when they exercised a put option to sell their remaining interest (pdf) to Berkshire for $2.05 billion.  Based on this purchase, the implied value of Iscar was $10.25 billion in mid 2013, up from $5 billion seven years earlier, as Mr. Buffett noted at the time:

“Since the time IMC entered our lives, my partner, Charlie Munger, and I have enjoyed Berkshire’s association with the company, the Wertheimer family, and the company’s management team,” said Warren Buffett, Berkshire Hathaway Chairman and Chief Executive Officer. “As you can surmise from the price we’re paying for the remaining interest, IMC has enjoyed very significant growth over the last seven years, and we are delighted to acquire the portion of the company that was retained by the Wertheimer family when IMC first became a member of the Berkshire group of companies. We look forward to continuing our stewardship of this unique company founded by the Wertheimer family in Israel 60 years ago and nurtured into a truly global enterprise.”

Berkshire provides limited disclosure on Iscar in its annual reports so we do not have the information required to independently analyze Iscar’s value.  However, the valuation arrived at in 2013 was clearly set in 2006 at the time of the original acquisition.  The Wertheimer family negotiated a put option with Berkshire that specified the value of their remaining stake based on some kind of formula that clearly took into account the economic value of the company.  The model of acquiring a large majority stake from a family owned business and having the family retain significant ownership has been used before (Nebraska Furniture Mart is an example that comes to mind) and can align the interests of the family with Berkshire in the years immediately following an acquisition.  Ultimately, however, Mr. Buffett is relying on the management of these formerly family owned businesses to continue coming to work far past the point where there is any economic need to work.

After the 2013 transaction, Mr. Buffett noted that arcane accounting rules required Berkshire to substantially write down the value of the initial 80 percent ownership of Iscar due to the fact that the company acquired the remaining 20 percent.  This mystifying accounting rule also caused Berkshire to write down the value of Marmon when a similar series of transactions eventually resulted in full ownership.

Berkshire has paid a total of approximately $6 billion in aggregate for full ownership of Iscar which had a valuation in excess of $10 billion in mid 2013, and part of the $6 billion (the amount was not specifically enumerated) has been written down due to accounting requirements.  We do not know whether Iscar has remitted any cash to Berkshire over the years, or the precise amount if it has.  However, based on the information we do have, it is quite clear that Berkshire’s acquisition of Iscar worked out very well.  The Wertheimer family no longer has an ownership interest in Iscar but Eitan Wertheimer continues to be involved in the business along with the management team that he assembled over the past three decades.

Given Berkshire’s current shareholders’ equity, it would take a deal almost three times the size of the initial Iscar acquisition in 2006 to have a similar impact today.  The number of family owned businesses like Iscar of a size required to “move the needle” at Berkshire is smaller today than it was in 2006.  Nevertheless, this acquisition model can still be useful for Berkshire as well as for aspiring “mini Berkshires”.

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