Assessing Catastrophe Risk—A Quick Way to Say Yes or No

This is Part 4 of a Series. Go to Part 3: Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

The following is an edited partial transcript of Alice Schroeder’s speech/lecture during the Value Investing Conference 2008 held at the Darden School of Business, University of Virginia.

He didn’t say no because it was a technology company. He said no because he went to the first step in his investing process. And this is where I think, what he does is very automatic and isn’t well understood. He acted like a horse handicapper. And the first step in his investing process is always to say: what are the odds that this business can be subject to any catastrophe risk that could make it just fail?

Before computers were digital, they actually read off of punch cards, they were called mark-sense cards, and these were big deck of cards that had holes punched in them and they would be stuck in the computer and, being non-electronic, they were sent mechanically through the computer. So this company was formed because IBM had to divest off this business. It was an incredibly profitable business. In fact, because these cards were trivial compared to the mainframe computers that IBM sold, it marked them up to get more than a 50% profit margin. This was IBM’s most profitable business.

So Wayne Eaves and John Cleary, two friends of Warren, saw that IBM was going to have to divest in this business and they thought they’re going to buy a Carroll press which was the press that makes these cards. They’re going to compete with IBM because they’re based in the Midwest; they can ship faster, and provide better service. They went to Warren and said: should we invest in this company and would you come in with us? And Warren said no.

Well, why did he say no? He didn’t say no because it was a technology company. He said no because he went to the first step in his investing process. And this is where I think, what he does is very automatic and isn’t well understood. He acted like a horse handicapper. And the first step in his investing process is always to say: what are the odds that this business can be subject to any catastrophe risk that could make it just fail? And if there’s any chance that a significant amount of his capital could be subject to catastrophe risk, he just stops thinking. No. And he won’t go there. And it’s backwards the way most people invest. Most people find an interesting idea, they figure out the math, the financials, the projections, and then in the end, they ask themselves: okay what could go wrong? Warren starts with what could go wrong. And here, he said: a startup business competing with IBM could fail. No, sorry. And he didn’t think another thing about it.

But Wayne Eaves and John Cleary went ahead anyway. They started up this business, and within a year, they were printing 35 million tab cards a month. So at that point they knew they had to buy more Carroll presses. They came back to Warren and they said: We need money, would you like to come in? Continue to Part 5: Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail