Handicapping, Compounding, and the Margin of Safety—Alice Schroeder’s Take on Buffett’s Approach

This is Part 3 of a Series. Go to Part 2: The Margin of Safety Mentality—A Cornerstone of Value Investing

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.

But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is, handicapping, compounding, and the margin of safety. These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly

I think everybody, or everyone who’s read the Snowball knows, how hard Warren Buffett has worked and how much learning he’s done. But there are three other factors to his success that I would like to talk about and focus a little bit differently than he normally explains the way he invests. That is:

• Handicapping
• Compounding
• The Margin of Safety

These are three concepts that work together. He uses them in a slightly different way than he would think of describing them publicly; they’re all discussed in the book.

I’d like to take you through a case study on an investment called Mid-Continent Tab Card Co. This was a private investment that he did in his personal portfolio and this kind of shows you how I saw him invest based on his personal files and what he actually does, and I’ll update that up to the present day.

This company was an outgrow of IBM. And as you all know, in the 1950’s, Warren did not use computers but he was very aware of them. IBM was the only computer company of any size and importance at that time and Warren’s aunt Katie and uncle Fred decided to invest in Controlled Data which was a start-up company that was going to compete with IBM. Katie’s brother, who was Bell Norris was founding Controlled Data because he wanted to create a business where, he thought, that IBM is slow and bureaucratic. Warren told aunt Katie and Fred not to invest in Controlled Data. He said to them: Don’t do it. Who needs another computer company? Those were his famous last words.

They invested in Controlled Data anyway and they made a huge amount of money. And what was notable about this incident is that Warren told them not to invest because he actually knew a lot about IBM. He’d been studying IBM since 1952; it had been in court, embroiled in a trust case for being a monopoly. Warren studied their financials even though by then he already declared IBM outside his circle of competence. But he felt that even though IBM might have to be broken up someday, that its monopoly was so overwhelming ... that to compete with it would probably be futile. So what happened was that IBM did actually settle with the Justice Department. And as part of that settlement, it was required to divest of a business making tab cards. Continue to Part 4: Assessing Catastrophe Risk—A Quick Way to Say Yes or No