Handicapping—The One or Two Factors that Could Make the Horse Succeed or Fail

This is Part 5 of a Series. Go to Part 4: Assessing Catastrophe Risk—A Quick Way to Say Yes or No

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.

Everybody that I know or knew as an analyst would have created a model for this company and would have projected out earnings and would have looked at its return on investment in the future. Warren didn't do that, in fact in going through hundreds of his files, I've never seen anything that resembled a model. What he did is: he did what you would do to a horse. He figured out the one or two factors that could make the horse succeed or fail. And on this case, it was sales growth and making the cost advantage continue to work.

Okay, so now, Warren is interested. Because the catastrophe risk element of the equation is gone. They are competing successfully against IBM. So he asked them the numbers and they explained to him that they were turning their capital over seven times a year. So a Carroll press costs $78,000. Every time they run off a set of cards through and turned their capital over, they’re making over $ 11,000. So basically, their gross profit a year on a press is enough to buy another printing press.

At this point, Warren’s very interested. Their net profit margins are 40%. It’s like the most profitable business that he’s ever had the opportunity to invest in. Notably, people are now bringing Warren special deals. It’s 1959. He’s been in the business two and a half years running the partnership. Why are they doing that? It’s not because they know he’s a great stock picker. They don’t know that. He hasn’t yet made that record. It’s because he knows so much about business, and because he started so early that he has a lot of money. So this is something interesting about Warren Buffett. By 1959, people are already bringing him special deals like what they’re still doing today with Goldman and G.E.

He decided that he would come in and invest in this company, Mid-Continent Tab Card Co. but interestingly, he did not take Wayne and John’s word for it because the numbers they gave him were really enticing but again, he went through and acted like a horse handicapper.

Now here's another point of departure from what almost anybody else would do. Everybody that I know or knew as an analyst would have created a model for this company and would have projected out earnings and would have looked at its return on investment in the future. Warren didn't do that, in fact in going through hundreds of his files, I've never seen anything that resembled a model. What he did is: he did what you would do to a horse. He figured out the one or two factors that could make the horse succeed or fail. And on this case, it was sales growth and making the cost advantage continue to work. Continue to Part 6: Buffett’s “Discounted Cash Flow Model”