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If I were a rich man

‘There’s class warfare all right, but it’s my class, the rich class,
that’s making war, and we’re winning’. New York Times, 26th Nov2006

So said, with more than a hint of shame, the person revealed by Forbes magazine last month to be the world’s richest man – Warren Buffett. With a fortune estimated to be in the region of 62 billion dollars, Buffett is now a couple of billion ahead of the Mexican telecoms tycoon Carlos Slim, and four billion or so ahead of his friend and bridge partner, Bill Gates. Britain’s richest man, Labour Party donor Lakshmi Mittal, is fourth, one of 49 billionaires living in the UK. Buffett, dubbed the ‘Sage of Omaha’ because of his homespun wit and wisdom, is something of an enigma, a compulsive accumulator of wealth that he is in some respects embarrassed about. He may be the richest man in the world, but lives in the same house he bought for $31,000 when he was 28, exists on a diet of hamburgers, candy bars and Cherry Coke, and refuses to have more than one car (an old one, at that). In a world obsessed by conspicuous consumption, he is hardly a man given to ostentatious displays of wealth. From a very early age Buffett was fascinated by numbers, mathematical calculations and money, and was obsessed with becoming rich, to such an extent that according to Mary Buffett, as a child in 1938, ‘in the sweltering summer heat of Nebraska, he walked miles to the racetrack where he spent hours on his hands and knees scouring the sawdust-covered floors for discarded racing stubs, hoping to find a winning ticket’ (The New Buffettology). The son of a Nebraska stockbroker, he made his first stock market investment when he was eleven (three shares in a firm called Cities Service) and by the time he was old enough to go to college he had made $6,000. Harvard reject After his degree, Buffett applied to study at the prestigious Harvard Business School and was rejected. But this was a blessing in disguise for him, because he ended up going to Columbia University instead where he studied under Benjamin Graham, considered by many at the time (and plenty since) to have been the greatest investment analyst of the twentieth century. Graham wrote two seminal works: Security Analysis (co-authored with David Dodd) in 1934, and The Intelligent Investor, the original edition of which was published in 1949. The teachings of Graham, and these two books in particular, had a profound impact on Buffett, to such an extent that he eventually persuaded Graham to take him on at his own Wall Street investment firm (at one stage he even offered to work for free). When Graham retired in the 1950s, a homesick Warren Buffett returned to Nebraska to set up his own investment partnership. This was the real beginnings of his fortune, where he began to turn an initial investment of $105,000 collected from friends and family (only $100 of which was his own) into the $62,000,000,000 it is now. Buffett’s fund management fees were performance-related and by 1969, when he decided to close down the partnership, assets under management had grown to around $104 million, in which Buffett’s personal stake was over $20 million. By this time Buffett was convinced that a bear market was around the corner, where sustained downward pressure would be put on share prices after the end of the 1950s and 60s economic boom. But it was also in this period that Buffett laid the foundations for his greatest leap in wealth, taking over the company with which he has been synonymous ever since: Berkshire Hathaway. This ailing textile company was steadily bought up by Buffett and his partners typically for around seven to eight dollars a share and in 1965 they seized control of it. When Buffett dissolved his investment partnership he offered his partners a choice of either cash or a stake in Berkshire Hathaway. Those who took the shares instead of cash have seen them rise in price in the period since to the extent they currently trade in excess of $140,000 each on the New York Stock Exchange.

Woodstock for capitalists
So, how did Buffett really become so rich and help other Berkshire Hathaway shareholders to be the same? By being, in Buffett’s own words, in the right place, at the right time, but also by being the perfect capitalist. As Buffett would be the first to admit, he has never invented or made anything; indeed, he is very far from being the great all-American entrepreneur of popular mythology – he’s happy to let Bill Gates take that sobriquet. Instead, he is the most famous example of a phenomenon Friedrich Engels wrote about in the nineteenth century, where Engels identified that the key technical role that entrepreneurs played in the growth of capitalism was on the wane:

‘All the social functions of the capitalist are now performed by salaried employees. The capitalist now has no other social function than that of pocketing dividends, tearing off coupons, and gambling on the stock exchange, where different capitalists despoil one another of their capital.’ (Socialism: Utopian and Scientific).

In this sense, the capitalist class, as owners of capital who no longer have to work and whose key technical function in the rise of capitalism has been largely taken away, become functionaries of capital – and interestingly, Buffett has defined himself as being an ‘allocator of capital’ above all else. In this respect, Buffett is a very modern capitalist – an investor in companies and markets rather than an inventor of things. Every year, Berkshire Hathaway shareholders arrive in Nebraska for their annual shareholders’ meeting to pay homage to Buffett and his side-kick Charlie Munger in an event they call ‘Woodstock for capitalists’; there is little entrepreneurial spirit to be seen, for there is no need.

Meet ‘Mr Market’
Buffett used Berkshire Hathaway as an investment vehicle, using it to take over insurance companies and other firms that generated steady cash flow. In owning firms outright, he was able to mitigate his exposure to the stock market when he felt it necessary. Over time, though, Buffett used Berkshire’s excess cash to selectively buy back into stocks.

In doing so, he abided by the investing principles handed down to him by his mentor, Ben Graham, often referred to as ‘value investing’. In essence, this meant investing in companies based on their real value and assets (and their ability to grow them) rather than what was likely to happen to their short or medium-term share price. Graham and Buffet both took the view that value and price were not identical, even if they gravitated in the same direction over the long-term (leading Graham to famously comment that ‘in the short run the stock market is a voting machine but in the long run it’s a weighing machine’).

In particular, Graham and Buffett took issue with the academic theory known as ‘Efficient Markets Hypothesis’. This theory states that stock market prices (allegedly like all other prices) are efficient, in that all known information is reflected in them so that it is impossible for significant market inefficiencies to occur, and impossible for any investor to ‘beat the market’ in the long run through anything other than pure luck.

Ben Graham had attacked this view with his parable of ‘Mr Market’, an agreeable potential business partner who is always ready on any given day to do a deal over a business or share of a business so long as he can name the price. One Graham and Buffett acolyte has explained the concept this way:

‘Mr Market is bipolar. Our partner goes through gigantic mood swings from the highest euphoria to the lowest depression. Most of the time Mr Market is taking his meds, and on most days he’s pretty lucid about the prices he sells and buys at. That means most of the time the price of a business is pretty close to its value. But sometimes he can get so insanely optimistic that he prices everything insanely high. On other days Mr Market can get so depressed that, unlike Annie, he’s convinced the sun will not come up tomorrow . . .
It’s kind of a shame to take advantage of someone who’s emotionally unbalanced, but then again, he doesn’t seem to mind. He’s been bipolar for so long he just thinks it’s normal. He doesn’t honestly think that he’s mispricing anything, even if one day the price is $100 a share and just a few months later it’s $10. And if you ask the professors who study Mr Market, they’ll tell you the guy is fine.’ (Phil Town, Rule 1.)

In essence, this is how Buffett has made most of his money – by realising that the market economy isn’t intrinsically an efficient allocator of resources and is driven by wild swings of sentiment that often belie underlying reality. In the great bear market of 1973-4, when stocks in the US more than halved in price measured by the S & P 500 index, and fell by nearly three-quarters in the UK, Buffett said he felt ‘like an over-sexed guy in a whorehouse’. He invested massive amounts and saw share prices recover within a year or so, despite no significant change in the performance of the underlying economy or the companies within it.

Buffett is no lover of the free-market and has made much of his money through exploiting the fact that capitalism isn’t nearly the competitive ideal that many of its fiercest advocates assume. Illustrative of Buffett’s approach is the type of company he has used Berkshire Hathaway to buy into: those he identifies as having an economic ‘moat’, a durable competitive advantage or quasi-monopoly position that their competitors (if they have any) cannot easily breach. Buffett hates, and steers clear of, companies that operate in price-competitive markets, as they are the most vulnerable to the vicissitudes of the capitalist economy and those whose growth is least assured and steady over time. Instead, he typically invests in companies that have very different characteristics – for example, firms:

that achieve dominance through having strong brands that involve repeat buying (Buffett has been a major shareholder in both Coca-Cola and Gillette),
that can exercise control over a service through which they allow access by charging others for the privilege (such as some utility network companies),
that secure massive forward orders based on major long-term contracts, typically with the state sector, for outsourcing, regeneration, etc.,
that have a product that becomes so all-pervasive that switching to a competitor isn’t worth the trouble (Microsoft),
that have a company secret such as a patent that acts as a barrier to entry for other firms (e.g. Intel, GlaxoSmithKline),
that have such economies of scale they can undercut their competitors and achieve market dominance (e.g. Wal-Mart in the US and a recent Buffett buy in the UK, Tesco).

When these type of firms are mispriced in the stock market because of negative sentiment – giving what Graham called a ‘margin of safety’ to the buyer – then Buffett starts accumulating shares. Companies with an economic moat typically grow their profits well in excess of 10 per cent per annum on average; indeed, Buffett usually looks for firms that can grow their ‘book value’ and profits at 15 per cent, potentially giving him a huge compounded return over the years, especially if he has already bought them well below their real value. And he has declared his favourite holding period for such companies to be ‘forever’ (Buffett rarely involves himself in short-term speculation and when he does it tends to be through taking advantage of arbitrage opportunities, again based on market mispricing).

In many respects, Buffett probably has a better understanding of how capitalism works than most other supporters of it. While, for instance, he understands the need of workers to organise themselves in trade unions so as to defend their interests, he is apparently wary about investing in highly unionised companies:

‘The inherent financial weakness of the price-competitive business has given organized labor enormous power to demand a higher cut of a company’s profits . . .  in situations like these, unions become demanding semi-owners with whom shareholders must constantly share their wealth or risk a strike that could lead to the financial destruction of their business. Warren doesn’t like to own businesses that have organized labour.’ (Mary Buffett, The New Buffettology).

This quote illustrates that Buffet knows perfectly well what is going on in the struggle between capital and labour (and which side he necessarily sits on).

One of the many ironies of Buffett’s life is that he has accumulated capital for the sake of it, very much as the system demands, yet has never really known what to do with his vast personal wealth; he spends very little of it and doesn’t believe in inherited wealth either. So in 2006 he declared he was going to give away at least $30 billion of his fortune to the Bill Gates Foundation, so that it could be spent improving healthcare across the world.

In many ways this was a noble gesture, and a more generous act than anything from most of the world’s other rich men, yet it is the very system in which he is a proud ‘allocator of capital’ that leads to world poverty and lack of decent healthcare in the first place. Buffett has recently attacked the Republican administration in the US on the grounds that it is obscene that he pays less of a proportion of his income in tax than someone on the minimum wage. Yet, above anyone else, Buffett should know that in capitalism, capital accumulates to those who have it and invest it. And it expands because those who are relatively poor (the working class) create value greater than they ever receive back in wages and salaries, with this ‘surplus value’ created by those who have to work for a living sustaining those who don’t, generating rent, interest and profit for the system as a whole than can be reinvested in the capitalist treadmill. In the market economy, the rich are rich because the poor are poor. Indeed, companies grow because the rich are rich and exploit the poor, and it can’t work any other way.

Mr Buffett may be a highly intelligent man and a great philanthropist, but the bipolar extremes characteristic of Mr Market are no way to run a sane society, but are characteristic instead of a system where only a minority can be winners and they depend for their position on the vast majority being losers. And no amount of well-intentioned philanthropy is ever likely to change it.