The Side to Play

New York City • 1954–1956

Howie was a “difficult” baby. Whereas Little Sooz had been quiet and placid, Howie was like an alarm clock you couldn’t turn off. His parents kept waiting for the clamor to lessen, but it only increased. The apartment suddenly seemed full and noisy all the time.

Of course, it was Big Susie who jumped to the sound of the alarm clock. Not even Howie’s howling nights distracted Warren much. In his little office in the apartment’s third bedroom, he could lose himself for hours in his thoughts.

At work he had become absorbed in a complicated new project that would become a seminal event in his career. Shortly after Warren joined Graham-Newman, the price of cocoa suddenly spiked from a nickel to more than fifty cents a pound. Over in Brooklyn, Rockwood & Co., a chocolate maker “of limited profitability,”¹ faced a dilemma. Its number one product was Rockwood chocolate bits, the kind of nuggets used in chocolate chip cookies, and the company couldn’t raise its prices much on this grocery item, so it began running a huge loss. However, with cocoa-bean prices so high, Rockwood also had a chance to unload the cocoa beans it already owned to reap a windfall profit. Unfortunately, the ensuing tax bill would eat up more than half those profits.²

Rockwood’s owners approached Graham-Newman as a possible buyer of the company, but Graham-Newman wouldn’t pay the asking price. So they turned instead to the investor Jay Pritzker, who had spotted a way to avoid the huge tax bill.³ What he realized was that the 1954 U.S. Tax Code said that if a company was reducing the scope of its business, it could pay no tax on such a “partial liquidation” of its inventory. So Pritzker bought enough stock to take control of Rockwood, choosing to keep the company going as a maker of chocolate bits, and to get out of the cocoa-butter business. He attributed thirteen million pounds of cocoa beans to the cocoa-butter side of the business, the amount of beans that would be “liquidated.”

Rather than sell the beans for cash, however, Pritzker offered them to the other shareholders in exchange for stock. He did so because he wanted their shares to increase his ownership of the company. So he offered them a good deal as an incentive—$36 worth of beans⁴ for shares that were trading at $34.⁵

Graham spotted a way to make money from this offer—Graham-Newman could buy Rockwood stock and swap it to Pritzker for cocoa beans it could sell to make a $2 profit on every share. This was arbitrage: two nearly identical things trading at a different price, which enabled a canny trader to simultaneously buy one and sell the other and profit on the difference, with virtually no risk. “In Wall Street the old proverb has been reworded,” as Buffett wrote later. “Give a man a fish and you feed him for a day. Teach a man to arbitrage and you feed him forever.”⁶ Pritzker would give Graham-Newman a warehouse certificate, which is just what it sounds like: a piece of paper that says the holder owns so many cocoa beans. It could be traded like a stock. By selling the warehouse certificate, Graham-Newman would make its money.

Virtually no risk, however, means there is at least some risk. What if the price of cocoa beans dropped, and the warehouse receipt was suddenly worth only $30? Instead of making two dollars, Graham-Newman would lose four bucks for every share of stock. To lock in its profit and eliminate that risk, Graham-Newman sold cocoa “futures.” It was a good thing, too—for cocoa prices were about to drop.

The “futures” market lets buyers and sellers agree to exchange commodities like cocoa or gold or bananas in the future at a price agreed upon today. In exchange for a small fee, Graham-Newman could arrange to sell its cocoa beans at a known price for a specified period of time, thus eliminating the risk that the market price would drop. The person on the other side of the trade—who was acquiring the risk that the price would drop—was speculating.⁷ If cocoa beans got cheaper, Graham-Newman was protected, because the speculator would have to buy Graham-Newman’s cocoa beans for more than they were worth.⁸ The speculator’s role, from Graham-Newman’s perspective, was to sell what amounted to insurance against the risk of the price dropping. At the time, of course, neither knew which way cocoa prices would move.

Thus, the goal of the arbitrage was to buy as many Rockwood shares as possible while at the same time selling an equivalent amount of futures.

Graham-Newman assigned Warren to the Rockwood deal. He was made for it; he had been arbitraging stocks for several years, buying convertible preferred stock and shorting common stock issued by the same company.⁹ For several weeks, Warren spent his days shuttling back and forth to Brooklyn on the subway, exchanging stock for warehouse certificates at Schroder Trust. He spent his evenings studying the situation, sunk in thought while singing “Over the Rainbow” to Little Sooz and shutting out the screams as Big Susie struggled to give Howie a bottle.

On the surface, Rockwood was a simple transaction for Graham-Newman: Its only cost was subway tokens, thought, and time. But Warren recognized the potential for even more “financial fireworks” than Graham-Newman had.¹⁰ Unlike Ben Graham, he did not do the arbitrage. Thus he did not need to sell cocoa futures either. Instead, he bought 222 shares of Rockwood stock for himself and simply kept it.

Warren had thought through Pritzker’s offer carefully. When he divided all the beans Rockwood owned—not just the beans attributed to the cocoa-butter business—by the number of Rockwood shares, it amounted to more than the eighty pounds per share that Pritzker was offering. So people who did not turn in their shares would end up with stock worth more cocoa beans per share. Not only that—all the extra beans left on the table by those who did turn in their stock would bump up the number of beans per share even more.

Those who kept their stock would also profit because they wound up with a share of the company’s plant, its equipment, money due from customers, and the rest of the Rockwood business that was not being shut down.

Warren had inverted the situation, thinking about it from Pritzker’s point of view. If Pritzker was buying, he wondered, why did it make sense to sell? And after doing the math, he could see that it didn’t make sense. The side to play on was Pritzker’s. Warren had looked at the stock as a little slice of the business.

With fewer shares outstanding, his slice was worth more. He was taking more risk than had he simply done the arbitrage—but he was also making a calculated bet with odds heavily in his favor. The $2 profit from the arbitrage was easy to earn, however, and riskless. When the price of cocoa beans dropped, the futures contracts protected Graham-Newman. They, and a significant percentage of other shareholders, accepted Pritzker’s offer and left a lot of cocoa beans on the table.

Hanging on to the stock, however, turned out to be a brilliant call. Those who played the arbitrage, like Graham-Newman, made their $2 a share. But Rockwood stock, which had traded for $15 before Pritzker’s offer, shot up to $85 after it was over. So instead of making $444 from his 222 shares, as he would have from the arbitrage, Warren’s calculated bet earned him an extraordinary sum—around $13,000.¹¹

In the process, he had also made a point of getting to know Jay Pritzker. He figured anybody smart enough to have figured out that deal “was going to do more smart things later.” He went to a shareholders’ meeting and asked some questions, and that was his introduction to Pritzker.¹² Warren was then twenty-five, Pritzker thirty-two.

Even working with a relatively small amount of capital—less than $100,000—Warren saw that by using this kind of thinking he could open up a world of possibilities for himself. His only constraints were the money, energy, and time he had available. It was lumberjack labor, but he loved doing it. This was nothing like the way most people invested: sitting in an office and reading reports that described research performed by other people. Warren was a detective, and he naturally did his own research, just as he had collected bottle caps and thought about fingerprinting nuns.

To do his detective work he used the Moody’s Manuals—Industrial, Banks and Finance, and Public Utility. Often he went down in person to Moody’s or Standard & Poor’s. “I was the only one who ever showed up at those places. They never even asked if I was a customer. I would get these files that dated back forty or fifty years. They didn’t have copy machines, so I’d sit there and scribble all these little notes, this figure and that figure. They had a library, but you couldn’t select from it yourself. You had to request things. So I would name all these companies—Jersey Mortgage, Bankers Commercial, all these things that nobody’d ever requested, ever. They’d bring them out, and I’d sit there taking notes. If you wanted to look at SEC documents, as I often did, I went down to the SEC. That was the only way to get them. Then, if the company was nearby, I might very well go see the management. I didn’t make appointments ahead of time. But I got a lot done.”

One of his favorite sources was the Pink Sheets, a weekly printed on pink paper, which gave information about the stocks of companies so small that they were not traded on a stock exchange. Another was the National Quotation book, which came out only every six months and described stocks of companies so minuscule that they never even made it into the Pink Sheets. No company was too small, no detail too obscure. “I would pore through volumes of businesses and I’d find one or two that I could put ten or fifteen thousand dollars into that were just ridiculously cheap.”

Warren was not proud; he also felt honored to borrow ideas from Graham, Pritzker, or any useful source. He called that riding coattails and did not care whether the idea was glamorous or mundane. One day he followed up on a lead of Graham’s, the Union Street Railway.¹³ This was a bus company in New Bedford, Massachusetts, selling at a big discount to its net assets. Through some legwork and a visit to the company’s management,¹⁴ he made about $20,000 profit on this one stock in just a few weeks.

Nobody in the history of the Buffett family had ever made $20,000 on one idea. In 1955, that was several times more than the average person earned for a whole year’s work. Doubling your money and then some for a few weeks’ work was spectacular. And yet, what was more important to him was doing it without taking any significant risk.

Susie and Warren did not talk about the details of cocoa-bean arbitrage and bus-company stocks. She wasn’t interested in money, except as something to be spent. And what she knew was that even though waves of money were rolling in to the little apartment in White Plains, Warren gave her only a small household allowance. She hadn’t grown up keeping track of every tiny expense, so being married to a man who saved money by making deals with newsstands to buy week-old magazines meant a whole new way of life. She did her best to manage the household herself, but the disparity between what Warren was making and what he gave his wife had become stunning. One day she telephoned her neighbor Madeleine O’Sullivan in a panic.

“Madeleine, something terrible has happened,” she said. “You’ve got to come down here!” Madeleine rushed down to the Buffett apartment and found Susie distraught. She had accidentally thrown a batch of dividend checks that had been sitting on Warren’s desk into the apartment’s incinerator chute, which led straight down to the building’s furnace.¹⁵

“Maybe the incinerator isn’t running,” Madeleine said, so they called the building superintendent, who let them into the basement. Sure enough, the incinerator was cold. They rooted through the garbage looking for the checks, with Susie all the while wringing her hands and saying, “I can’t face Warren.” When they found the checks, Madeleine’s eyes grew wide. They were for as much as thousands of dollars, not $25 or $10 as she had assumed.¹⁶ The Buffetts, living in the little apartment in White Plains, were getting truly rich.

Warren’s brilliant performance at Graham-Newman had made him the golden boy of the firm. Ben Graham took a personal interest in Warren, and in his warmly outgoing and beleaguered wife. Graham had given them a movie camera and projector as a baby gift when Howie was born, and even showed up at their apartment with a teddy bear for the little boy.¹⁷ On one or two occasions when he and his wife, Estey, had the Buffetts over for dinner, he noticed that Warren gazed googly-eyed at Susie, and that the two of them held hands a lot. But he could also see that Warren did not woo his wife, and that Susie might have liked the occasional romantic gesture.¹⁸ When Susie mentioned with longing that Warren did not dance, Graham dropped by Warren’s desk with a gift certificate to the Arthur Murray dance studio in White Plains, where Graham clumped around the dance floor during his own lessons. Graham checked with the studio a little later and found that his protégé had never used the gift certificate. He mentioned this to Warren and encouraged him to go ahead. Now on the hook, Warren stumbled through three lessons with Susie, then dropped out. He never did learn to dance.¹⁹

This didn’t get in the way of his rapid ascent at Graham-Newman. Within eighteen months of his starting there, both Ben Graham and Jerry Newman seemed to be treating Warren as a potential partner, which meant a certain amount of family socializing. In mid-1955, even the dyspeptic Jerry Newman extended an invitation to the Buffetts to what they thought was to be a “picnic” at Meadowpond, the Newmans’ mansion in Lewisboro, New York. Susie arrived wearing something suitable for a hayride, only to find the other women in dresses and pearls. Though they felt like a couple of hillbillies, the faux pas did nothing to hurt Warren’s golden boy status.

Walter Schloss was not invited to events like these. He had been pigeonholed as a journeyman employee who would never rise to partnership. Jerry Newman, who rarely bothered to be kind to anyone, treated Schloss with more than his usual contempt, so Schloss, married with two young children, decided to strike out on his own. It took him a while to get up the nerve to tell Graham,²⁰ but by the end of 1955 he had started his own investment partnership, funded with $100,000 raised from a group of partners whose names, as Buffett later put it, “were straight from a roll call at Ellis Island.”²¹

Buffett was certain that Schloss could apply Graham’s methods successfully and admired him for having the guts to set up his own firm. Though he worried that “Big Walter” was starting out with so little capital that he would not be able to feed his family,²² Buffett put not a dime of his own money into Schloss’s partnership, just as he had not invested in Graham-Newman. It would be unthinkable for Warren Buffett to let someone else invest his money.

He did find someone to replace Schloss, however. Buffett had met Tom Knapp at a luncheon at Blythe and Company down on Wall Street.²³ Ten years older than Warren, tall, handsome, dark-haired, blessed with a wicked sense of humor, Knapp had taken one of David Dodd’s night courses and gotten hooked; he changed his major from chemistry to business on the spot. Graham hired Knapp as the second gentile in the firm. “I told Jerry Newman, ‘It’s the old story—you hire one gentile, they take over the place,’ “ Buffett says.

By the time Knapp was sitting at Walter Schloss’s old desk next to Buffett, Warren had begun to be aware of the private side of Graham’s life. Knapp himself got initiated when Graham invited him to watch a speech at the New School for Social Research, where, he says, he found himself seated at a table with six women. “As Ben spoke,” Knapp says, “I became aware that each one of those women was in love with him. And they didn’t seem to be jealous of each other, and they all seemed to know him very, very well.”²⁴

Indeed, by early 1956, Graham was bored by investing: His outside interests—women, the classics, and fine arts—tugged at him so strongly that he had a foot out the door. One day when Knapp was out, the receptionist directed a gangly young man into the windowless lair where Warren was filling out forms. Looming over him was Ed Anderson, who explained that he was a chemist, like Knapp, not a professional investor. He worked at the Livermore Laboratory of the Atomic Energy Commission in California, but followed the market in his spare time. He had read The Intelligent Investor, with its copious examples of cheap stocks like Easy Washing Machine, and was wildly impressed. My God! he thought. That can’t be true. How could you buy these companies for less money than they had cash in the bank?²⁵

Intrigued, Anderson had been riding Graham’s coattails. After buying a single share of Graham-Newman, he used its quarterly statements to figure out what Graham was doing, then bought those stocks. Graham never discouraged this; he liked other people to learn from and emulate him.

Anderson had come in because he was thinking about buying another share of Graham-Newman, but he had noticed an oddity and he wanted to ask about it. Graham had loaded up on shares of American Telephone & Telegraph. It was the least Graham-like stock imaginable—owned, studied, and followed by all, valued fairly, with as little potential as it had risk. Was something going on? he asked Warren.

Warren thought for a second. It was impressive that this man with no business background—a chemist—had the perception to see that AT&T was out of pattern. Too many people thought that “business” was some sort of priesthood practiced only by those with special training. He said to Anderson, “This might not be the best time to buy another share.”²⁶ They chatted a bit longer and then parted in a friendly way, intending to keep up the acquaintance. Warren was very glad that his friend Schloss had gone out on his own. From watching the firm’s trading patterns and keeping his ears open, he had already figured out that Graham was going to shut down his partnership.

Ben Graham’s career was coming to an end. He was sixty-two years old, and the market had surpassed the peak of 1929.²⁷ Its priciness made him nervous. He had beaten the market by 2.5 percent for more than twenty years.²⁸ He wanted to retire and move out to California to enjoy life. Jerry Newman was also retiring, but Mickey, Jerry’s son, would stay on. In the spring of 1956 Graham gave notice to his partners. But first he offered Warren the opportunity to become a general partner in the firm. That he would choose someone of Warren’s age and experience shows how valuable he had made himself in such a short time. Nevertheless: “If I had stayed I would have been sort of the Ben Graham of it, and Mickey would have been the Jerry Newman of it—but Mickey would have been the senior partner by miles. It would have been called Newman-Buffett.”

Even though Warren was flattered, he had gone to Graham-Newman to work for Ben. Without Ben there, it wasn’t worth it to him to stay, not even to be thought of as Graham’s intellectual heir. Moreover, all the while that he was carrying out the bus bell-ringer and the cocoa-bean caper he was thinking, “I don’t like living in New York. I’m on the train back and forth all the time.” Above all, he was not cut out to work with a partner—least of all as someone’s junior partner. He turned the offer down.