In June 1960, an anonymous tipster called American Express to expose a massive fraud at Allied Crude Vegetable Oil Refining Corporation. At the time, Allied was the largest customer of American Express’s field warehousing subsidiary, which was in the unenviable position of having guaranteed millions of dollars’ worth of Allied’s soybean oil inventory.
The tipster, whom American Express employees called “the Voice,” said he worked the night shift at Allied’s facility in Bayonne, New Jersey. He challenged American Express employees to inspect Tank No. 6006, one of the largest tanks on the property. He explained that there was a narrow metal chamber filled with oil positioned directly under the measuring hatch. Everything else in the tank was seawater.
In this excerpt from
Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism, hedge fund manager and Columbia Business School professor Jeff Gramm explains why a bet on American Express’s recovery from the “Great Salad Oil Swindle” became one of the defining moments in Warren Buffett’s career.
Warren Buffett makes investing sound easy. Part of his investment philosophy comes directly from Benjamin Graham: He views shares of stock as fractional ownerships of a business, and he buys them with a margin of safety. But unlike Graham, when Buffett finds a security trading at a large discount to its intrinsic value, he eschews diversification and buys a large position. To Buffett, with his superhuman gift for rational thinking, this value investing strategy is easy. For the rest of us mere mortals, it is a minefield littered with the corpses of its practitioners. It is very hard to avoid career-imploding mistakes with a hyperconcentrated value investing strategy. Buffett is the exception that proves the rule.
Every year, I make a pilgrimage to Omaha to hear Buffett and his partner, Charlie Munger, take questions for six hours at the Berkshire Hathaway shareholders’ meeting. I never tire of hearing them talk about business and industry. I don’t even mind listening to them discuss politics and macroeconomics. When they philosophize about value investing, however, it makes me a little uneasy.
To be clear, Buffett and Munger don’t say anything about value investing that isn’t true. They are right that you don’t need a superhigh IQ to be a successful investor. They are right that it is relatively easy to evaluate the competitive dynamics of an industry and value companies. They are right that, if you are patient enough, the market will give you some fat pitches to swing at. And they are right that concentrating your portfolio into your very best ideas will give you the best outcome if you do good work.
Every tenet of Buffett’s value investing strategy holds true, but there’s a cruel irony to contend with: Buffett-style investing is tailor- made to magnify irrational thinking. Nothing is going to coax out the inherent irrationality of a portfolio manager — his or her weakness to the forces of greed and fear — like supersize positions. Munger once said he would be comfortable putting more than 100% of his net worth into one investment. Most of the earnest business school students attending the Berkshire Hathaway meeting wouldn’t stand a chance if they started investing like that. Investors need ice water in their veins to make concentrated value investing work.
Buffett’s biography, The Snowball, is not the story of an everyman from America’s heartland succeeding on just hard work and determination. Buffett is a singularity, and even his worst mistakes tell an interesting story. Berkshire Hathaway, for instance, was a bad investment. The company featured a lethal combination of high capital intensity and low returns on invested capital. In other words, you had to put a lot of money back into the business for little, if any, return. Yet Buffett somehow parlayed Berkshire into one of the most valuable companies in the world, with more than 340,000 employees.
Buffett’s biggest triumph
Berkshire Hathaway is itself an anomaly, just like the man who built it. It is a huge, decentralized, global conglomerate that somehow retains a corporate culture of excellence. Berkshire’s business model is simple — find good businesses run by capable managers, let them do their jobs, and then harvest the cash flows. Like Buffett’s value investing strategy, it is intuitive, it generates incredible results, and nobody else does it nearly as well.
It’s hard to believe there was ever a time when Buffett’s aptitude for business was anything but superhuman. We think of him as a fully formed portfolio manager from the moment he launched his first investment partnership in 1956, when he was only twenty-five years old. He compounded wealth for himself and his investors at an astounding rate over the next twelve years and never suffered a losing year. Despite this stellar track record, the Buffett Partnerships were very much a work in progress. Buffett was constantly refining his investment style, even toying with short selling and pair trades at one point. As he told the New York Times in 1990, “I evolved. I didn’t go from ape to human or human to ape in a nice, even manner.”
Buffett learned lessons from his mistakes as well as his victories. His biggest triumph was American Express. It proved to be a major turning point in his career.
The Great Salad Oil Swindle was an audacious fraud that nearly toppled American Express in the 1960s. It is a complicated story filled with valuable lessons about the fallibility of businessmen, and their capacity to ignore reality at critical junctures. While the saga exposes terrible behaviour and a true villain, it features many more honest and capable people who unwittingly developed deadly blind spots. The fallout from the fraud also pitted Buffett against a handful of shareholders who wanted American Express to maximise its short-term profits by ignoring salad oil claimants.
When Buffett intervened at American Express as a large shareholder, he didn’t demand board representation or ask probing questions about the company’s operating performance. He didn’t call for a higher dividend or question the company’s capital spending. Instead, he wanted American Express to use its capital liberally to recompense parties who were defrauded in the swindle. Buffett had done enough research on American Express to understand that it was a phenomenal business. He would later refer to companies like this as “compounding machines,” because they generate huge returns on capital that can be reinvested at the same rate of return. Buffett knew that walking away from the salad oil claims would damage American Express’s reputation and its substantial long-term value. He wanted to prevent short-term-oriented shareholders from jamming the compounding machine’s gears just to save a few dollars. This was a new position for Buffett to be in. Before he bought American Express stock, Buffett was the kind of penny-pinching investor who sought to extract value from his stock holdings as quickly as possible.
The typhoon will pass
American Express lost $125 million in market value after the swindle became public. It eventually reached an agreement with salad oil claimants that would cost only $32 million net of taxes. But a funny thing happened on the way to resolution: American Express’s settlement was delayed by an unlikely group — the company’s own shareholders. A small group of shareholders filed suit to block any settlement, on the grounds that American Express had no legal obligation to pay the warehousing subsidiary’s liabilities. Howard Clark may have felt he had a moral obligation to creditors, but shareholders argued that American Express legally owed nothing. They believed paying a cash settlement was a “gift” and a negligent use of assets that would damage shareholder value. They were especially frustrated that holders of forged receipts would receive any cash at all.
When public company shareholders don’t have opinions, or hold them tighter than they hold their stocks, the few who choose to speak up are afforded a tall soapbox. But if an empowered few assume the voice of all shareholders, how can we be sure they are looking out for committed, long-term owners? The outsize influence of active shareholders probably weighed on Buffett’s mind when American Express holders began agitating for the company to ignore the salad oil claims. Buffett knew the odds of this happening were slim, but why risk letting a handful of shareholders dominate the debate?
In Buffett’s early years, he occasionally clashed with management teams and boards of directors of underperforming, asset-rich companies. When he was forced to go active, it often meant seizing control and dismantling assets. At Dempster Mill, for example, he generated shareholder value by taking money out of the business as quickly as possible. American Express was a different situation altogether. Management was making the right moves to protect the franchise, yet other shareholders were agitating to block them. The swindle generated national news coverage and many of the claimants were large financial institutions that sold American Express travellers checks. Buffett worried that shareholders’ shortsighted attempt to avoid a settlement could permanently impair American Express’s valuable brand. With a quality business at stake, Buffett wanted to intervene to protect the company’s competitive advantage.
Republished with permission from
Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism, by Jeff Gramm. Copyright © 2016 by HarperBusiness. All rights reserved.