An example of good balance sheet analysis and some activism
In his 1959 Partnership Letter, Warren Buffett wrote to his investment partners that he had found a special opportunity to invest in. As it later turned out, this opportunity was a company called Sanborn Map Company. Buffet didn’t disclose the name of this company until 1961 (3 years later). This was after he was done with the investment and had made his money. According to Buffett this opportunity was such an obvious bargain that he was going to put a substantial amount of money in it:
“Late in the year we were successful in finding a special situation where we could become the largest holders at an attractive price . . . This new situation . . . represents about 25% of the assets of the various partnerships. While the degree of undervaluation is no greater than in any other securities we own (or even less than some) we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation. In this particular holding we are virtually assured of performance better than that of the Dow-Jones for the period we hold.”
As said, Buffett did not mention the company by name. He was very secretive about his investments in general. Of course, he wanted to be certain that no one was able to copy his investment style. Why this secrecy? Well, information is key in the investment world. If you’ve analyzed a company correctly and diligently and have found information in it’s financial reports that is not reflected by the market value of the company, you can make a substantial amount of money. And Buffett certainly did a good job of analyzing this particular company.
Indeed, we now know that this company was the Sanborn Map Company. Sanborn Map was a company that made maps (obviously). But these weren’t any old maps, they were specialized maps aimed at fire insurance companies. They were, thus, highly sophisticated maps of cities that included minute details about the buildings and their surroundings. These were then used by fire insurance companies to assess risk and determine the price of insurance.
Sanborn was a company with a long history dating back to the 1860’s. It was a profitable company with a large market-share, and for a long time it had a competitive advantage in its industry. But as is often the case, technology came along and started eating away at Sanborn’s profits. From around 1950 to 1958 the company’s steady net income was in decline. It was actually declining by around 10% each year. It went from ca. $700,000 in 1950 to ca. $300,000 in 1958. This happened, party, because fire insurance companies started using a technique called carding. This was a formulaic approach to insurance, not based on the structure and surroundings of a building, but on the building’s costs.
So back to this investment. A year later, in 1960, Buffett wrote that his stake in the company had now increased from 25% to 35% of his partnership’s total assets at the time. Why would Buffett put money in a company of which earnings were slowly declining without hope of recovery? Buffett himself gave a hint as to why in his 1960’s letter to his partners:
“In effect, this company is partially an investment trust owning some thirty or forty other securities of high quality. Our investment was made and is carried at a substantial discount from asset value based on market value of their securities and a conservative appraisal of the operating business.”
It turned out that, over the years, Sanborn had invested a part of their money in some stocks. In 1958, the company was being valued on the market at a price of $4.7 million. Buffett diligently read Sanborn’s financial statements and noticed that the stock portfolio they held was being valued at $2.5 million. Big deal, you might think. Here’s a company that is losing 10% of its net profit every year. Granted, they have a sound investment portfolio, but is the rest of the company really worth $2.2 million? Here’s the kicker. When Buffett looked at the footnotes of the financial statements he noticed that those $2.5 million of investments that Sanborn held were valued at cost. It turned out that their market value at the time (in 1958) was about $7.2 million! So here was a company that was trading at a value far below the worth of just their stock portfolio. In essence, you could buy the whole company for $4.7 million, and in return would receive a stock portfolio of $7.2 million plus the rest of the company.
In addition, Buffett realized that although the company was not as profitable as it used to be, it was still making money and had the potential to be turned around. Maybe not to the heights of it’s glory days, but good management decisions could still cause the company to provide adequate returns. After all, Sanborn still had valuable maps and valuable information in its possession and it should be possible to utilize that in some other way.
It was a win-win scenario. The only thing that was needed was a Board of Directors that would be willing to realize the potential for it’s shareholders. Buffett, unconvinced that the board of directors was willing to facilitate the necessary change, acquired enough shares to get a board seat and a substantial voting stake. In his 1961 letter the partners he explains:
“There was considerable opposition on the Board to change of any type, particularly when initiated by an outsider, although management was in complete accord with our plan . . . To avoid a proxy fight . . . a plan was evolved taking out all stockholders at fair value who wanted out. The SEC ruled favorably on the fairness of the plan . . . The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.”
Buffett eventually managed to exercise his plan for the company and pocketed an impressive return on his investment. This episode in Buffett’s investment history should teach us to look at two important areas of focus when it comes to analyzing companies:
Even though a company is earning less and less money each year, rational management decisions can still make the company a financial success. A company doesn’t need to grow forever, it just needs to churn out good returns on investment.
2. Financial Statements:
Don’t just blindly trust the stock market price of a company. Sometimes you can discover value that others have overlooked by diligent evaluation of the financial statements of a company.
Of course, Buffett, over the years, has had many successful investments in different situations, but this particular investment is a great example of diligent work and the discovery of obvious value, not recognized by the market.