Book Extract: Buffett’s Early Investments by Brett Gardner

The field warehouser would ensure that the inventory existed and had value and would write out a receipt for the value of the inventory. The borrower would take the receipt to a bank to get a loan, allowing the bank to earn interest while the warehouser earned revenue through storage fees paid by the borrower.

The warehouser guaranteed the value of the inventory and was responsible if the amount was less than the amount certified. In one sense, then, a field warehouser was a simple financial guarantor earning what it considered to be ‘easy’ insurance premiums for guaranteeing what it considered to be ‘easy’ risks, just as MBIA would do decades later.

Due to the success of its better-known Travelers Cheques and money order businesses, American Express’s leadership thought entering field warehousing was a logical extension of its operations. The company’s treasurer at the time thought offering this service would allow banks to make loans they otherwise, wouldn’t consider, which would augment American Express’s vital relationship with the banks that sold its cheques and money orders. And so, in 1944 American Express incorporated the American Express Field Warehousing Corporation with $1 million of capital as a subsidiary of the parent. The entity was little more than an afterthought until 1957, when Tino De Angelis sought to become a client.

Ignoring common sense, American Express took him on. Shortly after becoming an Amex customer, De Angelis found himself indicted by the Justice Department for suborning perjury during the SEC’s investigation in 1953. An ex-employee of Gobel asserted that De Angelis had instructed him to lie when he testified that the stated value of the company’s inventories was accurate. Foreshadowing future events, Tino had even borrowed money against phantom inventories. The case collapsed when the employee changed his testimony.

But Tino’s skirmishes with authority piled up: After becoming a client of American Express, he would be fined and barred (and reinstated) from participating in certain programs by the Agriculture Department, mired in a quarrel with the IRS, and attacked as ‘disreputable’ by a senator. The ticking Tino time bomb aside, was field warehousing even worth the trouble for American Express? No. From 1944 to 1962, the warehousing subsidiary made money in ten years and lost it in nine, cumulatively producing a loss. The profit or loss never exceeded $101,000. Helped by Allied, its best year was 1959 when it earned a net profit of $98,871. In contrast, American Express’s total net income that year was $8.4 million. By the late 1950s, American Express Field Warehousing had around 500 accounts, with two responsible for all profits: Freezer House Corp. and Allied Crude Vegetable Oil Refining Corporation, both enterprises controlled by De Angelis, with Allied as the more important of the two.

The subsidiary became a source of tension within American Express, with some executives wanting to dispose of it. Some employees were aware that no one at the company knew enough about vegetable oils to value the inventory. Michael  Casserly, assistant secretary of the field warehousing subsidiary, thought having an Allied employee as a custodian was a foolish idea. Casserly also knew that underground pipes connected the tanks, providing an opportunity for fraud American Express also had plenty of specific warning signs that something was amiss. In June of 1960, the president of the field warehousing subsidiary, Donald Miller, received a call from an anonymous person who said Tino’s operation was a fraud. This person, who identified himself as “Taylor,” said he worked at Bayonne. Miller had several conversations with Taylor, who claimed that Allied’s tanks were filled not with valuable oil but with useless water.

Taylor pointed to Tank 6006, which he asserted had a metal chamber that went from the top of the tank to the bottom, while the rest was full of water. When an Amex inspector tested the tank, he would unwittingly drop his sampling device directly into the oil-filled chamber, leading to a sham measurement. In response to the tip, Miller sent four men to inspect Allied. They found water in the first five tanks checked. The water in the tanks ranged from one foot to eight feet in the 24-foot tanks, when no more than six inches (as a result of condensation) were supposed to be in there. As the inspection continued, they found unusual amounts of water in five more tanks, for a total of ten of the 70 tanks at Bayonne.

The tanks were connected through a series of pipes, and some of Allied’s ex-employees, now working as American Express custodians, had the keys for the tank locks. The inspection took place over several days. Over this period, the men were likely moving oil from tank to tank to hide the true water level from American Express Field Warehousing inspectors. They even allowed Tino’s employees to provide some of the tank readings. Despite this farce, American Express Field Warehousing concluded its inspection without taking action, comforted by their finding that there was still more than enough oil to cover the firm’s outstanding receipts. Miller was so naive that he later said, “We thought Allied would be as interested as we were in finding out if the tanks contained water.” Tino appeared apoplectic over the search, threatening to take his business elsewhere. His cousin, in fact, provided American Express with a letter ending the warehouse contract. While American Express, in theory, had all the leverage in the relationship—Tino needed Amex more than Amex needed him—the fat fraudster didn’t act that way: When Amex asked Tino for a balance sheet, he told them he couldn’t show it to them since it was a competitive secret.

In November, a man who identified himself as an associate of Taylor’s made a call to Howard Clark, who had become president and chief executive officer of American Express in April of that year. He was routed to Clark’s assistant, Hasbrouck Miller (unrelated to Donald). Taylor’s supposed associate said Donald Miller’s inspection was a joke and that Tino had fooled the inspectors.

After talking to other Amex employees about conducting a search without Donald’s knowledge, Hasbrouck concluded only Donald knew enough to perform a proper investigation. As a result, Hasbrouck called Donald, who took the extraordinary step of warning Tino about the calls. There was simply no interest within American Express in uncovering the fraud. And Bayonne’s inventories kept growing. In 1962, they rose from 165 million pounds in March to almost half a billion in September. By November, the field warehousing subsidiary had issued receipts for more than 400 million pounds, essentially guaranteeing $40 million worth of borrowing power, which Allied used to obtain loans from the largest banks in the country.

Finally, in early 1963, Clark decided the subsidiary was not worth American Express’s time and chose to dispose of it since he didn’t think it would be able to reach his target of $500,000 of profit per year. He decided to sell the business to Lawrence Warehousing Company for $1.1 million. However, Donald Miller persuaded him to keep his two largest clients, saying they had never had an issue with the Allied or Freezer House accounts, a clearly false assertion levied by an employee desperate to keep his job. He also stated, “The account has never falsely represented any fact or circumstances to us.” So, in May 1963, Clark sold the legacy subsidiary and incorporated American Express Warehousing Ltd. to handle only Tino’s business. A month before the formation of this new subsidiary, inventories at Bayonne hit 850 million pounds, and the predecessor subsidiary had issued receipts for 804 million... which was more soybean oil than the U.S. Census Bureau said existed in the entire country.

Clark continued grappling with what to do, wavering on whether field warehousing for only two clients was worth the risk. He went out to Bayonne to meet with Tino in July. Clark’s visit prompted him to ask the company’s auditor and American Express employees to review the controls and systems of the warehouse division, as he was concerned about the risks and adequacy of controls in place. American Express’s auditor, Haskins & Sells, recommended enhancing controls but stated, “In our opinion, on the basis of our review, the system of internal controls of American Express Warehousing is satisfactory.” Tino had fooled them, too.

Senior vice president N.F. Page said the probe demonstrated that there was enough oil on hand at Bayonne to exceed the warehouse receipts. Page also pointed out that Amex had $30 million of insurance. Although the last warehouse receipts covered $51.5 million of oil, he remarked, “It is inconceivable that $21.5 millions of oil could disappear without our knowledge.” Page wrote in a memo to the Amex president, “Our only risk is that of dishonest operations which we failed to detect and it is inconceivable that this could reach proportions greater than our insurance coverage.” Other executives, such as George Pfifer, urged Clark to dispose of the business, thinking the risk was too high. Plus, they found Tino difficult to deal with. Some credit officers responsible for a loan to Allied were frustrated when Tino failed to respond to their demands for additional collateral.

Between August 30 and September 27, the American Express Warehousing receipts for soybean oil went from 752 million pounds to 937 million pounds.190 American Express Warehousing issued almost $20 million of receipts during September 1963, bringing the total to $87.4 million.

Finally, Clark chose to get out of the business entirely. While the American Express CEO was concerned about the size of the account, the catalyst for his change of heart was that he thought some of his warehousing employees had been compromised. Donald Miller had owned shares in one of Tino’s companies, which led to his resignation. Other Amex employees had also bought stock in Tino’s companies and invested alongside him in his futures speculations.

Lawrence Warehousing, which bought the previous Amex field warehousing subsidiary, agreed to purchase the last two accounts, with the deal expected to close on December 1, 1963. American Express told Tino that it would no longer issue warehouse receipts since it was exiting the business, but would honor the old receipts. So, at the end of September, the warehousing subsidiary was only issuing receipts to replace previously issued ones. With a two-month gap until Lawrence took over, Tino was in a bind.

Tino solved his problem of not being able to receive additional warehouse receipts from American Express. He simply stole them. Tino began forging American Express Warehouse receipts on October 14.

Meanwhile, Tino’s buying on the futures exchanges continued to explode. His buying pushed prices higher, which made it less likely that a big order—which he needed to be able to unwind his trading—would come through. Commodity market rumors spread that the Soviet Union, after disastrous crops in Russia and Ukraine, would soon be forced to buy vegetable oil from the United States.

These rumors ignored the fact that the Soviet Union government had sold oil to Spain the month before, something it wouldn’t have done if there had been a shortage.

On Friday, November 15, 1963, Tino informed his aides that they couldn’t buy any more contracts as the company’s brokers were worried about the Congressional opposition to selling commodities to Russia. Allied’s brokers prevented the firm from buying more contracts, so Tino created dummy accounts. These accounts were supposed to post margin to a broker, but Allied got around this because a partner of the brokerage firm was away attending his father’s funeral. Tino also raised cash by forging orders to release the oil, leading to American Express issuing receipts that Tino could use to raise cash. The Commodity Exchange Authority, aware that Allied’s had been the vast majority of the buying on the Produce Exchange, sent an investigator to Bayonne to look at Allied’s books. News of the Senate suspending debate over Russian wheat without a deal being reached led to short selling that drove commodity prices down. Tino realized the jig was up and contacted a lawyer to help place Allied into receivership. Allied declared bankruptcy on Tuesday, November 19. When American Express learned about it, the company was unworried, comforted by its belief that there was enough oil to cover its receipts. Clark thought the company was also protected by $30 million of insurance coverage. But this nonchalance ended quickly: By the end of the week, the inspectors looked at the tanks and couldn’t find the soybean oil. Allied clients asserted that oil was missing, and it became clear that Tino had forged receipts. Bunge Corporation sued American Express’s subsidiary, claiming it had lost more than $15 million of its oil. The New York  Stock Exchange suspended two brokerage firms with exposure to De Angelis after Allied failed to meet its margin calls to them. What became known as the salad oil scandal was front page news. Tank 6006, the one Taylor warned about, was supposed to hold $3,575,000 worth of soybean oil. Instead, saltwater poured out of it for 12 days. And sure enough, the special chamber, which did hold a few hundred pounds of soybean oil, fell to the bottom of the tank.

Despite all this, American Express’s stock didn’t plummet immediately when news of the fraud broke. The stock closed at $62.19 the Friday before Allied’s bankruptcy and dropped to $60.81 the following Thursday. President John F. Kennedy’s assassination on November 22, 1963, rattled the entire market, with the Dow Jones Industrial index falling 2.9% and American Express declining 4.6% to $58.00 that day. But unlike the Dow, American Express kept falling as reports of the missing oil leaked out. Its stock ended the month of November 26.5% below where it traded the day before Lee Harvey Oswald fired his shot. In contrast, the Dow was up 2.4% over the same period.

After the fact, it emerged that people in the warehousing business had known that something was up, with one president of another warehousing company that didn’t operate at Bayonne later stating, “We heard about funny business at Bayonne for years. At the workingman level you often heard talk about it. All of the men who worked there were getting extremely high salaries. But we couldn’t prove anything, so we minded our own business.” These revelations came too late for American Express: Inspectors could now only find 134 million pounds of oil at Bayonne. Between the 878 million pounds of oil American Express issued receipts for with a stated value of approximately $82 million and the 395 million pounds worth of forged receipts worth $39 million, American Express had vouched for nearly 1.3 billion pounds of oil. Plus, Bunge had accused American Express Warehousing of losing 161 million pounds of oil worth around $15 million, bringing the total attributable to American Express to around $135 million.

Including the other companies Tino defrauded, there was a total shortage of 1,854,000,000 pounds of oil valued at $175 million. The banks and export companies, who were legally only creditors of American Express’s field warehousing subsidiary, looked to American Express (the parent company) for payoffs. Not only did the company have insurance and a large balance sheet, but it also couldn’t afford to tarnish its relationships with the banks or compromise its brand name. Throughout its history, American Express had relied on being trusted, allowing it to create enormous value across several business lines over the previous 113 years.

As if the situation wasn’t stressful enough, American Express shareholders did not possess limited liability. Due to its history in the express business, where a lack of disclosure was a competitive advantage, the company had never incorporated. This meant that creditors could go after individual shareholders if the company couldn’t pay its debts. On December 23, the Department of Justice indicted Tino. Receipt holders were stunned when American Express put its field warehousing subsidiary into bankruptcy on December 30, 1963. The subsidiary had slightly more than $130,000 in assets. American Express said this was only a procedural step, executed to flush out all receipt-holding creditors through the bankruptcy process. $210 million of claims arose.196 American Express’s consolidated equity at the end of 1963 was only $78.7 million.197 The future of the entire company seemed to be in doubt. By the end of the year, American Express stock had fallen to $38.63, down nearly 40% since November 15, erasing over $100 million from the company’s market capitalization.

What became known as ‘the salad oil scandal’ was a textbook case of management incompetence and stupidity, and investors abandoned the company in droves. The 33-year-old Buffett had kept his eye on the scandal since it broke, but he waited months to start buying. And he started building his investment—the best of the Partnership—during a particularly trying time for him and his family, as his father Howard lay hospital-ridden in the final weeks of his life in April 1964. To the extent he was known at all at the time, Buffett was known for his ability to find quantitative bargains among the semi-anonymous flotsam and jetsam of American capitalism, but American Express was an extremely well-known company.

Moreover, Buffett proceeded to write a remarkable letter to Clark in which he rather breezily absolved Amex management of any responsibility for the scandal, encouraged it to use shareholder money (which included Buffett’s) to pay creditors harmed by the scandal, and more or less encouraged Clark to forget the whole thing. Finally, and most importantly, Buffett continued adding to his American Express position long after the scandal had diminished in importance. By the time he sold his position years later, American Express had become the most important individual contributor to the results of the Buffett Partnership and arguably the biggest turning point in Buffett’s career.

Brett Gardner Buffett’s Early Investments: A new investigation into the decades when Warren Buffett earned his best returns Harriman House, Hampshire, 2024. Pb. Pp. 256 Rs 499

Buffett's Early Investments investigates ten investments that legendary investor Warren Buffett made in the 1950s and 1960s – earning him his first million – and uncovers unique insights in the process. Using the same documents Buffett used when he made these investments, the author reveals the fascinating inside stories of: How Philadelphia and Reading, Buffett’s largest investment in 1954, transformed from a declining coal company to a diversified conglomerate whose stock went up twentyfold due to the intervention of Buffett’s mentor, Ben Graham. How Buffett and Charlie Munger made their first formal investment together in Hochschild-Kohn. How corporate governance issues actually presented serious risk to Buffett’s 1966 investment in Walt Disney.

Other investments analysed include American Express, British Columbia Power, Cleveland Worsted Mills, Greif Bros, Marshall-Wells, Studebaker, and Union Street Railway. Not all of these investments worked out—this book shows why. Buffett’s Early Investments helps readers understand how history’s greatest ever investor really made his returns in the years where he produced his best numbers.

Despite the almost mythical origins of Buffett and Munger’s early business successes,making it seem as if picking stocks was almost effortless, with fat bargains just waiting forthe enterprising capitalist to pick up, Brett Gardner was sceptical that investing was as simple and easy as the two often made it sound. Therefore, he started researching some of Buffett’s earliest stock purchases. He discovered that Buffett’s investments were not as straightforward as he liked to make them seem. He realised that Buffett’s own overly simplistic characterisation of his investments often did a disservice to the intensity of the work he performed to amass his early fortune.

Broadly, Buffett’s career can be divided into two stages: 1) When he bought the ‘cigar-butt’ stocks that traded below asset value. This phase was primarily shaped by his teacher and mentor at Columbia University, Ben Graham (The Intelligent Investor). 2) When Buffett started buying better businesses, where he was heavily influenced by Charlie Munger and Common Stocks and Uncommon Profits author Phil Fisher. The investments in the first stage had more of their value derived from the balance sheet, while the companies bought in the later stage had more value dependent on the ability of the business to generate and grow free cash flow. In this second stage, business quality —the ability to sustainably earn high returns on invested capital – mattered more than in the first stage.

The author chooses to write about ten investments Buffett made in the 1950s and 1960s. These were selected based on three criteria: 1) The author’s ability to secure the proper documents for the investments. 2) To question whether his research was differentiated enough. His prime purpose being to write about investments that added value to existing Buffett research. 3) How interesting was the story behind the investment discussed? In order to do so, Gardner did not have access to Buffett’s trade data, instead he delved into public libraries and other archives that contained papers of years gone by. Usually, entire documents of corporates etc. He put together the ten case studies by wading through empirical evidence.

Based on his research, he concluded that four factors drove Buffett outperformance in this period of his career:
1. Buffett’s use of activism helped him generate spectacular profits. He took significant positions in companies and influenced management teams to change corporate policy to help close the price-to-value gap.

2. Buffett ran a highly concentrated portfolio, occasionally investing more than 20% of his fund in a single investment idea. Great investment ideas are rare; Buffett seized on them whenever he uncovered them.

3. Buffett was a tenacious and creative researcher, traveling extensively to learn about companies and industries, pushing his understanding of business beyond what he
could learn from the documents. While he was certainly a voracious reader, he also applied similar ferocity to uncovering information through people.

4. Buffett possessed a remarkable filter. His ability to sift through investment opportunities quickly, something he has honed throughout his career, allowed him to
seize on the best ideas and concentrate his efforts on wringing the most profit out of those.

Layering these factors onto the value investing philosophy made Buffett rich. The bottom line is that Buffett may have become the rich man that he is, but Gardner demonstrates that the billionaire achieved such remarkable returns on his investments through intense work and creative approaches.

The book extract has been taken from the fascinating chapter on the credit card company American Express. If you can, read the entire chapter. It is too long to extract here but it is brilliantly written, explaining in detail the origin of American Express, linking it to the expansion of the railroads and delivery services, and becoming a profit-making company. The focus in this section is on Warren Buffett’s first investment in the 1960s and then later in the 1990s. A masterclass in making sharp business decisions regarding investment and divesting.

Brett Gardner is an investment analyst who has worked at multiple investment firms. Brett has made investments across the capital structure deploying value investing principles and has led activist campaigns against publicly traded companies. He bought his first stock when he was 16 years old. Brett graduated from St. John’s University within three years of matriculation. Brett currently resides in New York City. Buffett’s Early Investments is his first book.