In 1973, business magnate Warren Buffett — Chairman and CEO of Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB), one of the most successful conglomerate holding companies on the planet — invested $10.6 million in the Washington Post Company. As Buffett explained in his 1985 letter to shareholders, by 1974, the investment sank to a market value of about $8 million, a loss of nearly 25 percent. At a glance, a crushing defeat for a then still-rising investment manager.
But Buffett, perennially patient, was unfazed. In the same letter, he told his shareholders not that the investment was a bad idea, but that, “What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.”
Buffett’s keen eye for value in a habitually inefficient market — one that would value the Washington Post Company at $100 million in 1973, when “most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million” — showed him that far from being a bad investment, his pick had the potential to become far more valuable.
“You know the happy outcome,” Buffett told his shareholders. Shortly after Buffett invested his millions and the market decided to keep selling, Kay Graham, then CEO of the Washington Post Company, “had the brains and courage to repurchase large quantities of stock for the company at those bargain prices” — a result of the inexplicable fire sale — “as well as the managerial skills necessary to dramatically increase business values.”
The rest, in retrospect, is history. The company’s market value soared. According to Buffett’s calculations in 1985, Berkshire Hathaway proceeds from the investment totaled $221 million, some $160 million greater than the same investment in “any of a half-dozen media companies that were investment favorites in mid-1973″ would have yielded. At the end of the second quarter of 2013, Berkshire Hathaway’s 1.7 million shares in the Washington Post Company were worth $974.5 million.
Buffett appears to have a soft spot for level-headed, well-meaning business leaders (really, who doesn’t?) and Kay Graham fit the bill. Buffett became a member of the Washington Post Company’s board in 1973 and served as a director until May 2011. Beginning with, or perhaps just encouraged by, Buffett’s presence in the company, the two became notorious partners in crime.
In 1975 — in the wake of the Watergate scandal when The Washington Post forever claimed a position in the pantheon of great news organizations — Buffett sent a memo to Graham that has now become infamous. The memo, now 30 years old, is timeless (or, at least, still relevant in 2013) in its prescience, and is credited with being the document responsible for what could rightly be called a financial miracle. That is, The Washington Post’s pension fund, one of the few that can be considered less of a liability and more — Buffett may argue — of a business segment in and of itself.
When it came to light that Amazon (NASDAQ:AMZN) founder and CEO Jeff Bezos would be purchasing The Washington Post newspaper from the company for $250 million, it was quickly found out that the company’s pension fund was not just healthy, but, as of 2012, over funded by about $600 million.
So how did this monstrous miracle happen? As Washington Post Company Chairman and CEO Donald Graham put it at an investor conference in 2011, ”The reason we have an overfunded pension plan is summed up in the two words: Warren Buffett.” And all that because of a memo Buffett sent Kay Graham nearly 40 years ago.
Writing Graham in 1975, Buffett began by saying that, “There are two aspects of the pension cost problem upon which management can have significant impact: 1. maintaining rational control over pension plan promises to employees and 2. increasing investment returns on pension plan assets.” While this may seem intuitive to some, it has become clear that both the private and public sector are bad at managing pensions. Very, very bad.
In 1975, Buffett compiled some data on pension fund performance versus the market. For the trailing 9.5-year period, he found that the Dow Jones Industrials had an annual compounded rate of return of 2.8 percent and the S&P 500 had returned 3.8 percent. Over the same period, three pension funds had returned an average of 2 percent.
This is particularly important because a mismatch between expected and actual returns on a pension fund is a sure way to find disaster. Buffett identified many problems with the pension system as it stood at the time (some of which still persist today), but perhaps the most relevant is the idea that companies often tried to hire money managers that could reliably “beat the market.”
This expectation — that some money managers could maintain above-average performance — was unrealistic. And, as indicated, even expectations to perform on par with the market were by no means a sure thing. This created an environment where fund managers had an enormously difficult time balancing obligations with actual returns.
As Buffett said in the memo that, “A little thought, of course, would convince anyone that the composite area of professionally managed money can’t perform above average. Estimates are now that about 70% of stock market trading is accounted for by professionally managed money. Any thought that 70% of the environment is going to substantially out-perform the total environment is analogous to the fellow sitting down with his friends at the poker table and announcing: ‘Well, fellows, if we all play carefully tonight, we all should be able to win a little.’”
But this belief was not very widely held. Companies still funded pensions and made promises of pension payments in such a way that demanded their funds out perform the market. And, in the end, many programs found themselves in deep trouble.
So how did the Washington Post manage to stay out of trouble? Instead of finding an all-star fund manager or taking safety in bonds — strategies commonly used by other fund managers — Buffett recommended that the Washington Post engage in a “mildly unconventional” strategy of “treating portfolio management decisions much like business acquisition decisions by corporate managers.” This is a position very similar to how Buffett manages his own holding company.
He argues that, “If decisions regarding internal rates of return of the business are reasonably correct — and a small portion of the business is bought at a fraction of its private-owner value — a good return for the fund should be assured over the time span against which pension fund results should be measured.” That is, over a long time.
As part of the acquisition, Bezos is getting $333 million to fund the newspaper’s pension, which reports indicate is about $50 million more than is necessary to meet current obligations. Here is the entire memo, as shared by Fortune.