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Why Warren Buffett's Blue Chip Stamps Deal Was so Revolutionary

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- By Rupert Hargreaves

I have recently been re-reading Janet Lowe's book on Charlie Munger (Trades, Portfolio), titled "Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger."


Published in 2005, this book provides a detailed look at the early years of Munger's career. It contains plenty of additional insights from the billionaire himself as well as many of his friends and former work partners. These insights go far beyond the comments Munger has made at lectures and in various annual meetings over the years. They give the reader an insight into this man's workings and the challenges he has faced over the years.

Indeed, it's easy to believe that Munger and his partner, Warren Buffett (Trades, Portfolio), have had it relatively easy over the past few decades. But that is just not the case. Lowe's book detailed the struggles these two investors faced in the early years and challenges in the latter years. It also profiled missed deals and opportunities, as well as losses, two things that are often overlooked in the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) story.

The book also took a close look at how Berkshire Hathaway was formed. To begin with, the name was attached to a struggling textile business. However, by 1971, Buffett, along with his wife, investors and business partners, including Munger, owned such a tangled web of investments that they had to simplify. As the book explained:


"In 1971, Warren and Susan Buffett personally owned 13% [of Blue Chip Stamps]; Berkshire Hathaway, of which the Buffett's were 36% owners, held 17%, and Diversified Retailing Inc., of which the Buffett's owned 42%, held 16%. In addition, Diversified Retailing owned shares in Berkshire, and Munger's partnership owned 10% of Diversified Retailing, plus 8% of Blue Chip. [Rick] Guerin's partnership owned 5% of Blue Chip."



Berkshire, Diversified and Blue Chip were all deeply undervalued businesses Munger, Buffett and Guerin had been buying for their partnerships. By gaining control of these companies, they could then use the business' own capital to increase their investments in other deeply undervalued securities. In one way, these three value investors were using deep value stocks to buy more deep value stocks, leveraging each company's cash flow to boost their capital resources.

Eventually, Munger dissolved his partnership. Diversified was then merged into Berkshire. After these two actions, the book noted that Berkshire's Blue Chip ownership hit 60%. "Together, Berkshire, Buffett, and Munger owned nearly 75% of the outstanding shares of Blue Chip," it summarized.

With this voting power, Buffett and Munger could take over the investment committee of Blue Chip, which gave them a significant capital resource. The funds were used to buy other businesses, including See's Candy, Wesco Financial, The Buffalo Evening News and Precision Steel. These are the foundations of Berkshire as we know it today. Therefore, it could be argued that the foundations of Berkshire were built by Blue Chip, which was managed by Munger. He sent his own letter to investors out every year in the annual report.

In July 1983, Berkshire acquired the remaining 40% of Blue Chip that it did not already own. Each outstanding share was exchanged for 0.077 of a share of Berkshire. The combined assets of the new group totaled $1.6 billion.

The Blue Chip deal's importance in the Berkshire story cannot be understated. The acquisition of the controlling interest in the company gave Munger and Buffett access to a significant amount of capital, which they could deploy into other growth opportunities. Blue Chip's assets were acquired at a discount, which only improved the deal's economics. Then, where Berkshire and Blue Chip merged, the all-share transaction further increased Buffett's financial firepower without him having to invest any additional capital.

Disclosure: The author owns no share mentioned.

Read more here:

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This article first appeared on GuruFocus.