How Did Warren Buffett Build His Fortune?

According to the Google search engines for this site, one of the most queried subject topics is something to the effect of “How did Warren Buffett get rich?” That’s an unsurprising curiosity, considering that Warren Buffett is without a doubt the most famous man in American history in the realm of investing. Some people are simply curious about any man who can compound wealth at nearly 20% for the entirety of his life, others are drawn to his personal style of maintaining a witty sense of humor and basic tastes despite amassing one of the largest fortunes in all of recorded human history.

In answering this question, there is one thing I’d like to point out to begin with: the investing bug had been in Buffett’s DNA right from the start, and his life is a story of what happens when you combine advantage upon advantage with advantage upon advantage: He had the instincts for investment, he was son of a Congressman and thus had access to brokers at an early age and was free to try his hand at investing, he had a towering intellect from the very beginning, and he had such a strong obsession with investing that it took up his mind at least twelve hours of every day.

Even when Buffett was a kid, he was coming up with ways to own Washington Post paper routes and then outsource them to other kids so that he could become the overseer and collect a profit. He would buy six packs of glass Coca-Coca bottles for a quarter and sell them in individual servings for a nickel a piece. He would buy pinball machines at pizzerias and collect money from it every month. He would purchase farmland and outsource the land to a tenant-farmer. When he was a teenager, he was making twice as much money annually as the average American household.

But his real wealth got build in his thirties (during the 1960s) when he ran the Buffett Partnership. In the early 1960s, Buffett started a partnership that allowed him to collect an annual fee from the investors in exchange for crossing a certain hurdle rate (20% of profits in excess of 6%)—this is the key to everything: the Warren Buffett model is about scalable wealth and generating income of the funds of others.

When Buffett closed down his fund in 1969, he had achieved returns of 29.5% annually (while the Dow Jones had increased 7.4% annually over the same period). But Warren collected 5.7 percentage points in fees, so that if you invested with him, you actually netted 23.8% after paying Warren Buffett his share but before paying your due to the tax man. It is these 5.7 percentage points that really propelled Warren Buffett from the upper middle class in America to one of the rich guys in America. By 1969, the Buffett Partnership had over $100 million in total assets, due to the number of people clamoring for Buffett to invest on their behalf as well as the stellar returns that he generated over that time period. This is what enabled Warren Buffett’s partnership to scale from somewhere around $1 million in net worth to somewhere over $25 million in net worth. His net worth increased twenty-five fold over the course of the 1960s not only because he was able to invest quite well, but because he managed to collect a service fee off of the assets of others (a fee, of course, that he clearly earned).

From there, Warren Buffett was able to build his fortune in two primary ways: by owning private companies that generate large amounts of income for him to deploy, and by entering the insurance business to get his hands on cheap investment capital. Warren Buffett abhorred debt; it wasn’t his style to borrow money at 5% and try to invest it at 12% (Munger, meanwhile, built his large fortune by taking out margin loans to amplify his high conviction stock picks). Instead, Warren Buffett used the “free money” provided by insurance premiums allowed Buffett to use leverage—by investing the money for a return before he had to pay the money back to those making successful insurance claims, Buffett was able to use this spread to build quick wealth.

The notion that Warren Buffett became “Warren Buffett” by buying and holding large chunks of blue-chip stocks is part of the story, but it does not adequately explain why he has been able to build a $50 billion fortune. It is the operational leverage through his insurance holdings and private businesses that his made him the richest man in the world.

This is not to say that his blue-chip investments in Procter & Gamble, Coca-Cola, and so on, have not played a role in making him rich. After all, Coca-Cola currently trades at $40 per share, and Berkshire Hathaway’s cost per share in $3.25. Increasing wealth twelve fold in 25 fives is nothing to ignore. It’s hard to construct an alternative hypothetical universe, but my guess is that if Warren Buffett had to only own blue-chip stocks his entire life, then his net worth would probably be between $50 million and $150 million today instead of $50 billion.

Without leverage, Buffett would be some random rich guy that you’d never heard of—he’d be able to give his kids and grandchildren $13,000 stock gifts for Christmas, and he’d be able to spend his life in the top 0.001% of humanity that ever existed—he’d have complete control over his time, and he could only a couple homes, and vacation whenever he desired. But if you want to know what made him really, really rich, then you have to look to the cash generators.

A potential lesson from Warren Buffett’s life is that it is important to own something outright that gives you money to invest. It’s one thing to be saving $500 per month and putting it into blue-chip stocks. That’s very nice, and it builds wealth. But if your ambition is to use blue-chip stocks as part of a strategy to get really rich, then you need to have an asset under your belt that gives you lots of regular income to deploy. Imagine someone owning a $3 million apartment complex that spins off $300,000 in annual income. If you owned an asset like that, you’d have life made. You could enroll in the DRIP program of your 15 favorite stocks,  and have $1,000 invested into them every month. Wealth starts to get built very, very quickly when you have a primary cash-generating asset that gives you regular money to invest.

In my case, that’s why I’m waiting on the next bottom of the energy cycle. That’s when energy MLPs will start yielding north of 10%. If you built a basket of twenty or so energy MLPs (basically, a pseudo-index form of energy MLP investing) that are bought at attractive valuations, you could be in the position of building a cash generator that will give you regular income to deploy for the rest of your life. Imagine if you allocated $100,000 into twenty different energy MLPs at cheap valuations—you’d have $10,000 to invest in blue-chip stocks every year for perpetuity. You’d see a dividend cut or two every year, but you’d also see dividend increases elsewhere.

But if you study Warren Buffett’s life, the important lesson is to get your hands on an asset generator—it might be real estate, it might energy MLPs, it might be the local car wash—own it outright, and then taking the constant flow of funds to start buying blue chip stocks. Charlie Munger talks about “drowning in income.” Well, that’s the lesson from Buffett’s life. You work your ass off to own a cash generator, and instead of treating that money as a windfall to upgrade your lifestyle, you use it exclusively to purchase blue-chip stocks. That allows your life to become a perpetual wealth-building machine. If you reach a point where you have a system in place to invest thousands of dollars per month, you can’t help but win and get wealthier with each passing year. In the game of life, you’ve won.