Spoiled Rotten Investors

Middle-aged Midwestern farmers did their part during WWI by dropping significant chunks of their food off with local U.S. government food officials that transported the food to the Allied Cause in exchange for Liberty bonds. A liberty bond was exactly what you think it is–a low-interest bond that was created by the United States government to facilitate borrowing to fund the war effort.

It was heavily marketed as a patriotic duty, with movie stars like Douglas Fairbanks and Mary Pickford rallying the public to delay gratification and accept as any bonds in lieu of cash as was possible to survive, and Liberty bond posters decked the local churches and government halls.

By the time the Allies had secured armistices from Austria-Hungary and Germany in November 1918, many Nebraska farmers were looking to unload their Liberty bonds. It wasn’t just for the liquidity purpose of getting their hands on cash that they wished they would have had in years prior. It was also an economically intelligent decision to discard of Liberty bonds because their interest rates significantly trailed the wildly high inflation rate at the end of the war.

Liberty bonds were sold in four increments in 1917 and 1918. Depending on which of the four bond installments you owned, you were collecting: 3.5%, 3%, 4.5%, or 4.25% interest on your investment. In 1917, the U.S. inflation rate rose to 17.4% and then hit an all-time high for the United States of 18% in 1918 (an aside: most people wouldn’t intuitively guess this, but the excessive creation and use of U.S. currency during WWI gave America the highest annual inflation rate of nearly 10% that it would ever see, and the “Roaring 20s” actually experienced modest deflation contrary to the flapper image because most Americans still lived on farms and the price of corn lost more than half its value during 1921-1929).

Now, imagine yourself being a post-WWI Midwestern farmer. After five of scarce living, you are beginning a return to normalcy. You’re chuck full of liberty bonds from the war effort, and you almost certainly want to sell them as quickly as possible. And yet, you also realize something–this is an opportunity for your family to finally get a little something for yourselves. The years of living lean on the farm have created a windfall of sorts, as the pending sale of liberty bonds have created an opportunity for you to have more cash on hand than you need in immediate working capital for the farm–your once-in-a-lifetime chance to make an investment that could generate some passive income for your family to help things along.

Now, imagine the other side of the coin. In 1919 America, there are no federal laws for stock promoters. Federal securities law, and the birth of the SEC, didn’t come until the aftermath of the 1929 stock market crash when President Roosevelt ushered in the Securities Act of 1933 and The Securities Exchange Act of 1934. Before that, any regulation of securities was the purview of state blue-sky laws which were exceptionally relaxed compared to the federal requirements that would come in days after.

With light oversight of the securities markets, and many Midwestern farmers lacking the sophistication and resources to perform due diligence on potential investments, scammy stock promoters hit the scene to scoop up liberty bonds in exchange for shares of dubious insurance and bank corporations that were created as a guise to separate honest farmers from their acquired bond surplus during the Great War.

In Nebraska, stock promoters fastened onto a corporation called the “National American Fire Insurance Company” to peddle $100 share certificates to farmers in exchange for their liberty bonds. I say “fastened onto” because a corporation by that name had been formed in 1800, and had become defunct with no assets, and stock promoters bought out that name as a way to add gravitas to their developing scam. Because most of the liberty bonds didn’t become fully redeemable until the 1921-1923 period depending on which of the four installments you owned, many Midwestern farmers were eager to shed their bonds that were getting pummelled by inflation and also an ownership interest in a corporation that could enable their family to lay the groundwork for dreams of better days ahead.

William Ahmanson, a well-known insurance agent in the rural communities of Nebraska, was named the head of the National American Fire Insurance. He, too, was fooled by the scammers.

But you should always keep in mind what a share of a corporation is. It is a residual claim on the assets of a corporation that entitle you to a proportional share of the profit after all the contract and tort claimants have been paid their due. When a corporation is initially formed, and that IPO stock is sold, you are actually providing start-up capital for the corporation to build up “residue” for shareholders.

Perhaps driven by pride, William Ahmanson decided to build National American Fire Insurance into something respectable even though it was a corporation born of sinful nothingness. The Nebraska farmers, feeling duped, would hide their NAFI stock certificates away in their bedroom drawers–ashamed that they had been fooled by a group of sweet-talking city slickers at a time when they were most naive.

And yet, something unusual started to happen in the coming decades. Ahmanson had gradually grown the profits from $0 with no capital into $29 per share by the mid-1950s. He and his son Howard were shrewd insurance operators, and were quite pleased with themselves for turning the fraud around into a respectable business.

But you must also remember that there was no easy way to figure out a company’s earnings–you couldn’t just hop on google, enter a few keystrokes, and figure out what NAFI was earnings. There were some Nebraska laws that required filing earnings, debt, and cash information, but you would have to pay $15.32 for a Moody’s Manual or visit a library in the city to check this information out. And by the time NAFI had grown into something respectable, many Nebraska farmers had already given up on the stock and didn’t stay-up-to-date on a stock that had come to represent a dashed hope. If it didn’t produce tangible profits in the first decade of its existence, why would it suddenly produce something in decades two and three?

Although the Ahmanson family was never dishonest, they also desired to benefit from their information asymmetry advantage over the farmers that had paid $100 per share for stock they believed to be worthless.

Hayden Ahmanson, the younger brother of Howard Ahmanson, had begun offering farmers $30 in cash for each share of NAFI they had bought in the post-WWI exuberance of Allied victory and bond surplus. This open offer of $30 per share cash enabled the Ahmanson family–which consisted of the now retired William Ahmanson and his two sons Howard and Hayden–to accumulate 70% of the outstanding National American Fire Insurance stock.

Hmmm…1960s Nebraska…who do you think owned a Moody’s Manual that signalled National American Fire Insurance was earning $29 per share and had a most recent sale price of $30 per share? Yep, you better believe it was Warren Buffett.

And yet, Warren Buffett had four problems that prevented him from acting upon his valuable piece of new knowledge: (1) The Ahmanson family owned 70% of the stock, meaning only 30% of the float was available for trade; (2) the remaining 30% of available float was scattered throughout the state in physical certificates frittered away in some farmer’s hiding spot; (3) the shareholder list wasn’t accessible to Buffett; and (4) any contact with these farmers would have to be done on the sly to avoid detection by the Ahmanson family which could trigger a bidding war or development of a corporate strategy designed to box out Buffett.

With these limitations in mind, Warren Buffett tried to reverse engineer the shareholder list by looking at the records of directors and shareholders of record from the original issuance in 1919, figuring that there hadn’t been much turnover in the past forty years and an address look-up could help him find the geographical hot spots in the state where most of the NAFI stock was sold.

Dan Monen, Warren Buffett’s appointed proxy, was hired by Buffett to drive around the state and do the investigative work to locate the old farmers sitting on stock. When Monen found farmers, most of them had been already propositioned by the Ahmanson family for $30 per share, and weren’t too interested in Monen’s cash offering price of $35 per share. If $30 didn’t interest you in the years prior, $35 probably wasn’t going to get you to part. Buffett acquired only five shares of stock through this $35 offering price method.

Even as a young man, Warren Buffett knew about the psychological influence of anchoring bias–once we get that initial point in our mind, it anchors itself there and serves as a reference point from which we measure everything. The Nebraska farmers had paid $100 per share for the stock in 1919. No one wants to take a nominal loss. Even though an inflation adjusted equivalent would have been much higher, the farmers quickly sold to Buffett as soon as he began offering $100 per share in cash.

Eventually, Monen’s door-to-door pitch with $100 induced farmers to part with 2,000 shares of National American Fire Insurance Stock, which was 10% of the company’s 20,000 share capitalization. By the time Buffett had finished accumulating it, the Ahmanson family owned around 14,000 shares, Buffett owned around 2,000 shares, and the remaining farmers that couldn’t be located or refused to part with their stock owned 4,000 shares. Even at a price of $100 per share, Buffett was able to get his hands on the stock for 3.44x earnings. The stock quickly tripled in value thereafter.

I tell you this story because it is easy to forget what a privilege it is to buy ownership interests digitally in this day and age. If you wanted to acquire ownership in a local firm back in the day, you had to put in the leg work. Because stock markets are impersonal, it is easy to forget that companies have a fixed number of shares and require a buyer and seller on each side of a transaction.

When Exxon has a ten-day trading volume of 13 million shares, the liquidity is so enormous that all you have to do is come up with $50 and put a buy order through Computershare for a $0 fee (actually, when you buy stock of Exxon through computershare, you are effectively engaging in an IPO-type transaction in which Exxon is creating a new share and you are giving $83 to the corporation…but if you bought it through a discount broker, you would get matched up with a seller and have to pay $83 for the share plus $8-$10 in fees. On that, my recommendation is that you try and keep transaction costs below 1% so invest in $800-$1,000 increments when you $8 to $10 in fees).

If you wanted to purchase shares of a small company until recently, you would have to actually track down a human being, haggle over the price, and get the stock certificate signed over to you. Want to own the local battery or local clothing company? Then find someone willing to sell their ownership interest.

And with transaction fees so low now, and the sources of market participation so great, you don’t have to be like the Nebraska farmer saving up for their one-time high liquidity event in which to make an investment.

In the scheme of human history, it has never been easier to become a passive investor in corporate activity. We really are spoiled rotten. Up until the past two or three decades, it has always been arduous. It has always involved leg work. It has always involved finding people on the other side, or paying hundreds of dollars in commissions to make a trade through an actual honest-to-God stockbroker who contacted stockbrokers in other cities to find willing sellers on the other side. The magic of innovation is frequently lost as it becomes increasingly ordinary over time. Don’t disregard this blessing–it has taken over two centuries of innovation to get us to a point where we can become part-owners in a business that sells nearly any kind of good or service, and you should feel inspired to feel gratitude and act upon it after you reflect upon the difficulties of past generations to do something that we now cavalierly take for granted.