As my reputation as an investor quietly spread around UC, Irvine, friends and members of the university community asked me to manage money for them. Using the warrant hedging techniques in Beat the Market, I took on several accounts with a minimum investment of $25,000. Among my new clients was Ralph Waldo Gerard, dean of the graduate school at UCI, and his wife, Frosty, so-called because of her crown of white hair. Ralph, a distinguished medical researcher and biologist, was a member of the select National Academy of Sciences. Courtly, curious, and widely informed, he enjoyed discussing big ideas with me, as he had with one of his relatives, the great stock market theorist and philosopher Benjamin Graham. Graham and Dodd’s Security Analysis, first published in 1934, was the landmark book for the fundamental analysis of common stocks, revised and updated several times. Through Graham, Gerard had met Warren Buffett and was an early investor in one of his investment vehicles, Buffett Partnership, Ltd.
Warren, who would become Graham’s greatest student and arguably the most successful investor of all time, started his first investment partnership, Buffett Associates, Ltd., in 1956 at the age of twenty-five with $100,100. He told me with a laugh that the $100 was his contribution. After starting ten more partnerships he merged them all into Buffett Partnership, Ltd., early in 1962. During the twelve years from 1956 to 1968, these funds Buffett managed compounded at a rate of 29.5 percent, before he took his fee of one-fourth of the gain in excess of 6 percent. He had no down years, whereas large company stocks and small company stocks each fell in four of those years. After Buffett’s fee, Gerard’s investment was growing at 24 percent a year, surpassing the typical stock market investor’s experience, as measured by small-company stocks, which compounded at 19 percent per year, and large-company stocks, which returned 10 percent. Before taxes, $1 for Buffett’s limited partners grew to $16.29. Each of Warren’s own dollars, growing without the deduction of his fees, became $28.80.
So why were the Gerards interested in moving their money from the thirty-eight-year-old Buffett, who had been investing since he was a child and with whom they were netting 24 percent a year, to the thirty-six-year-old Thorp, who had been investing for only a few years and from whom they could expect, on the basis of past performance, to net just 20 percent a year? It was because, after the upward spike in stock prices in 1967, when holders of large-company stocks gained 38 percent on average over the two-year period and small-company stocks were up a manic 150 percent, Warren Buffett said it was too tough to find undervalued companies. Over the next couple of years he would be liquidating his partnership. His investors could cash out or, along with Warren himself, take some or all of their equity as shares in two companies owned by the partnership, one of which was a troubled little textile company called Berkshire Hathaway. Buffett himself now owned $25 million of the $100 million partnership, as a result of his management fees and their growth through reinvestment in the partnership.
The Gerards chose to take their distribution entirely in cash and were looking for a new home for it. Ralph liked the analytic approach in Beat the Market and my other writings, and he wanted not only to check me out himself but, as I realized later, to get a reading from the great investor with whom he had done so well. Thus it happened that in the summer of 1968 the Gerards invited Vivian and me to their home for dinner with Susie and Warren Buffett.
From their home in the Harbor View Hills section of Newport Beach, the Gerards enjoyed looking at Newport Harbor, the Pacific Ocean, and the spectacular evanescent sunsets behind Catalina Island to the west. After we sat down for dinner, Ralph’s wife, Frosty, asked each person at the table to introduce themselves. Susie Buffett told us about her ambitions to be a nightclub singer and how Warren was encouraging her. She also discussed her activities in organizations that helped people, such as Fair Housing, and the National Conference of Christians and Jews.
Warren was a high-speed talker with a Nebraska twang and a stream of jokes, anecdotes, and clever sayings. He loved to play bridge and had a natural liking for the logical, the quantitative, and the mathematical. As the evening went on, I learned that he focused on finding and buying into undervalued companies. Over a period of several years, he expected each of these investments to substantially outperform the market, as represented by an index such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500). As his mentor Ben Graham did before him, Warren also invested in warrant and convertible hedging and merger arbitrage. It was in this area that his and my interest overlapped, and where Buffett, unknown to me, was vetting me as a possible successor to manage investments for the Gerards.
As we chatted about compound interest, Warren gave one of his favorite examples of its remarkable power, how if the Manhattan Indians could have invested $24, the value then of the trinkets Peter Minuit paid them for Manhattan in 1626, at a net return of 8 percent, they could buy the land back now along with all the improvements. Warren said he was asked how he found so many millionaires for his partnership. Laughing, he said to me, “I told them I grew my own.”
Then Warren asked me if I knew about three oddly numbered dice. He had recently heard about them and, in the years to come, would enjoy using them to baffle one smart person after another. Like standard dice, each face has a number between one and six, but unlike normal dice some numbers can be the same. In fact, for the dice Warren asked me about, each die has no more than two or three different numbers. These dice are used to play a gambling game: You pick the “best” of the three dice, then from the remaining two I pick the “second best.” We both roll and the high number wins. I can beat you, on average, even though you chose the better die. The surprise for nearly everyone is that there is no “best” die. Call the dice A, B, and C. If A beats B, and B beats C, it seems plausible that since A was better than B and B was better than C, A ought to be much better than C. Instead C beats A.
This puzzles people, because they expect things to follow what mathematicians call the transitive rule: If A is better than B and B is better than C, then A is better than C. For example, if you replace the phrase better than by any of the phrases longer than, heavier than, older than, more than, or larger than, the rule is true. However, some relationships don’t follow this rule. For instance, is an acquaintance of and is visible to do not. And, if we replace better than by beats on average, these dice don’t follow the transitive rule. So they’re called nontransitive dice. The childhood game of Rock, Paper, Scissors is a simple example of a nontransitive rule. Rock beats (breaks) Scissors, Scissors beats (cuts) Paper, and Paper beats (covers) Rock.
Another nontransitive example with great practical impact is voting preferences. Often a majority of voters prefer candidate A over candidate B, candidate B over candidate C, and candidate C over candidate A. In these elections, where voting preference is nontransitive, who gets elected? It depends on the structure of the election process. Mathematical economist Kenneth Arrow received the Nobel Prize in Economics for showing that no voting procedure exists that satisfies an entire list of intuitively natural desirable properties. A Discover magazine article on this subject argued that, with a more “reasonable” election procedure, based on voter comparisons of all the major Democratic and Republican candidates, in 2000 John McCain would have received the Republican nomination and then been elected president instead of George W. Bush.
Back in Newport Beach, the die was being cast. I passed Warren’s test when I told him if the dice are numbered as A = (3, 3, 3, 3, 3, 3), B = (6, 5, 2, 2, 2, 2) and C = (4, 4, 4, 4, 1, 1) then calculations show that, on average, A beats B two-thirds of the time, B beats C five-ninths of the time, and C beats A two-thirds of the time. Other sets of nontransitive dice are possible as well. I have entertained people by marking a set of three dice like this and letting my opponent pick his die first. After trying all three dice in turn and losing each time, people are typically stumped.
Warren invited the Gerards and me to join him another time for an afternoon of bridge at his house in Emerald Bay. This upscale gated community of the very rich at the north end of Laguna Beach, California, had its own magnificent private beach and ocean views. As Warren and I talked, the similarities and differences in our approaches to investing became clearer to me. He evaluated businesses with the aim of buying shares in them, or even the entire company, so cheaply that he had an ample “margin of safety” to allow for the unknown and the unanticipated. In his view, such opportunities arose from time to time when investors became excessively pessimistic about an individual company or about stocks in general: “Be fearful when others are greedy and greedy when others are fearful.” His objective was to outperform the market in the long run and so he judged himself largely on his performance relative to the market.
In contrast, I didn’t judge the worth of various businesses. Instead I compared different securities of the same company with the object of finding relative mispricing, from which I could construct a hedged position, long the relatively undervalued, short the relatively overvalued, from which I could extract a positive return despite stock market ups and downs. Warren didn’t mind substantial variations in market prices over months or even a few years because he believed that in the long run the market would be up strongly and by regularly beating it during its fluctuations his wealth would grow over time much faster than the overall market. His goal was to accumulate the most money. I enjoyed using mathematics to solve certain interesting puzzles, which I found first in the world of gambling, then in the world of investing. Making money confirmed my theories by showing that they worked in the real world. Warren began to invest while still a child and spent his life doing it remarkably well. My discoveries fit in with my life path as a mathematician and seemed much easier, leaving me largely free to enjoy my family and pursue my career in the academic world.
Warren’s house in Emerald Bay became newsworthy later on during Arnold (“The Terminator”) Schwarzenegger’s successful 2003 campaign to become governor of California. Initially, Buffett was a supporter and an economic adviser to Arnold. One campaign issue was how to cut California’s budget deficit. The problem was caused largely by the anti-tax measure Proposition 13, adopted by California voters in 1978. This limited the tax on real estate to 1 percent of the assessed valuation with a cap of 2 percent per year on any revaluation upward. With California’s soaring prices, the tax on houses that weren’t traded fell over time to a small fraction of 1 percent of their current value, thus sharply eroding the tax base and expanding the budget deficit. A house was reassessed at the current market price only when it was resold. As a result, taxes on comparable houses varied greatly, depending on when they last changed ownership. This led to major inequities in the taxes paid by different homeowners. In addition, by drastically lowering the overall effective tax rate on residences, Proposition 13 reduced the annual expense of homeownership, which in turn fueled the excessive rise in California home prices.
Businesses did even better than homeowners. They created companies to hold properties. Instead of selling a particular property, they sold the company that owned it. By keeping the same “owner,” this scheme could preserve forever the original low valuation of the individual properties a particular company owned rather than increasing the tax based on a new, higher and more realistic sales price. The revenue the state lost would have been enough to eliminate all the California budget deficits from 1978 until now, and to make unnecessary all the cuts in funding for education and law enforcement, provided of course that politicians, seeing no deficits as a result, restrained themselves from adding foolish or wasteful new expenditures.
Buffett, aware of the economic harm to the state, publicly advised Schwarzenegger to shift to a fair and equitable property tax. He pointed out that by virtue of Proposition 13 the property tax on his Emerald Bay house, which he purchased in the 1960s and was now worth several million dollars, was substantially less than on his house in Omaha, currently valued at $700,000. The governor-to-be, expecting to lose votes if he followed this advice, said, “I told Warren that if he mentions Proposition 13 again he has to do five hundred sit-ups.” Warren quietly discontinued advising Schwarzenegger.
Afterward, when I was thinking about Buffett, his favorite game—bridge—and the nontransitive dice, I wondered whether bidding systems at bridge might be like those dice. Could it be that no matter which bidding system you use, there will always be another system that beats it, so there’s no best system? If so, the inventors of new “better” bidding systems could be chasing their tails forever, only to have their systems beaten by still newer systems, which in turn might then lose to old previously discarded systems.
Could one find the answer to this question? Possibly when computers can play bridge and bid at the expert level. How? By letting the computer play large numbers of hands, pitting various bidding systems against one another, and keeping track of how they do.
Suppose it turned out that no bidding system is best. Then your best strategy would be to ask the opponents to disclose their bidding system, as they are required to do, then choose the most lethal counter to it. When the opponents catch on and demand that your team chooses its bidding system first, this leads to an impasse that might have to be resolved by a lottery to see who chooses first, or by some kind of random assignment of bidding systems.
Bridge is what mathematicians call a game of imperfect information. The bidding, which precedes the play of the cards, gives some information about the four concealed hands held by the two pairs of players who are opposing each other. As the cards are played, players use the bidding and the cards they have seen so far to make inferences about who has the remaining unplayed cards. The stock market also is a game of imperfect information and even resembles bridge in that both have their deceptions. As in bridge, you do better in the market if you get more information sooner and put it to better use. It’s no surprise that Buffett, arguably the greatest investor in history, is a bridge addict.
Impressed by Warren’s mind and his methods, as well as his record as an investor, I told Vivian that I believed he would eventually become the richest man in America. Buffett was an extraordinarily smart evaluator of underpriced companies, so he could compound money much faster than the average investor. He also could continue to rely mainly on his own talent even as his capital grew to an enormous amount. Warren furthermore understood the power of compound interest and, clearly, planned to apply it over a long time.
My prediction came true for a few months in 1993, at which time he was the richest man in the world, until he was passed by Bill Gates and, later, a few other dot-commers. Buffett regained the world’s top spot in 2007 only to trade places with his bridge buddy Gates again in 2008. By then, time spent with Warren had become a commodity of great value. In a vigorous auction on eBay, an Asian investor bid $2 million, to be donated to charity, for the privilege of having lunch with him.
Ralph Gerard gave me copies of Buffett’s letters to his partners and his partnership document, a simple two-page affair. It was clear from this that the ideal plan would be to pool my investing for myself and others in a single limited partnership just as Warren had eventually done.
At the time, I was managing a total of about $400,000. At 25 percent a year, the accounts were grossing $100,000, and as my performance fee was 20 percent of the profits, I was earning at the rate of $20,000 a year, roughly the same as my salary as a professor. With the assets of the accounts pooled into a single account, I could manage more with less effort. A particular warrant hedge only had to be set up and managed once, rather than replicated individually for each managed account.
While I was deciding on my next steps, I got a phone call from a young stockbroker in New York named Jay Regan, who had read Beat the Market and told me he wanted to get into the investing business using a limited partnership to implement my convertible hedging approach. Thinking he might be able to handle the business aspects of running a hedge fund while I focused on choosing the investments and on doing further research into the markets, I arranged to meet him at my office in the UCI Math Department one day in 1969.
Ten years younger than I and of medium height, the twenty-seven-year-old Regan had thinning reddish hair, freckles, and the social skills of a promoter. A Dartmouth graduate in philosophy, he quickly took in the principles on which I based my investment methods.
We seemed to make a natural team. I would generate most of the ideas but he would bring suggestions and trading possibilities from “the Street.” I would do the analysis and compute orders for him to execute through various brokers. He was to handle taxes, accounting, and most of the legal and regulatory paperwork, things I wished to avoid so I could focus on research and development.
We shook hands that day and agreed to create and manage together a new investment partnership based on the ideas in Beat the Market. Newport Beach was to be the think tank and trade generator, and New York the business office and trading desk. Discussing how much capital we needed to start with, we set $5 million as our target. If we made 20 percent net of expenses and charged 20 percent of that as a performance-based fee each year, we’d share 4 percent of $5 million, or $200,000, more than my remuneration as a professor of mathematics and what I was making from my smaller pool of managed accounts.
Our operation was an example of what had come to be known as a hedge fund. A hedge fund in the United States is simply a private limited partnership managed by one or more general partners (each of whom risks the loss of their entire net worth should things go badly wrong) and a group of investors, or limited partners, whose loss is limited to the amount they commit. The investors are primarily passive, with no role in the management of the partnership or in its investments. At the time, such funds were only lightly regulated, provided there were no more than ninety-nine partners and they did not solicit the general public. Hedge funds based overseas, called offshore, may also be structured as corporations or trusts.
Although hedge funds were few in number at that time, they were not a new concept. Jerome Newman and Buffett’s mentor, Benjamin Graham, had started one as early as 1936. Under skilled managers whose interests were more or less aligned with the investors through the incentive of profit sharing, investors hoped for substantially better returns. The name hedge fund probably came about when the journalist Alfred Winslow Jones, inspired by what he learned after researching an article he was writing about investments, started a partnership in 1949. In addition to buying stocks he believed were cheap, he attempted to limit, or “hedge,” risk by also selling short shares he believed were overpriced. The short seller profits if the price falls and loses if the price rises. Short selling allows an investor to profit in a down market; a fund like Jones’s can, potentially, have more stable returns. Though Jones’s idea didn’t receive wide attention at first, a 1966 article in Fortune magazine by Carol Loomis, “The Jones Nobody Keeps Up With,” announced that Jones’s hedge fund had beaten all of the several hundred mutual funds over the last ten years and the possibilities became widely apparent.
I knew that finding investors was not going to be easy. Just as 1967–68 had been a manic two years for the markets and for the few existing hedge funds, 1969 was a major downer. Large-company stocks lost an average of 9 percent, and small-company stocks were crushed by an alarming 25 percent. Most hedge funds suffered severe losses and were closing down. Though we explained we were to be market-neutral and hedged, thus protecting principal, our ideas were new and people were scared. We finally signed up fourteen limited partners plus ourselves, each for $50,000 or more. My individual investors were among our first partners; Regan found more money by going to the courthouse, getting lists of limited partners from documents that had been filed by other hedge funds, and cold calling. I flew to New York to meet prospects, explain our methods, and add cachet with my books and academic position. By late October we had managed to get only $1.4 million in commitments but we decided to move ahead anyhow. We’d simply grow through profits, and these would attract more capital later from both current and new investors. Convertible Hedge Associates (later renamed Princeton Newport Partners) opened its bicoastal doors on Monday, November 3, 1969. An article in the Wall Street Letter announced our start, setting it in the context of that year’s widespread market rout and the closing down of several hedge funds.
MONEY ON THE MOVE. As some hedge funds break up in the aftermath of sour performances this year, new investment partnerships continue to be formed. One of the newest is Convertible Hedge Associates, whose general partners are Ed Thorp and Jay Regan. Thorp is the fellow who developed a computerized system for beating the blackjack tables in Las Vegas, before they changed the rules on him, and wrote the book Beat the Dealer. He’s turned his computer talents to money management and has a book out called Beat the Market. Regan has been with Butcher & Sherrerd, Kidder, Peabody and White, Weld. Among their limited partners are Dick Salomon, chairman of Lanvin-Charles of the Ritz; Charlie Evans (formerly of Evan-Picone) and Bob Evans (Paramount Pictures), and Don Kouri, president of Reynolds Foods, Ltd.
We completed our first two months of operation with a 4 percent profit, or $56,000. The S&P 500 Index was down 5 percent in the same two months. My $5,600 share of the general partner’s fee exceeded my university income for the same period.
It was clear that I was at a crossroad. I could use my mathematical skills to develop strategies for hedging and possibly become rich; or I could compete in the academic world for advancement and distinction. I loved university-level teaching and research, and decided to stay with it as long as I could. My best quantitative financial ideas would be saved for our investors, not published, and over time would be rediscovered by and credited to others.
Buffett’s report on me to the Gerards must have been favorable, since they joined us and their trust fund retained an investment in the partnership until after the deaths of Ralph and then Frosty. The time I spent with him had two major effects on my life: It helped move me along the path to my own hedge fund, and it later led me to make a very profitable investment in the company he transformed, Berkshire Hathaway.