In 1905, 18-year-old Ralph Leroy Nafziger started baking breads in the basement of a church in downtown Kansas City. The breads were good and sold well. The success motivated Nafziger to build and purchase a number of real bakeries. Twenty years later, he sold the bakeries to a competitor, but soon afterwards used the proceeds from the sale to purchase a number of other bakeries that, in 1930, he combined to form Interstate Bakeries. Over the next 30 years, Nafziger acquired 15 additional bakeries, building Interstate into one of the largest bread and snack cake companies in the United States.

Interstate’s business included distribution and marketing as well as baking. Bread has a relatively short shelf life. Therefore, it must be delivered to stores soon after it is baked. To accomplish this, in the 1980s, Interstate operated a fleet of more than 3,000 delivery vehicles that transported its breads and other baked products to tens of thousands of supermarkets, smaller grocery stores, convenience stores, and restaurants. The drivers of the vehicles, who belonged to the Teamsters union, placed the newly baked products on the shelves and removed the products that were not fresh. Most of the stale bread was sold at deeply discounted prices through 450 thrift stores operated by the company. The thrift shops were an unprofitable burden on the company but were necessary.

I became interested in Interstate in the fall of 1985 when a friend mentioned that Howard Berkowitz purchased 12 percent of the company’s outstanding shares, became chairman of the company’s board, and hired a new CEO, who was convinced that he could materially improve the company’s profits. I knew Howard Berkowitz and believed that he was a particularly experienced and astute investor. Howard was a founding partner in 1967 of one of the earliest and most successful hedge funds: Steinhardt, Fine, Berkowitz & Co. By the mid-1980s, Howard had left Steinhardt, Fine, Berkowitz and had formed a new hedge fund: HPB Associates. In my opinion, Howard was motivated, caring, and completely honest. I reasoned that Howard would not risk his own money and reputation on Interstate Bakeries unless he was quite confident that his investment would be a success. That is why I became interested in the company’s shares.

I knew that the bakery business is a miserable business—among the worst. Most shoppers do not have a strong preference for one brand of bread over another. White bread pretty much is white bread. Whole wheat bread pretty much is whole wheat bread. This relative lack of brand preference gives stores bargaining power over bakeries. A store can threaten a bakery that, if it cannot purchase bread at a certain price, it will seek another supplier. Thus, stores can play one bakery off against another, and they do. Warren Buffett likes businesses that are protected by moats. There are no moats surrounding the bakery business. There are not even any fences or “beware of dog” signs. Therefore, the prices received by the bakeries often are driven to levels so low that it is difficult for the bakeries to earn a decent profit, if any profit at all. This is a key reason why the bread business is a miserable business.

There are other reasons why most bakeries are a poor business. The Teamsters and other unionized employees have work rules that often prevent management from implementing efficiencies. And some of the unionized workers are participants in multiemployer pension plans that the bakeries have little control over—and that can become unquantifiable and burdensome liabilities to the bakeries. Furthermore, managements not only have difficulties controlling prices and labor, but also controlling raw material costs. The prices of wheat, sugar, and other bread ingredients fluctuate based on perceived supply and demand. And management has no control over the price of the gasoline required to fuel the thousands of delivery vans.

For all these reasons, bakeries usually suffer from relatively low profitability and low cash flows. Moreover, because their cash flows are weak, they often struggle to generate sufficient funds to properly maintain and modernize their facilities. Even a mother would have a hard time loving a bakery.

Howard Berkowitz had become interested in Interstate Bakeries at a time when the company was suffering from legacy problems. In 1979, Interstate had been purchased by a failing computer leasing company named DPF. DPF was in the process of liquidating its leasing operations and wanted to purchase another business to justify its continued existence. Also, DPF had large tax loss carry-forwards that could be used to offset the tax obligations of an acquired company. In 1981, DPF finally exited the leasing business and changed its name to Interstate Bakeries. Saddled with DPF’s heavy debt load, the renamed Interstate lacked the financial resources to properly modernize and maintain its facilities. Furthermore, management lost focus on the bread business during the years it had to concentrate on unwinding the leasing business. Interstate’s profits slipped badly in the early 1980s, and the company was unprofitable in 1984. One of Howard Berkowitz’s first actions after becoming chairman of Interstate in 1984 was to replace the existing CEO with Bob Hatch, who had been an executive vice president at General Mills. Bob Hatch quickly announced plans to reduce Interstate’s debt and improve its profitability by divesting inefficient plants, optimizing the routing of deliveries, and instituting general cost cutting and efficiencies.

In the fall of 1985, when I decided to analyze Interstate, its shares were selling at about $15. I almost always start my analysis of a company by studying its balance sheet. It is said that a shareholder makes money off the income statement, but survives off the balance sheet, and I agree. Because of my keen desire to survive by minimizing risks of permanent loss, the balance sheet then becomes a good place to start efforts to understand a company. When studying a balance sheet, I look for signs of financial and accounting strengths. Debt-to-equity ratios, liquidity, depreciation rates, accounting practices, pension and health care liabilities, and “hidden” assets and liabilities all are among common considerations, with their relative importance depending on the situation. If I find fault with a company’s balance sheet, especially with the level of debt relative to the assets or cash flows, I will abort our analysis, unless there is a compelling reason to do otherwise. In the case of Interstate, Bob Hatch appeared to have performed an excellent job reducing the company’s debt and otherwise strengthening its balance sheet. Net debt had declined by $25 million in the company’s fiscal year that ended on May 31, 1985, and was continuing to decline in fiscal 1986. I projected that, on May 31, 1986, the company would have only $25 to $28 million of debt versus $85 to $88 million of shareholders’ equity. Most other aspects of Interstate’s balance sheet also appeared to be in good shape. I was concerned about one potential liability that was not on the balance sheet: potential future liabilities to the multiemployer pension plans. But because the stock market had been strong in recent years, one could reasonably conclude that the asset values of the plans had appreciated sharply and therefore that they would not be a material liability to Interstate in the near future.

If a company’s balance sheet passes muster, I then try to get a handle on management. The competence, motivation, and character of management often are critical to the success or failure of a company. To form an opinion on management, I normally pay careful attention to the management’s general reputation, read what the management has said in the past, assess whether the management’s stated strategies and goals make sense, and analyze whether the management has been successful carrying out its strategies and meeting its goals. However, I am humble about my abilities to accurately assess managements. Experience shows that investors can be unduly impressed by executives who are charismatic or who purposely say what investors want to hear—who play to their audience. Also, investors frequently will undeservedly credit management for a company’s favorable results and vice versa. Favorable or unfavorable results often are fortuitous or unfortuitous. A number of years ago, I was one of a few hundred securities analysts attending a particularly charismatic Wall Street presentation by Dennis Kozlowski, the CEO of Tyco International. At the end of the presentation, the audience burst into applause, and one attendee turned to me and said: “Kozlowski might be the single best executive in the country today.” A few years later, Tyco was near bankruptcy and Dennis Kozlowski was headed for prison. This is just one example of why one should be humble about his abilities to judge a management. With respect to Interstate Bakeries, I had confidence that Howard Berkowitz had the ability and motivation to select a strong management, and I was impressed by what Bob Hatch had quickly accomplished to improve the company’s efficiency and balance sheet.

After trying to get a handle on a company’s balance sheet and management, we usually start studying the company’s business fundamentals. We try to understand the key forces at work, including (but not limited to) quality of products and services, reputation, competition and protection from future competition, technological and other possible changes, cost structure, growth opportunities, pricing power, dependence on the economy, degree of governmental regulation, capital intensity, and return on capital. Because we believe that information reduces uncertainty, we try to gather as much information as possible. We read and think—and we sometimes speak to customers, competitors, and suppliers. While we do interview the managements of the companies we analyze, we are wary that their opinions and projections will be biased. From experience, we have learned that you should never ask your barber if you need a haircut. In the case of Interstate, it did not take much work to conclude that that the baking business was a lousy business—a particularly lousy business.

It is usually difficult to analyze large quantities of information without the benefit of an insight on how to proceed with the analysis. The insight permits us to separate the information that is critical for decision making from the information that is of secondary or tertiary importance. Once we have determined what is critical, we can start forming opinions and estimating earnings and cash flows. In the case of Interstate Bakeries, I isolated five fundamentals and estimates that appeared critical to our analysis of the company: (1) the balance sheet was OK; (2) management seemed competent and motivated; (3) the business was low-margined and otherwise unattractive; (4) as a best guess, revenues might grow at a 5 percent average annual rate; and (5) a projection by Bob Hatch that pretax margins could increase to 3.5 percent within a few years seemed credible. I note that, whenever we make estimates, we fully realize the impossibility of projecting the future with any certainty. Investing is probabilistic.

When analyzing a company, we almost always build a model of the company’s past, present, and projected earnings. Model building helps us structure our thinking and helps us analyze the importance of key variables. Our models normally include earnings projections for the next two or three years.

Once we complete building an earnings model, we usually have sufficient information to value a company. Normally, our valuation is based on a multiple of projected earnings and cash flows. The multiple, in turn, is a function of a company’s estimated strengths and projected growth. Over the 50-year period 1960 to 2010, the stock market, as measured by the S&P 500 Index, sold at an average price-to-earnings (PE) ratio of 15.8. Therefore, when valuing companies, I simply use a 15.8 PE ratio for companies of average quality and growth potential, a PE ratio below 15.8 for companies of below-average quality and growth potential, and, of course, a PE ratio above 15.8 for companies of above-average quality and growth potential. It is often difficult to accurately value a company. However, my experience is that a knowledgeable and experienced investor who possesses good judgment can value most companies with sufficient accuracy that he can successfully base his investment decisions on the valuations. Valuations can be directional.

My Excel model for Interstate estimated that the company would earn $2.30 per share in its fiscal year 1988. My assumptions behind the estimate were that revenues would grow at a 5 percent annual rate to $775 million, that pre-tax profit margins would be 3.5 percent, that the effective tax rate would be 30 percent, and that the diluted share count would be 8.2 million.

When valuing Interstate, my conclusions were that its longer-term business fundamentals were unfavorable, its management was good and motivated, and its projected growth rate was somewhat below average. On balance, I valued the company at 11 times earnings. Therefore, I concluded that, two years hence, Interstate’s shares would be worth about $25, or about 66 percent above their existing price of $15.

After completing my valuation, my first reaction was that Interstate’s shares were not sufficiently inexpensive enough to purchase given the unattractiveness of the business. However, I then had second thoughts. Howard Berkowitz had made a major investment in the company, and he was a knowledgeable gem. I like to follow sound and successful investors who are particularly knowledgeable about a company or industry they are investing in. Also, between mid-1982 and October 1985, the S&P 500 Index had risen by about 68 percent from about 110 to about 185. In October 1985, most stocks were relatively expensive, and I was having difficulty filling our portfolios with stocks that appeared to be more attractive than Interstate’s. I find that, in the stock market, it is best to be flexible and not be tied to conventions or rules. Sometimes, it is best to follow your intuitions—and in the case of Interstate, my intuition was that we should own the shares. Over the next few months, I purchased about 8 percent of the outstanding shares of Interstate Bakeries at an average cost of roughly $15 per share.

I note that the processes we use to value stocks and make investment decisions may appear to be ordered, but, in fact, they are quite messy. We constantly are faced with incomplete information, conflicting information, negatives that have to be weighed against positives, and important variables (such as technological change or economic growth) that are difficult to assess and predict. While some of our analysis is quantitative (such as a company’s debt-to-equity ratio or a product’s share of market), much of it is judgmental. And we need to decide when to cease our analysis and make decisions. In addition, we constantly need to be open to new information that may cause us to alter previous opinions or decisions. It has been said that, if anyone thinks he has a formula for analyzing common stocks, he does not understand how to analyze common stocks.

During the summer of 1986, Howard Berkowitz invited me to join Interstate’s board as an ally of his interests. I accepted. My first board meeting on October 15 was a sketch. The meeting was held near the company’s headquarters in Kansas City. About a dozen brown-nosing executives approached me, introduced themselves, welcomed me, and commented that they were happy to have me on the board. I didn’t know why they were happy to have me on the board. They had never met me before; they did not have my resume; they did not know the first thing about me. One executive, the head of marketing, handed me two enormous garbage bags filled with samples of the company’s products. Interstate made dozens of different types of breads sold under various labels and dozens of different types of snack cakes sold under the Dolly Madison and other brand names, and I was gifted a sample of each of them. It was all I could do to lug the huge garbage bags around for the rest of the day and then stuff them into a taxi for the ride back to Kansas City International Airport. The real problem came at the airport. I could not check the garbage bags with the luggage, so I had to carry them aboard the airplane and try to fit them into the overhead storage compartments. They did not come close to fitting. I pushed and pushed and squeezed and squeezed, but to no avail. I then starting removing individual loaves of breads and packages of cakes from the garbage bags and positioning the loaves and cakes in between other passengers’ carry-ons, laptops, raincoats, umbrellas, hats, and whatnots. The airplane’s pilot announced that the plane could not leave the gate until all passengers were seated with their seat belts fastened. I was standing with my seat belt unfastened and with a loaf of Butternut Light Wholesome Rye Bread in my left hand and a loaf of Butternut Enriched Thinly Sliced Sandwich Bread in my right hand. Another passenger and a flight attendant tried to come to my rescue, while other passengers simply gave me dirty or quizzical looks. I became an unwanted center of attention. Passengers were shaking their heads in disbelief that a man in a formal dark pin-striped suit with a red tie was lugging about 25 loaves of bread and dozens of boxes of donuts and cakes from Kansas City to New York—in garbage bags. Just as I was about to close one of the overhead compartments, a loaf of Millbrook Enriched Pumpernickel Bread lost its balance and landed on a lady’s head. Then a bag of Dolly Madison Powdered Donuts landed on another lady’s lap. I apologized and told the second lady she could keep the donuts. She looked at me as if I were crazy. And I felt crazy.

When I arrived home late that night, I deposited the garbage bags in the kitchen and went to bed—exhausted more from garbage bags than from the board meeting. The next morning, I could hardly wait to show my wife, Sue, the wide variety of exciting products made by the company I had just become a director of. I displayed the breads and cakes on our kitchen countertops, which they consumed. I thought that their carefully designed packaging brought credit to our kitchen. But Sue thought otherwise. She was aghast when she read the ingredients listed on the labels: “partially hydrogenated animal shortening, cellulose gum, folic acid, sorbic acid, thiamine mononitrate, artificial colors, artificial flavoring, sulfur dioxide.” Sue turned to me: “You studied chemistry. Do you know what thiamine mononitrate is? It sounds awful. It sounds like an explosive.” I had to admit that in spite of spending hundreds and hundreds of hours in the chemistry laboratories of New Rochelle High School and MIT, and in spite of being a contestant in the Westinghouse Science Talent Search, I did not have the foggiest notion what thiamine mononitrate was. But the name did sound awful—and the names of many of the other ingredients sounded even worse than awful. So when my wife said that the breads and cakes and donuts had to “go immediately,” I quickly agreed. Anyway, it would have taken us months to consume all the products, and they would have totally devastated our waistlines. I suggested that we donate the breads and cakes to a soup kitchen, but Sue immediately nixed the suggestion: “Laden with all those chemicals, they are not fit for anyone.” So, the 25 or so loaves of bread and the dozens of varieties of sugary sweet cakes and donuts went back into their garbage bags and were deposited with the garbage.

We completely lucked out with our investment in Interstate Bakeries. Between early 1986 and mid-summer 1986, the price of wheat fell from about $3.20 per bushel to as low as $2.25 in reaction to prospects for a large crop. Also, between the fall of 1985 and mid-summer 1986, the price of crude oil collapsed from close to $30 per barrel to about $10. Because Interstate consumed large quantities of wheat and gasoline (for its delivery trucks), the sharp declines in the prices of wheat and crude oil were major cost savings for the company. When the prices of raw materials decline, competition usually forces companies to pass on most of the cost savings to their customers, but with a lag. In the case of Interstate Bakeries, the cost savings were so large and the lag in price reductions was sufficiently long that the company’s profits increased sharply. In the fiscal year that ended on May 31, 1986, Interstate’s pretax profits before restructuring charges were $14.6 million. A year later, the comparable number was $20.7 million. While a portion of the 42 percent increase in earnings should be credited to management’s successful efforts to reduce costs, the largest percentage by far was due to the sharp decline in the cost of wheat and gasoline.

In February 1987, Howard Berkowitz wisely decided that it was a good time to take advantage of the large increase in profits by selling the company. The board of directors readily agreed and retained Goldman Sachs to value Interstate and to advise on how it should be sold. On March 27, Goldman told a committee of the board that, if the company was auctioned, its shares might be worth $32 to $35 if the purchaser was not in the baking business and might be worth up to $40 if the purchaser was a baker that could achieve strategic or synergistic benefits and eliminate a competitor. My original valuation had been $25 per share. Thus, I was smiling.

In the spring of 1987, Goldman Sachs prepared a selling brochure and contacted possible purchasers. In the meanwhile, Bob Hatch, who likely would have lost his job if Interstate was acquired by a competitor, contacted First Boston Corporation and suggested that First Boston and he should form a group to purchase control of the company. First Boston agreed. On June 6, the Hatch–First Boston group offered to purchase all the shares owned by the largest shareholders for $35 per share. The purchase would have given the group effective control of the company. After the Interstate board turned down the Hatch–First Boston bid, Bob Hatch told the board that it was a poor time to sell the company and suggested that the board terminate its efforts to sell. However, Howard Berkowitz held the chips—and Howard wanted to realize his profits at a time when the company’s profits seemed to be temporarily inflated.

Efforts to sell the company proceeded. Eleven parties showed a preliminary interest in acquiring Interstate, and four eventually demonstrated sufficient interest that they were willing to sign confidentiality agreements that allowed full access to all of the company’s confidential financial and operating data. The Hatch–First Boston group was one of the four parties. All the other three were other baking companies. By showing interest in acquiring Interstate, a competitor could obtain a free look at Interstate’s confidential books. Thus, a competitor would be foolish if it did not show interest in acquiring Interstate, whether the interest was serious or feigned.

On August 11, Interstate issued a press release stating that it had received informal indications of interest in acquiring the company. In response to the release, the price of Interstate’s shares jumped from $28.875 to $36.25.

Interstate’s board was concerned that the Hatch–First Boston group would be the only party seriously interested in purchasing the company and that the three competitor bakeries were only feigning serious interest. Therefore, it was decided that there would be a closed auction for the company. Bids would be submitted in sealed envelopes. At 5:00 p.m. on Friday, September 11, the envelopes would be opened. The winning bidder would be required to sign a definitive purchase contract almost immediately after its bid was accepted because the board was worried that, if the Hatch–First Boston group learned that it had been the only bidder, it would renege on its bid.

When the envelopes were opened by Goldman Sachs, Hatch–First Boston was the winning bidder at $38 per share. Hatch–First Boston was the only bidder. Goldman Sachs conferred with the board and it was decided to tell Hatch–First Boston that they could own the company if they increased their bid to $40.50. That took nerves. Huge nerves. At about 11:00 a.m. on the 12th, Hatch–First Boston agreed to the $40.50 price, and a few hours later a definitive purchase contract was signed.

Interstate’s board met on Sunday, September 13, to approve the transaction. Most of the meeting was conducted by Paul Roth of Schulte Roth & Zabel, the company’s legal counsel for the transaction. Paul read the riot act. It was the legal responsibility of the board to consider all offers for the company and all other alternatives. Before agreeing to the acquisition, the board had to make 100 percent certain that the transaction was the best available option for the company’s shareholders. Otherwise, the board would be guilty of woeful neglect or much worse. The discussion and analysis of the alternatives then commenced. I have a type AA personality, and after about two tedious hours of debate on whether Hatch–First Boston’s amazingly and unwisely high bid was in the best interest of the shareholders, I lost patience and blurted out: “You don’t have to step on a scale to know you are fat, and this board has been weighing the Hatch–First Boston bid for two long hours on a scale that continually measures that the bid is so fat that it is in danger of breaking the scale. So let’s approve the transaction and go back to our wives and children.” Paul Roth gave me a dirty look and stated that I evidently had not been listening to his description of the legal responsibilities of the board. The discussion and analysis then continued for another few tedious and seemingly unnecessary hours before the board formally approved the transaction.

The saga of the acquisition of Interstate was not complete on September 13. On October 19, the stock market fell apart. The S&P 500 Index declined by 20.9 percent during the day. I was concerned that Hatch–First Boston, now aware that they were the only bidder and aware that they were overpaying for a miserable business, would claim force majeure, and would try to wheedle out of the acquisition. Indeed, Hatch–First Boston did try to cancel the deal, but the purchase contract had been so tightly written by Paul Roth that there were almost no outs. On Monday, October 26, the acquisition was completed.

There is a postscript. The Hatch–First Boston group brought Interstate public again in 1991 and used the proceeds from the offering to reduce the company’s debt. Then, in 1995, Interstate acquired Continental Baking, a troubled subsidiary of Ralston Purina, for $330 million in cash plus 16.9 million newly issued Interstate shares. Five years later, Interstate repurchased 15.5 million of the 16.9 million shares held by Ralston Purina for $244 million. It appears that the repurchase was Interstate’s undoing. The repurchase increased Interstate’s debt by $244 million and reduced its tangible book value by a like amount. On May 31, 2001, Interstate had net debt of $595 million and a tangible book value of minus $20 million—which, of course, is a totally precarious balance sheet. The totally precarious balance sheet led to disaster three years later, when operating losses triggered a violation in the company’s bond indentures. The company was in deep financial trouble. On September 22, 2004, Interstate filed for bankruptcy under Chapter 11. It did not emerge from bankruptcy until 2009, and then was forced to refile under Chapter 11 in early 2012, partially because of large pension obligations to multiemployer union plans and partially because of inefficiencies stemming from restrictive work rules. In November 2012, the company announced that it could not continue as a going enterprise and intended to liquidate, selling off its various brands to the highest bidders. Interstate Bakeries had been a melting ice cube that had completely melted.

There are some lessons to be learned from Interstate Bakeries. While the company’s shares were not deeply undervalued relative to the quality of the company, I decided to place a sizable bet on the shares because its chairman was particularly capable and was highly incentivized to act in the interest of the shareholders. The bet paid off. When Interstate’s earnings surged due to sharply lower costs for wheat and gasoline, Howard Berkowitz was astute enough to realize that the surge likely was transitory. And because he owned 924,800 of the company’s shares, he was highly incentivized financially to put the company up for sale.

Bob Hatch, however, owned relatively few shares. In my opinion, his primary incentive was to maintain his position as CEO. As CEO, he earned more than $500,000 per year and enjoyed substantial perks and prestige. What role did Bob Hatch’s personal interests play in his initial opinion that the company should not be sold? What role did his interests play in the high price that Hatch–First Boston bid for the company, a winning bid that permitted Bob Hatch to remain CEO, but a bid that must have been based on considerable wishful thinking?

I do not have definitive answers to these questions, but I do believe that managements and investors tend to act in their own self-interest—and I strongly suspect that Interstate Bakeries is a case in point.

Another lesson is that too much debt can be fatal. My father-in-law advised me to invest cautiously so that, under arduous circumstances, we would survive and “live for another day.” When Interstate’s management highly leveraged the company by repurchasing $244 million of its shares, it jeopardized the financial viability of the company. As a result, Interstate Bakeries was not able to live for another day. I turn down many otherwise attractive investments because of their weak balance sheets, and I believe that this discipline is a material reason for our success over the years.