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as a possible buyer of the company, but Graham-Newman wouldn’t pay the asking price. So they turned instead to the investor Jay Pritzker, who had spotted a way to avoid the huge tax bill.3 What he realized was that the 1954 U.S. Tax Code said that if a company was reducing the scope of its business, it could pay no tax on such a “partial liquidation” of its inventory. So Pritzker bought enough stock to take control of Rockwood, choosing to keep the company going as a maker of chocolate bits, and to get out of the cocoa-butter business. He attributed thirteen million pounds of cocoa beans to the cocoa-butter side of the business, the amount of beans that would be “liquidated.”

Rather than sell the beans for cash, however, Pritzker offered them to the other shareholders in exchange for stock. He did so because he wanted their shares to increase his ownership of the company. So he offered them a good deal as an incentive—$36 worth of beans4 for shares that were trading at $34.5

Graham spotted a way to make money from this offer—Graham-Newman could buy Rockwood stock and swap it to Pritzker for cocoa beans it could sell to make a $2 profit on every share. This was arbitrage: two nearly identical things trading at a different price, which enabled a canny trader to simultaneously buy one and sell the other and profit on the difference, with virtually no risk. “In Wall Street the old proverb has been reworded,” as Buffett wrote later. “Give a man a fish and you feed him for a day. Teach a man to arbitrage and you feed him forever.”6 Pritzker would give Graham-Newman a warehouse certificate, which is just what it sounds like: a piece of paper that says the holder owns so many cocoa beans. It could be traded like a stock. By selling the warehouse certificate, Graham-Newman would make its money.

$34 (G-N’s cost for a share of Rockwood—which it turns in to Pritzker)

$36 (Pritzker gives G-N a warehouse receipt—which it sells at this price)

$ 2 (Profit on each share of Rockwood stock)

Virtually no risk, however, means there is at least some risk. What if the price of cocoa beans dropped, and the warehouse receipt was suddenly worth only $30? Instead of making two dollars, Graham-Newman would lose four bucks for every share of stock. To lock in its profit and eliminate that risk, Graham-Newman sold cocoa “futures.” It was a good thing, too—for cocoa prices were about to drop.

The “futures” market lets buyers and sellers agree to exchange commodities like cocoa or gold or bananas in the future at a price agreed upon today. In exchange for a small fee, Graham-Newman could arrange to sell its cocoa beans at a known price for a specified period of time, thus eliminating the risk that the market price would drop. The person on the other side of the trade—who was acquiring the risk that the price would drop—was speculating.7 If cocoa beans got cheaper, Graham-Newman was protected, because the speculator would have to buy Graham-Newman’s cocoa beans for more than they were worth.8 The speculator’s role, from Graham-Newman’s perspective, was to sell what amounted to insurance against the risk of the price dropping. At the time, of course, neither knew which way cocoa prices would move.

Thus, the goal of the arbitrage was to buy as many Rockwood shares as possible while at the same time selling an equivalent amount of futures.

Graham-Newman assigned Warren to the Rockwood deal. He was made for it; he had been arbitraging stocks for several years, buying convertible preferred stock and shorting common stock issued by the same company.9 He had studied arbitrage returns over the preceding thirty years in detail and had discovered that these “riskless” deals typically returned twenty cents for every dollar invested—a lot more than the seven or eight cents profit from the average stock. For several weeks, Warren spent his days shuttling back and forth to Brooklyn on the subway, exchanging stock for warehouse certificates at Schroder Trust. He spent his evenings studying the situation, sunk in thought while singing “Over the Rainbow” to