Investment Theory #1: Buffett’s Letters

Warren Buffett’s 1957 Letter to Partners

In 1956, Warren Buffett concluded his work for Benjamin Graham and returned to Omaha, where he started an investment partnership. This partnership was formed with seven limited partners, made up of family and friends, contributing $105,000, and Warren Buffet contributing $100.

The partnership, and the ones that would follow, went on to be wildly successful. This series of posts will attempt to understand the principle ideas behind that success.

Historical Context

In 1957, the DJIA return -12.8%.

On March 25, the Rome Treaty was signed which created a Common Market in Europe. By the month of June, flu deaths from a H2N2 influenza outbreak were spiking dramatically. On October 4, the Soviet Union launched Sputnik and signaled the beginning of the Space Age. On September 4, President Eisenhower, after local authorities refused to implement court-ordered desegregation, ordered federal troops to integrated schools in Little Rock. In late 1957, both the United States and the USSR successfully launched ICBMs.

1957 was a period of increasing racial and geopolitical tension. Given that context, it is no wonder the market performed poorly.

Warren on the General Market

On the general market condition, Warren wrote:

The past year witnessed a moderate decline in stock prices. I stress the word “moderate” since casual reading of the press or conversing with those who have had only recent experience with stocks would tend to create an impression of a much greater decline. Actually, it appears to me that the decline in stock prices has been considerably less than the decline in corporate earning power under present business conditions. This means that the public is still very bullish on blue chip stocks and the general economic picture.

Warren Buffet understands how important context is when making judgements. A year in which the DJIA lost 12%, may look like the end of the world to some, but when we take into account the deteriorating business fundamentals of the day, and the historical fluctuations in market prices, a 12% drop looks less sever. Things are rarely as bad or as good as they seem in the media. Earlier this week, we discussed the importance of context based judgement in those post on mere association. Warren goes on to say:

All of the above is not intended to imply that market analysis is foremost in my mind. Primary attention is given at all times to the detection of substantially undervalued securities.

In the top down vs bottom up analysis debate, Warren has always been firmly in the bottom up camp. However, Warren understands that having an understanding of where we are in a cycle is valuable to the investment process. As the saying goes, a rising tide lifts all boats and vice versa.

Warren on Asset allocation

A key takeaway from this letter is how Warren views asset allocation. In 1956, before the market drop of 1957, Warren wrote:

My view of the general market level is that it is priced above intrinsic value. This view relates to blue-chip securities. This view, if accurate, carries with it the possibility of a substantial decline in all stock prices, both undervalued and otherwise. In any event I think the probability is very slight that current market levels will be thought of as cheap five years from now.

There is a lot to dissect in this small paragraph. For starters, despite the aforementioned disinterest in market forecasting, Warren understands that a general market decline will hurt all securities indiscriminately. There is a great line in When Genius Failed, that states that during a crisis, the correlation of everything goes to 1. This means the good gets thrown out with the bad.

This passage also shows how Warren thinks in probabilities. As we reflected on earlier this week, in the post about Bayes Theorem, when the evidence changes, we should change our minds. Warren is looking at the overall valuation of blue chip securities and concluding that since they are high, the probability of high returns in the coming years will decrease. This is how a Bayesian framework of the world is supposed to work. If a sudden decrease in valuations were to occur, Warren would again revise the odds for future returns. Warren goes on:

If the general market were to return to an undervalued status our capital might be employed exclusively in general issues and perhaps some borrowed money would be used in this operation at that time. Conversely, if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio.

As the position of the market cycle changes, Warren changes his allocation of securities.

In times of market overvaluation, Warren increases his position in work-outs. Work-outs are special situations where the outcome of the investment is dependent on a specific corporate action rather than on a general advance in the price of the stock. Some examples of work-outs are spinoffs and mergers. The key feature is their lack of correlation with the market as a whole. In bear markets they will outperform and in bull markets they will underperform. The risk involved in these special situations is that something will disrupt the planned action. For example, a merger breaking down.

In times of market undervaluation, Warren increases his position in general issues. General issues are simple situations where a stock appears to be undervalued in relation to its intrinsic value. The risks involved in these situations are the risk of bad analysis and the risk of a general decline in market conditions. Warren goes on:

At the end of 1956, we had a ratio of about 70-30 between general issues and work-outs. Now it is about 85-15.

As the market declined in 1957, Warren put his money where his mouth is and allocated a greater portion of his portfolio to general issues. Much like we discussed earlier this week in the blog post about Newton’s Laws, for every action, there is a reaction. As the general level of the stock market falls, the future estimated returns on the stock market increases. We should react accordingly.

Warren on Diversification

There are two views of the world. One view claims that you shouldn’t put all your eggs in one basket. The other view claims that you should put all your eggs in one basket and then guard that basket. Warren states:

During the past year we have taken positions in two situations which have reached a size where we may expect to take some part in corporate decisions. One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%.

Warren is clearly in the camp of having all your eggs in one basket, so long as you have a deep understanding of the that basket. Situations that have a high risk of permanent capital loss have no place in a portfolio. We should only look for asymmetric return potential, where our upside is greater than our downside.

Warren on Time Horizons

Speaking about his time horizon, Warren says:

Both of these will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return with a minimum of risk.

When considering investments, it is less important how long they take to play out, and more important how much they are expected to yield annually after they do.

Warren on Benchmarks

Warren states that:

Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages, so in respect to these three partnerships, 1957 was a successful and probably better than average, year.

The return on the averages for 1957, after dividends, came out to -8.5%. Warren’s partnerships, at the time, had an average return of 13%. Warren continues:

To some extent our better than average performance in 1957 was due to the fact that it was a generally poor year for most stocks. Our performance, relatively, is likely to be better in a bear market than in a bull market so that deductions made from the above results should be tempered by the fact that it was the type of year when we should have done relatively well. In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.

Warren wants to be clear of the fact that during bull markets expectations should be tempered. Value investing as a whole should do better in bear markets than it does in bull markets. This is because the margin of safety demanded by value investors will help when the market is tanking, but will hurt our ability to find investments when the market is soaring.

Warren on Building Positions

Finally, Warren has this to say about the technical side of investing:

Obviously during any acquisition period, our primary interest is to have the stock do nothing or decline rather than advance. Therefore, at any given time, a fair proportion of our portfolio may be in the sterile stage. This policy, while requiring patience, should maximize long-term profits.

If we flood a stock with buy orders, its price will spike and eliminate our original discount. For this reason, building a position in an undervalued stock takes patience.

Conclusion

Warren Buffet’s 1957 letter to his partners contained two key insights. The first, is that market prices need to be put in the context of market fundamentals. When fundamentals deteriorate, a market drop should be expected. The second, is that investment allocations should to be altered when the predicted distribution of future market returns is altered.

References

http://www.historycentral.com/20th/1957.html

 

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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