Investment Theory #2: Buffett’s Letters

Warren Buffett’s 1958 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.

This post continues my series about the letters Warren Buffett wrote during this time. The goal of this series is to obtain some insight into the thought process behind one of the most successful investment vehicles in recent history.

Historical context

In 1958, the DJIA returned 38.5%

Tensions between the US and China flared up as the Communists began bombing two islands held by the Nationalist Chinese of Taiwan. Egypt and Syria joined together as the United Arab Republic after much lobbing by Gamal Abdel Nasser. The experiment of Pan-Arab Nationalism would be short-lived, as Syria would break away in 1961. On January 31, the US successfully launched their first satellite, Explorer I, into orbit. Before this accomplishment, it appeared that the Soviets had a major lead in space. On October 27, Pan Am introduced 707 trans-Atlantic jet service from New York to Paris.

1958 was a period of renewed optimism for the US, and the advent of trans-Atlantic travel was about to make the world a much smaller place.

Warren on the general market

Warren begins the letter with a general overview of market conditions:

During the past year almost any reason has been seized upon to justify “Investing” in the market. There are undoubtedly more mercurially-tempered people in the stock market now than for a good many years and the duration of their stay will be limited to how long they think profits can be made quickly and effortlessly. While it is impossible to determine how long they will continue to add numbers to their ranks and thereby stimulate rising prices, I believe it is valid to say that the longer their visit, the greater the reaction from it.

Warren is referring to the cyclical nature of mass psychology in the market. When people see other people making fortunes in the stock market, jealously and greed creep into the public consciousness. New participants enter the market, searching for gold, and bid up the prices of everything they can get their hands on. So long as the music doesn’t stop, this action is reinforced, and bubble like conditions begin to form. The longer it lasts, the more distorting it becomes. Warren continues:

I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, prices, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected.

This is a repeat of what Warren had to say in his 1957 letter. The fundamental ideas of investing are timeless, and repetition will be a common theme in these letters. The key insight here is that we should only be interested in the general market insofar as a general decline will have a negative impact on even our best holdings.

Commonwealth Trust Co. of Union City

This year, Warren reviews a specific investment that he made in Commonwealth Trust.

At the time we started to purchase the stock, it had an intrinsic value $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend at all despite earnings of about $10 per share which was largely responsible for a depressed price of about $50 per share. So here we had a very well managed bank with substantial earnings power selling at a large discount from intrinsic value. Management was friendly to us as new stockholders and risk of any ultimate loss seemed minimal.

Commonwealth was 25.5% owned by a larger bank (Commonwealth had assets of about $50 Million – about half the size of the First National in Omaha), which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely. Thus we had a combination of:

1. Very strong defensive characteristics;
2. Good solid value building up at a satisfactory pace and;
3. Evidence to the effect that eventually this value would be unlocked although it might be one year or ten years. If the latter were true, the value would presumably have been built up to a considerably larger figure, say, $250 per share.

There is a lot to unpack here. Warren was essentially paying five times after tax earnings for a business that he expected to grow at a rate of 7% a year. I have not been able to find the original financials for Commonwealth Trust (if anyone else has please send them my way), but there is still a lot we can deduce about this investment.

Warren estimated an intrinsic value of $125 for a company that had $10 dollars in earnings and a strong competitive position. This implies a 8% discount rate at a time when the risk free rate was 3.5%. Warren was basically saying that paying 12.5x earnings for a well run and growing company is a good conservative estimate of its value. And at 5x earnings, there was a significant margin of safety for him to be a buyer. Warren also gives us some insight into his own personal hurdle rate with the following:

Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller.

$65 would imply a 15% discount rate, or said another way, a 15% earnings yield. At this price, Warren was no longer interested in adding to his position and it is possible that anything less than 15% would not provide Warren with the margin of safety that he demands. It is also possible that Warren is just weighing the opportunity cost of other investments he could make.

In my opinion, the most important aspect of this investment was the catalyst that Warren saw for unlocking value. In this case, the catalyst was the parent company that was seeking a merger. It is important to remember that an undervalued investment can stay undervalued for years. When we make our investment decisions, we need to be aware any catalysts that will help in unlocking value.

Warren on selling

Warren goes on to talk about the decision to exit Commonwealth Trust.

Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share although the quoted market was about 20% lower at the time.

I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it.

At $80, the earnings yield would be 13.5%. At $50, the earnings yield was 20%. Warren judges every investment he makes against the opportunity cost of every other investment he could make. When a better opportunity is available elsewhere, Warren has no issue with modifying his portfolio. We should do the same.

Warren on ownership control

In talking about his new investment, Warren makes the following statement:

While the degree of undervaluation is no greater than in many other securities we own (or even than some) we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation. In this particular holding we are virtually assured of a performance better than that of the Dow-Jones for the period we hold it.

This is the key idea behind activist investing, and in some ways, Warren was the original activist investor. This is also a continuation of Warren’s desire to have a catalyst that will unlock value. Ideally, people would just realize the value of companies over time and any undervalued situation would correct itself. In reality, this is rarely the case, and we should be aware of that fact.

Warren on strategy adjustment

Warren, speaking about the current environment for investments, says the following:

The higher the level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.

To the extent possible, therefore, I am attempting to create my own work-outs by acquiring large positions in several undervalued securities.

We are seeing Warren’s evolution as an investor as it occurs in real-time. At the outset of the partnership, Warren was content with finding undervalued situations and holding them until they reached his estimate of intrinsic value. Overtime, as that strategy proved more difficult to execute, Warren shifted towards investments that had a direct catalyst for realizing value. As the enviroment adjusts, we as investors also need to adjust.

Conclusion

Earlier in the week we talked about algorithmic thinking and how it can help us make better decisions. In Warren’s 1958 letter to his partners, I believe we are getting a glimpse into the algorithms that Warren Buffett used for making investment decisions in those early days.

  1. Estimate conservative intrinsic value (12.5x earnings).
  2. Require good management and a competitive moat.
  3. Require a catalyst to realize value.
  4. Purchase only at a significant margin of safety (40-60% discount)
  5. Always weigh against other opportunities and sell if prudent.

References:
http://www.historycentral.com/20th/1958.html

Advertisements

Author: David Shahrestani

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

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s