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 is a continuation of my series about that partnership. The goal of this series is to dissect the letters Warren wrote to his investors, in the hope of gaining some insight into one of the most successful investment vehicles of modern history.
In 1959, the DJIA returned 19.9%
The European Free Trade Association was founded as a counterpart to the Common Market. Fighting between Communist China and the local population of Tibet broke out. The Tibetan government was dissolved and the Dalai Lama was forced into exile. On January 1, Fidel Castro marched into Havana and seized power. On January 3, Alaska was admitted to the Union as the 49th state. On June 3, Singapore became an independent state. On June 26, the St. Lawrence Seaway was opened, allowing ships to travel between the ocean and the great lakes. On July 24, The Kitchen debate between Nixon and Khrushchev took place. This was an informal debate over the merits of communism and capitalism. On August 21, Hawaii was admitted to the Union as the 50th state.
1959 was a period of increasing global tensions as the Cold War continued to heat up.
Warren on the general market
As with previous years, Warren begins with an overview of the general market:
The Dow-Jones Industrial Average, undoubtedly the most widely used index of stock market behavior, presented a somewhat faulty picture in 1959. This index recorded an advance from 583 to 679, or 16.4% for the year. When the dividends which would have been received through ownership of the average are added, an overall gain of 19.9% indicated for 1959.
Despite this indication of a robust market, more stocks declined than advanced on the New York Stock Exchange during the year by a margin of 710 to 628. Both the Dow-Jones Railroad Average and Utility Average registered declines.
The insight to take away here is that headline numbers rarely give the full story. Whether we are talking about GDP or the returns on a stock index, very little can be gleamed without diving deeper into the numbers. Warren continues:
Most of you know I have been very apprehensive about general stock market levels for several years. To date, this caution has been unnecessary. By previous standards, the present level of “blue chip” security prices contains a substantial speculative component with a corresponding risk of loss. Perhaps other standards of valuation are evolving which will permanently replace the old standard. I don’t think so. I may very well be wrong; however, I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a “New Era” philosophy where trees really do grow to the sky.
This except is a master class in defensive investing. It is thinking like this that would save Warren from the Dot Com bubble years later. To paraphrase Howard Marks, if we focus on avoiding the losers, the winners will take care of themselves. Warren is making the same point. He rather sacrifice gains in order to be absolutely certain that nothing is going to blow up his portfolio. Like with tennis, it is errors that will cause you to lose. Unlike with tennis, no one is forcing you to make errors. Charles Ellis popularized this idea in his classic book, Winning the Loser’s Game.
Warren on fund accounting
Warren takes time this year to discuss some of the back-end of the fund:
The overall net gain is determined on the basis of market values at the beginning and end of the year adjusted for payments made to partners or contributions received from them. It is not based on actual realized profits during the year, but is intended to measure the change in liquidating value for the year. It is before interest allowed to partners (where that is specified in the partnership agreement) and before any division of profit to the general partner, but after operating expenses.
The principal operating expense is the Nebraska Intangibles Tax which amounts to .4% of market value on practically all securities. Last year represented the first time that this tax had been effectively enforced and, of course penalized our results to the extent of .4%.
It is interesting that these disclosures almost comply with the global investment performance standards(GIPS®) of modern-day. Warren uses time-weighted returns and notes that they are before general partner fees. Warren’s partnership basically birthed the modern hedge fund industry.
Warren on portfolio positioning
Warren goes on to explain his current strategy:
Last year, I mentioned a new commitment which involved about 25% of assets of the various partnerships. Presently this investment is about 35% of assets. This is an unusually large percentage, but has been made for strong reasons. In effect, this company is partially an investment trust owing some thirty or forty other securities of high quality. Our investment was made and is carried at a substantial discount from asset value based on market value of their securities and a conservative appraisal of the operating business.
The remaining 65% of the portfolio is in securities which I consider undervalued and work-out operations. To the extent possible, I continue to attempt to invest in situations at least partially insulated from the behavior of the general market.
The company Warren is referring to is Sanborn Maps, and there will be a deep case study of it in the 1960 post. The main takeaway here is that Warren is still worried about general market conditions, and is doing everything he can to avoid investments that are highly correlated with the market as a whole.
This was one of Warren’s shorter letters. It is interesting to note, 1959 was also the year Warren met Charlie Munger of the famed “Sit on your ass” school of investing. Warren is continuing to seek investments that don’t rely on the market as a whole for success. He refuses to reach for higher returns, and continues to focus on downside protection. We would do well to emulate this behavior.