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 that partnership. The goal is to gain some insight into one of the most successful investment vehicles in modern history.
In 1960, the DJIA returned -6.3%.
On January 7, the United States launched the first Polaris missile from a submarine which led to the United States storing a significant portion of their nuclear deterrent on submarines. On May 1, a United States spy plane was shot down over the Soviet Union, which led to increased tensions and rhetoric between the two powers. On April 19, a student uprising in South Korea forced the resignation of President Syngman Rhee, which in turn, led to a period of political instability. During this period, Seventeen African nations won independence. This period also saw the deterioration of Sino-Soviet relations. The Chinease and Soviets could not agree on how communist rule should look going forward.
Buffett on the general market
As always, Buffett begins his letter by giving an overview of where the markets currently stood:
The Industrial Average declined from 679 to 616, or 9.3%. Adding back the dividends which would have been received through ownership of the Average still left it with an overall loss of 6.3%. On the other hand, the Utility Average showed a good gain and, while all the results are not now available, my guess is that about 90% of all investment companies outperformed the Industrial Average. The majority of investment companies appear to have ended the year with overall results in the range of plus or minus 5%. On the New York Stock Exchange, 653 common stocks registered losses for the year while 404 showed gains.
Buffet felt the market was overly optimistic in the preceding year, so this decline was probably welcomed.
Buffett on performance
Buffett, mainly speaking to new investors, reiterates the goal of the partnership:
My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average. I believe this Average, over a period of years, will more or less parallel the results of leading investment companies. Unless we do achieve this superior performance there is no reason for existence of the partnerships.
The ongoing debate between passive and active investing, really just boils down to this one insight. If we can’t beat the market, we should just buy the market. Buffett continues:
I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.
There are two main benchmarks for investment performance: relative or absolute. Buffett has chosen the relative approach. Either way, the takeaway here is that we should expect both good and bad years. If we get to caught up in recent performance, we might become emotional and commit errors. Kipling put it best:
If you can meet with Triumph and Disaster
And treat those two impostors just the same;
Yours is the Earth and everything that’s in it,
And-which is more-you’ll be a Man, my son!
Buffet goes on to make one final point about performance:
Although four years is entirely too short a period from which to make deductions, what evidence there is points toward confirming the proposition that our results should be relatively better in moderately declining or static markets.
Howard Marks puts it this way:
The biggest trap in our industry are people who respond to short-term performance. Short-term performance is an imposter. It’s like a roll of the dice, you throw two dice, they come up 7, you say, oh these dice always come up 7. But many other things are possible.
We should be skeptical of short-term performance in all walks of life. Linsanity was fun while it was going on, but it wasn’t representative of future performance.
Sanborn Maps case study
You might remember in the last post, Buffet said:
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.
This new situation is somewhat larger than Commonwealth and represents about 25% of the assets of the various partnerships. 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.
This year, Buffet explains the reasoning behind that investment. He beings with an overview of the company’s business.
Sanborn Map Co. is engaged in the publication and continuous revision of extremely detailed maps of all cities of the United States … The cost of keeping the map revised to an Omaha customer would run around $100 per year.
This detailed information showing diameter of water mains underlying streets, location of fire hydrants, composition of roof, etc., was primarily of use to fire insurance companies … The bulk of Sanborn’s business was done with about thirty insurance companies although maps were also sold to customers outside the insurance industry such as public utilities, mortgage companies, and taxing authorities.
For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort. In the earlier years of the business, the insurance industry became fearful that Sanborn’s profits would become too great and placed a number of prominent insurance men on Sanborn’s board of directors to act in a watch-dog capacity.
It is worth digressing to talk about monopoly power, since this will turn out to be a recurring theme. Let’s start with the opposite, commodity-like businesses.
Commodity-like businesses are characterized by hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. To remain profitable, a commodity-like business needs to either be the low-cost producer or to operate in a protected niche.
Monopoly-like businesses are characterized by few competitors, barriers to entry, and a product that is unique. These conditions allow for sustained profitability, and an ability to raise prices without the fear of competition. Monopolies emerge for a number of reasons. These include physical limitations (owning the supply of diamonds or electromagnetic spectrum), legal limitations (owning patents or government franchises), and economic limitations (economies of scale or “winner take all” markets).
In the case of Sanborn Maps, it would have cost a competitor tens of millions of dollars to reproduce the detailed information they had gathered over the years. This created a barrier to entry that helped them remain profitable. Now, let’s get back to what went wrong with this story. Buffet continues:
In the early 1950’s a competitive method of under-writing known as “carding” made inroads on Sanborn’s business and after-tax profits of the map business fell from an average annual level of over $500,000 in the late 1930’s to under $100,000 in 1958 and 1959. Considering the upward bias in the economy during this period, this amounted to an almost complete elimination of what had been sizable, stable earning power.
Monopolies rarely last forever. Consider the technological disruptions occurring across multiple industries today. Once stable newspaper monopolies are now fighting just to survive. The same thing happened with Sanborn. Sanborn was now a business in decline and if the story ended here, it wouldn’t be that interesting. It doesn’t though and Buffett continues:
However, during the early 1930’s Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.
Let me give you some idea of the extreme divergence of these two factors. In 1938 when the Dow-Jones Industrial Average was in the 100-120 range, Sanborn sold at $110 per share. In 1958 with the Average in the 550 area, Sanborn sold at $45 per share. Yet during that same period the value of the Sanborn investment portfolio increased from about $20 per share to $65 per share. This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions. In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.
So for $45 per share, Buffett was getting $65 dollars of investment assets and a map business that remained profitable. Back in 1959, Buffet described it this way:
In effect, this company is partially an investment trust owning 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.
When we consider both the asset value and the earnings power of Sanborn, a large margin of safety becomes apparent. It seems like a no brainier, so what could go wrong? The next lesson we will learn is a powerful one and shows the fundamental agent-principle problem in investing. The interests of owners and managers don’t always allign.
Buffet goes activist
Buffett made his purchase in Sanborn and began to wait for reality to be reflected in the share price. But the share price of Sanborn continued to languish. Buffett explains:
The very fact that the investment portfolio had done so well served to minimize in the eyes of most directors the need for rejuvenation of the map business. Sanborn had a sales volume of about $2 million per year and owned about $7 million worth of marketable securities. The income from the investment portfolio was substantial, the business had no possible financial worries, the insurance companies were satisfied with the price paid for maps, and the stockholders still received dividends. However, these dividends were cut five times in eight years although I could never find any record of suggestions pertaining to cutting salaries or director’s and committee fees.
As far as the directors were concerned, they were sitting pretty. They did not own any significant shares in the company, but they continued to receive their salaries and fees. Buffett, as a large shareholder, wasn’t as content. Buffett became a director and immediately lobbied for management to unlock the value of the investment portfolio. Buffett continues:
We hoped to separate the two businesses, realize the fair value of the investment portfolio and work to re-establish the earning power of the map business. There appeared to be a real opportunity to multiply map profits through utilization of Sanborn’s wealth of raw material in conjunction with electronic means of converting this data to the most usable form for the customer.
As a side note, Sanborn still exists today as an electronic provider of GIS information. Wikipedia explains their survival this way:
Government sales began to play a larger role, especially the Census Bureau and municipal planning agencies. Over time, the company diversified into other mapping activities, and is today a geospatial specialist and holder of electronic GIS assets and systems, though the fire insurance business continues as a niche department.
So it seems Buffett’s plan would have worked in the long run. However, the board was still resisting change. Buffett continues:
There was considerable opposition on the Board to change of any type, particularly when initiated by an outsider, although management was in complete accord with our plan and a similar plan had been recommended by Booz, Allen & Hamilton (Management Experts). To avoid a proxy fight (which very probably would not have been forthcoming and which we would have been certain of winning) and to avoid time delay with a large portion of Sanborn’s money tied up in blue-chip stocks which I didn’t care for at current prices, a plan was evolved taking out all stockholders at fair value who wanted out. The SEC ruled favorably on the fairness of the plan. About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value. The map business was left with over $l,25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated. The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.
In the end, management agreed to buy out dissatisfied investors. Buffett exchanged his shares for portfolio securities and made a 50% return on his original investment.
This wasn’t the first time Warren Buffet came across an investment with these characteristics. Roger Lowenstein, in his biography of Buffett, explains that:
This was a carbon copy of Northern Pipe Line—prized by Graham for its railroad bonds. Echoing his mentor, Buffett bought Sanborn stock through 1958 and 1959.
Following Graham page-for-page, Buffett became a director and lobbied the management to unearth the sub rosa value in its investment portfolio.
It is important to remember that a lot of investment success can be attributed to experience. History tends to repeat itself, and someone who has been in the game for a long time will start to notice patterns.
The important takeaway from this whole Sanborn Map melodrama, is that sometimes an investor needs to create their own catalyst. In a situation where management is content to just let a stock price languish, an activist role needs to be taken. Buffett accomplished this by actively negotiating with other shareholders to form a group that controled 44% of the company. This inflence allowed him to lobby for change. If instead, Buffett had just waited passively, the value of Sanborn may have remained depressed indefinitly.