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. Over time it grew.
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 1961, the DJIA returned 22.2%
On January 20, John F. Kennedy was inaugurated as the 35th president of the United States. On April 17, the Bay of Pigs invasion occurred and quickly became a total disaster. On June 4, the Vienna Summit took place, where Kennedy and Khrushchev debated issues including Laos, disarmament, Berlin, and general ideology. The Summit made little progress and Kennedy was quoted as saying, “Then, Mr Chairman, there will be a war. It will be a cold winter.” On August 13, the Berlin Wall was erected, dividing east from west Berlin.
This is the year Buffett began sending biannual letters to his investors. At the time, Buffett was trying to consolidate many of his partnerships into one single entity. For this reason, most of the letter contains administrative information. However, the letter does contain an interesting point about performance. Buffett explains:
One factor that has caused some reluctance on my part to write semi-annual letters is the fear that partners may begin to think in terms of short-term performance which can be most misleading. My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets.
Buffett goes out of his way every year to make sure that his investors and him are on the same page in regards to performance. He stresses that short-term results should be taken with a grain of salt. Investors can be emotional, and it makes sense to remind them that the short term isn’t always representative of the long-term. Time after time, investment managers have been burned by the inflow and outflow of hot money. Buffett then talks about his positing:
At all times, I attempt to have a portion of our portfolio in securities as least partially insulated from the behavior of the market, and this portion should increase as the market rises. However appetizing results for even the amateur cook (and perhaps particularly the amateur), we find that more of our portfolio is not on the stove.
A rising tide lifts all, but when the tide goes out you see who has been swimming naked. As others become less prudent in their affairs, we need to become more prudent in ours.
Performance in 1961
Buffett opens his full year letter with a reflection on performance:
During 1961, the general market as measured by the Dow-Jones Industrial Average showed an over-all gain of 22.2% including dividends received through ownership of the Dow. The gain for all partnerships operating throughout the entire year, after all expenses of operation, but before payments to limited partners or accrual to the general partner, averaged 45.9%.
Buffett had now completed five full years of partnership operation and the results were pretty spectacular. The partnerships had a compounded return of 251% vs 74.3% for the Dow. There’s not much to take away from this other than that the strategy seemed to be working.
Buffett on Par
You may remember that Buffett used the golf analogy of par when describing his hopes for the partnership. In this letter, he goes out of his way to make sure his investors and him are still on the same page. Buffett explains:
The rub, then, is in being sure that we all have the same ideas of what is good and what is poor. I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.
Buffett goes on to explain why he uses the Dow as his yardstick and why it is a hard yardstick to beat. He also compares his performance to the large mutual funds of the time. Buffett notes:
I do not present the above tabulations and information with the idea of indicting investment companies. My own record of investing such huge sums of money, with restrictions on the degree of activity I might take in companies where we had investments, would be no better, if as good. I present this data to indicate the Dow as an investment competitor is no pushover, and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.
Here, Buffett is explaining the inherent handicap of institutional investing. When you have too much money and a limit on what you can do, your opportunities shrink. For example, an institutional investor can’t buy small companies, take controlling positions, or trade without moving the market. In some cases, and institutional investor is even forced into action. For example, when the price of a stock drops below a certain amount, when a stock is added or removed from an index, or when a spinoff or merger occurs.
Buffett on strategy
You may recall that the original strategy included “generals” and “work-outs”. Overtime, and as more money flowed into the partnership, Buffett adapted his strategy. This year, Buffett added a category he called “control.” This can be thought of as modern-day activist investing. Buffett describes “generals” as follows:
The first section consists of “generals” where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself.
Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price.
A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.
We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.
Generals, or generally undervalued securities, are the bread and butter of value investing. Graham originally referred to these investments as “Cigar Butts” because they had one puff left. For Buffett, these investments consistently make up the largest category of his portfolio and provide the largest portion of returns. However, this category is also the most vulnerable to a declining market. Just because something is cheap, doesn’t mean it wont get cheaper.
Buffett describes “work-outs” as follows:
These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities.
Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies.
Buffett will talk about those oil producer sell-outs in later years, but they were basically merger arbitrage opportunities in which a company traded at a discount to a buyout offer. The downside of “work-outs” are that they are rare and perform worse in a rising market.
Buffett describes “control situations” as follows:
The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it.
Often times a “general” will turn into a “control situation” for Buffett. He explains:
Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation.
Control situations can be thought of as a put option on the price of the investment. If it ever gets too low or stagnates for too long, Buffett just takes control and extracts the value himself. For smaller investors, it is important to remember that there is more timing risk involved when you can’t be your own catalyst.
Buffett on conservatism
Buffett has a lot to say about how to conservatively manage money. He explains:
You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.
You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.
The only way to be truly conservative is to know what you are doing. Buying bonds because other people say they are safe – or gold, or bitcoins, or internet stocks – is not the right strategy. Instead, we should analyze the merits of each individual investment and demand a sufficient margin of safety. Only time will tell if we are truly positioned conservatively.
Buffett on size
As the partnerships continued to grow in size, Buffett felt the need to address how it would impact performance. He explains that increased size is like a double edge sword:
From the standpoint of “passive” investments, where we do not attempt by the size of our investment to influence corporate policies, larger sums hurt results. In some of the securities in which we deal (but not all by any means) buying 10,000 shares is much more difficult than buying 100 and is sometimes impossible. Therefore, for a portion of our portfolio, larger sums are definitely disadvantageous.
However, in the case of control situations increased funds are a definite advantage. A “Sanborn Map” cannot be accomplished without the wherewithal. My definite belief is that the opportunities increase in this field as the funds increase. This is due to the sharp fall-off in competition as the ante mounts plus the important positive correlation that exists between increased size of company and lack of concentrated ownership of that company’s stock.
This comment in 1961 predicted the course of Buffett’s career. Most investors fail to scale because they do not want to enter control situations for whatever reason. Today, Buffett almost exclusively invests in control situations by buying whole companies. This ability to successfully purchase and manage whole companies is extremely rare and explains why Buffett was never slowed down by his increasing capital base.
Dempster Mill Case Study Part 1
In 1956, Buffett initiated a position in a Dumpster Mill as a generally undervalued security. At the time, it had $50 in net current assets and was selling for $18. However the business was doing horrible and would remain horrible for years to come. This investment would play out over the next couple years, but for now let’s dissect what Buffett had to say in 1961:
We are presently involved in the control of Dempster Mill Manufacturing Company of Beatrice, Nebraska. Our first stock was purchased as a generally undervalued security five years ago. A block later became available, and I went on the Board about four years ago. In August 1961, we obtained majority control, which is indicative of the fact that many of our operations are not exactly of the “overnight” variety.
Dempster is a manufacturer of farm implements and water systems with sales in 1961 of about $9 million. Operations have produced only nominal profits in relation to invested capital during recent years. This reflected a poor management situation, along with a fairly tough industry situation. Presently, consolidated net worth (book value) is about $4.5 million, or $75 per share, consolidated working capital about $50 per share, and at yearend we valued our interest at $35 per share. While I claim no oracular vision in a matter such as this, I feel this is a fair valuation to both new and old partners. Certainly, if even moderate earning power can be restored, a higher valuation will be justified, and even if it cannot, Dempster should work out at a higher figure. Our controlling interest was acquired at an average price of about $28, and this holding currently represents 21% of partnership net assets based on the $35 value.
It is interesting to note that Buffet is valuing the company at a 50% discount to book value and a 30% discount to net current assets. The prices we obtain in liquidation are often far less than the values carried on book. As this drama plays out, Buffett will be saved by bringing in an amazing manager and successfully converting Dempster’s assets into portfolio investments. However, that is a story for another time.
In this letter, Buffett adapted his strategy to his growing capital base. He began to see control situations as a viable strategy for non correlated returns. Control also provided Buffett with his own catalyst in case a general languished in price. He also reaffirms his philosophy on returns and conservatism; that returns should be relative to the market and that conservatism is knowing what you are doing.