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 1962, the DJIA returned -7.6%
In February, John Glenn became the first American to go into orbit. In April, the steel industry voluntarily rolled back its prices after President Kennedy criticized “a tiny handful of steel executives whose pursuit of power and profit exceeds their sense of public responsibility.” In May, Adolf Eichman was executed by the State of Israel for his role in carrying out the Nazi’s extermination of European Jews. In June, the US Supreme Court declared school-sponsored prayers unconstitutional. On October 1, after federal troops intervened, James Meredith became the first African-American student to enroll at the University of Mississippi. On October 20, China launched a full-scale attack on Indian positions along its shared border. On October 15th, US intelligence obtained proof that the Soviets were installing ballistic missiles in Cuba. This sparked the Cuban Missile Crisis and led many to believe that nuclear war was imminent.
Once again, Buffett provides a midyear update to the partners:
During the first half of 1962 we had one of the best periods in our history, achieving a minus 7.5% result before payments to partners, compared to the minus 21.7% overall result on the Dow. This 14.2 percentage points advantage can be expected to widen during the second half if the decline in the general market continues, but will probably narrow should the market turn upward.
Please keep in mind my continuing admonition that six-months’ or even one-year’s results are not to be taken too seriously. Short periods of measurement exaggerate chance fluctuations in performance.
Two things to note. First, Buffett describes a negative 7.5% result as one of the best periods in the funds history. This reflects Buffett’s belief in relative performance. So long as he is beating the market by at least 10%, he feels he is doing a wonderful job. Second, Buffett reminds his audience of how misleading short-term performance is. Anyone who was spooked at the decline and jumped ship would have missed a subsequent rally in the second half of the year.
Performance in 1962
Buffett begins his full year letter with a review of performance:
If one had owned the Dow last year (and I imagine there are a few people playing the high flyers of 1961 who wish they had), they would have had a shrinkage in market value of 79.04 or 10.8%. However, dividends of approximately 23.30 would have been received to bring the overall results from the Dow for the year to minus 7.6%. Our own overall record was plus 13.9%.
My (unscientific) opinion is that a margin of ten percentage points per annum over the Dow is the very maximum that can be achieved with invested funds over any long period of years, so it may be well to mentally modify some of the above figures.
Buffett made back that midyear loss and than some. There is not much insight to be found in the performance section of these letters, but it does remind us how important it is to set a reasonable yardstick. As Buffett mentioned in past years, it’s easy to make yourself look good if you move the target after the fact.
The Ground Rules
This year, Buffett opens with an abridged version of the partnerships ground rules. Most are administrative, but here are some that stand out:
4. Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
This reiterates the relative performance yardstick.
5. While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
It’s prescient that Buffett includes a ‘speculative explosion’ exception. Years later, during the Dot-com boom, he would be in exactly that situation. Maybe if people remembered this letter they wouldn’t have jumped ship at exactly the wrong time.
6. I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership.
Investing isn’t about predicting what will happen tomorrow. It is about sticking with a disciplined system that works and slowly producing gains over the course of a full market cycle. Over the next 10 years the market will be up and down by double digits in any given year. The order shouldn’t matter for us.
7. I cannot promise results to partners. What I can and do promise is that:
a. Our investments will be chosen on the basis of value, not popularity;
b. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and
c. My wife, children and I will have virtually our entire net worth invested in the partnership.
As investors, all we can do is implement a strategy faithfully. Whether or not it works should determine whether or not it survives. There should be no misconception that any results are guaranteed in any specific strategy.
Buffett on compounding
Buffett takes time this year to put on his teachers hat and explain the joys of compounding:
I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.
Like escaping from prison in the movie Shawshank Redemption, investing is a matter of pressure and time. If we can increase the pressure by a few percentage points, over time, our results will increase dramatically. This is the reason investing fees are such a burden on performance. Even the smallest of percentage costs will have out-sized effects on performance. In investing, like in Football, we have to fight for every inch.
Buffett on strategy
Buffett reiterates his strategy of generals, workouts, and control situations, which we are familiar with by now. He does add some interesting color though. In speaking about generals, he notes:
Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.
The classic strategy of letting someone else do the hard work. However, it is important to note the downside of this, which has been displayed in many popular “Hedge Fund Hotel” stocks. For example, Valeant Pharmaceuticals was a company where coattail riding turned grim. Valeant plunged from a high of 250 to under 20 over the course of a few months, taking many a hedge fund down with it. Buffett goes on to make a note about workouts:
I believe in using borrowed money to offset a portion of our work-out portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.
Since 1962 was a down year in the market, you might think that such borrowing would hurt results. However, all of our loans were to offset work-outs, and this category turned in a good profit for the year.
My self-imposed standard limit regarding borrowing is 25% of partnership net worth, although something extraordinary could result in modifying this for a limited period of time.
This is the first insight we get into the role of leverage in the funds. Buffett notes that leverage should only be used in situations of arbitrage like returns, i.e. when results are almost guaranteed and the movement of the broader market is irrelevant. He also imposes a limit of 4:1 leverage. This is a far cry from the 1:40 leverage used most famously at Long Term Capital Management. And if you don’t know, that story ended badly.
Dempster Mill Case Study Part 2
This first part of this case study can be found here. This year, Buffett goes into more detail on how he values the assets of Dempster Mill. He opens:
The high point of 1962 from a performance standpoint was our present control situation –73% owned Dempster Mill. Dempster has been primarily in farm implements (mostly items retailing for $1,000 or under), water systems, water well supplies and jobbed plumbing lines.
The operations for the past decade have been characterized by static sales, low inventory turnover and virtually no profits in relation to invested capital.
We obtained control in August, 1961 at an average price of about $28 per share, having bought some stock as low as $16 in earlier years, but the vast majority in an offer of $30.25 in August.
This is a reiteration of last year’s information. It is important to note that even though Buffett first purchased stock at $16, the majority was acquired at almost double that. Anyone familiar with anchoring, will know how hard this is to do psychologically. However, Buffett isn’t phased in the least. He knows the value of the company, and the fact that it was $16 dollars a few years ago is irrelevant to whether it is a good buy at $30.
Buffett goes on to show his calculation of value per share in 1961:
Last year, our Dempster holding was valued by applying what I felt were appropriate discounts to the various assets. These valuations were based on their status as non-earning assets and were not assessed on the basis of potential, but on the basis of what I thought a prompt sale would produce at that date. Our job was to compound these values at a decent rate. The consolidated balance sheet last year and the calculation of fair value are shown below.
Buffet goes on to explain how he was hitting his head against a wall trying to work with the current management towards a more effective utilization of capital. Eventually, Charlie Munger recommended that he hire Harry Bottle for the turn around. Buffett explains:
Harry is unquestionably the man of the year. Every goal we have set for Harry has been met, and all the surprises have been on the pleasant side. He has accomplished one thing after another that has been labeled as impossible, and has always taken the tough things first. Our breakeven point has been cut virtually in half, slow-moving or dead merchandise has been sold or written off, marketing procedures have been revamped, and unprofitable facilities have been sold.
The results of this program are partially shown in the balance sheet below, which, since it still represents non-earning assets, is valued on the same basis as last year.
To put this into perspective, the percentage change between non-investment assets during the year was:
Three facts stand out: (1) Although net worth has been reduced somewhat by the housecleaning and writedowns ($550,000 was written out of inventory; fixed assets overall brought more than book value), we have converted assets to cash at a rate far superior to that implied in our year-earlier valuation. (2) To some extent, we have converted the assets from the manufacturing business (which has been a poor business) to a business which we think is a good business –securities. (3) By buying assets at a bargain price, we don’t need to pull any rabbits out of a hat to get extremely good percentage gains.
This is the cornerstone of our investment philosophy: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”
With the help of Harry Bottle, Dempster was being converted into an investment company in the same vein as the Buffett Partnerships. By January 2, 1963, Dempster had a security portfolio of about $35 per share. This was more than what Buffett paid for the entire company. Since Dempster was 100% an asset liquidation play, the company was also completely unaffected by the market drop that year.
Since Bottle was instrumental to the successful year, it’s worth taking a look at a letter he wrote to his customers in its entirety. This letter would become a blueprint of turnaround CEO communication in the years to come:
TO OUR DEMPSTER CUSTOMER:
We entered 1962 faced with many challenges—inventories were heavy, bank debts were high, expenses excessive, cash position low and employee complement for too great. We immediately established a set of basic corporate objectives to direct all phases of our operation.
Some of the things done, we must admit were distasteful to all of us, but we were determined in our objectives. We cleaned up our inventory by selling surplus, obsolete and scrap materials—we cut or eliminated expenses in all areas of operations—we promoted bargain and phase out sales of undesirable merchandise–we revitalized our marketing divisions and adopted distribution patterns to help you obtain a growing share of the implements, fertilizer and water systems market.
Our programmed objectives paid off. Sales improved—production schedules materialized—the cash position began to be workable. We can now report our financial position has been sufficiently strengthened to operate in 1963 in a normal fashion. Our friends and business associates now realize that Dempster is going places and in business to stay.
Proudly we look to 1963 with enthusiasm and optimism—we are dedicated to work hard and diligently for improved quality and service. We assure you that Dempster will solidify and consolidate its’ position and build the kind of successful, strong company of which you will be proud. This kind of Company assures our future together.
We appreciate the opportunity to engage in a person to person chat with you by means of this letter.
Yours very truly,
H. T. Bottle, President.
1962 was a difficult year for the stock market. Buffett outperformed by holding a large portion of his portfolio in workouts and control situations. Dempster was his largest success. The lessons of Dempster prove that analysis is important, but so is luck. If Buffett didn’t find Harry Bottle, the investment may have continued to flounder and Buffett’s legacy would be quite different. The drama of Dempster will continue in 1963.