Investment Theory #8: Buffett’s 1963 Letter

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.

Links to past years can be found here: 1957, 1958, 1959, 1960, 1961, 1962

Historical Context

In 1963, the DJIA returned 20.7%.

In January, the French vetoed a British bid to join the European common market. In April, the USS Thresher sank during deep-diving tests. It was the world’s first nuclear submarine to be lost at sea. In August, Martin Luther King marched on Washington with two hundred thousand civil rights protestors. He declared that he had a dream. In October, the United States and the Soviet Union agreed to ban above-ground testing of nuclear weapons. In November, the Vietnamese military overthrew the government of Ngo Dinh Diem, with the support of the United States CIA. On November 22, President Kennedy was assassinated by Lee Harvey Oswald. This marked the end of an era in American history.

Midyear update

The July letter is standard at this point. Buffett discusses his relative performance to the Dow and how the Dempster Mill liquidation is going. However, he makes an interesting comment about fund objectives:

Our partnership’s fundamental reason for existence is to compound funds at a better than-average rate with less exposure to long-term loss of capital than the above investment media. We certainly cannot represent that we will achieve this goal. We can and do say that if we don’t achieve this goal over any reasonable period excluding an extensive speculative boom, we will cease operation.

Buffett is making the point that better-than-average returns, in and of themselves, are not the goal. In a bull market, anyone can beat a benchmark by simply increasing their leverage. What really matters is the return in relation to the amount of risk taken on. Risk-adjusted returns are an important concept in investment theory and will be a recurring theme in these letters.

Performance in 1963

As always, Buffett begins his full year letter with a review of performance:

1963 was a good year. It was not a good year because we had an overall gain of $3,637,167 or 38.7% on our beginning net assets, pleasant as that experience may be to the pragmatists in our group. Rather it was a good year because our performance was substantially better than that of our fundamental yardstick –the Dow-Jones Industrial Average. If we had been down 20% and the Dow had been down 30%, this letter would still have begun “1963 was a good year.”

I would like to emphasize that, in my judgment; our 17.7 margin over the Dow shown above is unattainable over any long period of time. A ten percentage point advantage would be a very satisfactory accomplishment and even a much more modest edge would produce impressive gains as will be touched upon later. This view (and it has to be guesswork — informed or otherwise) carries with it the corollary that we must expect prolonged periods of much narrower margins over the Dow as well as at least occasional years when our record will be inferior (perhaps substantially so) to the Dow.

Buffett’s letters are a master course in expectation management. He showed an understanding of framing 10 years before Kahneman and Tversky published their landmark paper on the subject. He constantly reiterates the benchmark that he wants to be judged by, and he constantly beats that benchmark. “Under promise and over deliver.”

Buffett on compounding

Buffet puts on his teaching hat once again:

Last year, in order to drive home the point on compounding, I took a pot shot at Queen Isabella and her financial advisors. You will remember they were euchred into such an obviously low-compound situation as the discovery of a new hemisphere.

Since the whole subject of compounding has such a crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu 4,000 converted out to about $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion or over 3,000 times the present national debt, all from 6%. I trust this will end all discussion in our household about any purchase or paintings qualifying as an investment.

Investors should have a long-term mindset. The easiest formula for riches is to invest conservatively and to live a long time.

Texas National Petroleum Case Study

Over the past few years, Buffett had been referencing the sellouts of oil and gas-producing companies in his “workouts” section. Texas National Petroleum was one such “run-of-the-mill” workouts. Buffett explains:

Early in 1962 I heard rumors regarding a sellout to Union Oil of California. I never act on such information, but in this case it was correct and substantially more money would have been made if we had gone in at the rumor stage rather than the announced stage. However, that’s somebody else’s business, not mine.

In early April, 1962, the general terms of the deal were announced. TNP had three classes of securities outstanding:

(1) 6 1/2% debentures callable at 104 1/4 which would bear interest until the sale transpired and at that time would be called. There were $6.5 million outstanding of which we purchased $264,000 principal amount before the sale closed.
(2) About 3.7 million shares of common stock of which the officers and directors owned about 40%. The proxy statement estimated the proceeds from the liquidation would produce $7.42 per share. We purchased 64,035 shares during the six months or so between announcement and closing.
(3) 650,000 warrants to purchase common stock at $3.50 per share. Using the proxy statement estimate of $7.42 for the workout on the common resulted in $3.92 as a workout on the warrants. We were able to buy 83,200 warrants or about 13% of the entire issue in six months.

The risk of stockholder disapproval was nil. The deal was negotiated by the controlling stockholders, and the price was a good one. Any transaction such as this is subject to title searches, legal opinions, etc., but this risk could also be appraised at virtually nil. There were no anti-trust problems. This absence of legal or anti-trust problems is not always the case, by any means.

The only fly in the ointment was the obtaining of the necessary tax ruling. Union Oil was using a standard ABC production payment method of financing. The University of Southern California was the production payment holder and there was some delay because of their eleemosynary status.

This posed a new problem for the Internal Revenue Service, but we understood USC was willing to waive this status which still left them with a satisfactory profit after they borrowed all the money from a bank. While getting this ironed out created delay, it did not threaten the deal.

This was a classic risk arbitrage situation, where profits were guaranteed so long as the deal didn’t fall through. Gross profits in these situations are very small, but their predictability and short holding periods produce great annualized returns. Think of it as getting the last nickel after someone else exited with 95 cents.

In this situation, Buffett was confident that the deal would go through, he just wasn’t sure when. If the deal dragged on for years, the return would have been less appealing, but he was still protected on the downside. For this reason, Buffett would often juice the returns from these investments by using leverage. Buffett explains how the situation ended:

The ruling was received in late September, and the sale closed October 31st. Our bonds were called November 13th. We converted our warrants to common stock shortly thereafter and received payments on the common of $3.50 December 14, 1962, $3.90 February 4, 1963, and 15 cent on April 24, 1963. We will probably get another 4 cent in a year or two. On 147,235 shares (after exercise of warrants) even 4 cent per share is meaningful.

The financial results of TNP were as follows:

(1) On the bonds we invested $260,773 and had an average holding period of slightly under five months. We received 6 ½% interest on our money and realized a capital gain of $14,446. This works out to an overall rate of return of approximately 20% per annum.
(2) On the stock and warrants we have realized capital gain of $89,304, and we have stubs presently valued at $2,946. From an investment or $146,000 in April, our holdings ran to $731,000 in October. Based on the time the money was employed, the rate or return was about 22% per annum.

Buffett ends this case study with some key insights:

This illustrates the usual pattern: (1) the deals take longer than originally projected; and (2) the payouts tend to average a little better than estimates. With TNP it took a couple of extra months, and we received a couple of extra percent.

We attempt to obtain all facts possible, continue to keep abreast of developments and evaluate all of this in terms of our experience. We certainly don’t go into all the deals that come along — there is considerable variation in their attractiveness. When a workout falls through, the resulting market value shrink is substantial. Therefore, you cannot afford many errors, although we fully realize we are going to have them occasionally.

It is important to emphasize the “risk” in risk arbitrage. Many investors have been wiped out making leveraged bets on that last nickel. Long Term Capital Management was notorious for their currency spread arbitrage strategy. They would lever that nickel up by 40 to 1 in some cases. In the end, they blew up. In order to play in this field, investors need to have superior insight into the regulatory and legal aspects of a deal. On the flip side, this barrier to entry means there will always be opportunities available for people willing to do the work.

Dempster Mill Case Study Part 3

For those who haven’t been keeping up with the Dempster Mill Saga:

This situation started as a general in 1956. At that time the stock was selling at $18 with about $72 in book value of which $50 per share was in current assets (Cash, receivables and inventory) less all liabilities. Dempster had earned good money in the past but was only breaking even currently.

Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years. Just why any particular one should do so is hard to say at the time of purchase, but the group expectancy is favorable, whether the impetus is from an improved industry situation, a takeover offer, a change in investor psychology, etc.

Dempster wasn’t one of those situations that just worked out. Earnings continued to decline and management wasn’t responsive to change. So, Buffett built a controlling interest over the course of the next five years. On assuming control, he hired Harry Bottle to turn the situation around:

Harry:
(1) took the inventory from over $4 million (much of it slow moving) to under $1 million reducing carrying costs and obsolescence risks tremendously;
(2) correspondingly freed up capital for marketable security purchases from which we gained over $400,000
(3) cut administration and selling expense from $150,000 to $75,000 per month;
(4) cut factory overhead burden from $6 to $4.50 per direct labor hour;
(5) closed the five branches operating unprofitably (leaving us with three good ones) and replaced them with more productive distributors;
(6) cleaned up a headache at an auxiliary factory operation at Columbus, Nebraska;
(7) eliminated jobbed lines tying up considerable money (which could be used profitably in securities) while producing no profits;
(8) adjusted prices of repair parts, thereby producing an estimated $200,000 additional profit with virtually no loss of volume; and most important;
(9) through these and many other steps, restored the earning capacity to a level commensurate with the capital employed.

And the results of the effort:

1963 Dempster.png

The turn around went so well, that Dempster now had more capital than it needed. This presented a serious problem to anyone interested in producing a satisfactory return on the total capital committed to a corporation. On top of that, Buffett was facing heavy corporate taxes on any attempt to distribute the windfall. In order to avoid double taxation, Buffett set out to either de-incorporate Dempster or to sell the business outright. Buffet explains:

At virtually the last minute, after several earlier deals had fallen through at reasonably advanced stages, a sale of assets was made. Although there were a good many wrinkles to the sale, the net effect was to bring approximately book value. This, coupled with the gain we have in our portfolio of marketable securities, gives us a realization of about $80 per share. Dempster (now named First Beatrice Corp. – we sold the name to the new Co.) is down to almost entirely cash and marketable securities now. On BPL’s yearend audit, our First Beatrice holdings were valued at asset value (with securities at market) less a $200,000 reserve for various contingencies.

I might mention that we think the buyers will do very well with Dempster. They impress us as people of ability and they have sound plans to expand the business and its profitability. We would have been quite happy to operate Dempster on an unincorporated basis, but we are also quite happy to sell it for a reasonable price. Our business is making excellent purchases — not making extraordinary sales.

And that is how the seven-year drama of Dempster Mill ended. Recently, Buffett reflected on the situation in an interview:

Hiring Harry may have been the most important management decision I ever made. Dempster was in big trouble under two previous managers, and the banks were treating us as a potential bankrupt. If Dempster had gone down, my life and fortunes would have been a lot different from that time forward.

Conclusion

Dempster shows how hard investing can be. On paper, Dempster was a home run in 1956. But the priced continued to languish for five years. In 1961, Buffett double downed and bet one fifth of his partnership on a controlling interest. At first, Buffett couldn’t get a grip on the business. He would ask management to cut expenses and reduce inventory, but they would just pay him lip service. Buffett tried to sell the company, but there were no buyers.

Luckily, Buffett found Harry Bottle who did the hard work of laying people off and cutting production. In 1963, seven years after the 1956 home run purchase, Buffett sold Dumpster for nearly three times his initial investment. The take away here is that investors need patience, luck, and above all else, a good purchase price.

References:
http://www.historycentral.com/20th/1963.html
http://csinvesting.org/wp-content/uploads/2012/05/dempster_mills_manufacturing_case_study_bpls.pdf

 

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Author: David Shahrestani

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

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