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 1964, the DJIA returned 18.7%.
In January, the Surgeon General released its landmark report on the dangers of smoking. In February, the Beatles appeared on the Ed Sullivan Show. In April, IBM announced the system 360 computer which would become a staple in businesses. In July, the Civil Rights Act was enacted. In August, Congress passed the Gulf of Tonkin Resolution which allowed for the rapid escalation of the Vietnam war. In October, China detonated their first atomic weapon. In November, Johnson beat Goldwater in the presidential election. Goldwater ran on an extreme conservative platform which included using nuclear weapons in Vietnam.
Performance in 1964
There wasn’t much in the midyear update, so let’s get right into it. Buffett opens with a discussion of results:
The overall result for limited partners was plus 22.3%. Both the advantage of 9.1 percentage points on a partnership basis and 3.6 points by the limited partners were the poorest since 1959, which was a year of roughly comparable gains for the Dow.
Nevertheless, I am not depressed. It was a strong year for the general market, and it is always tougher for us to outshine the Dow in such a year. We are certain to have years when the Dow gives us a drubbing and, in some respects, I feel rather fortunate that 1964 wasn’t the year.
This is more of the same. Buffett reiterates the importance of relative performance and how it’s harder to come by in rising markets. Buffett goes on to have an insightful conversation about the shortcomings of the investment management industry as a whole:
The repetition of these tables has caused partners to ask: “Why in the world does this happen to very intelligent managements working with (1) bright, energetic staff people, (2) virtually unlimited resources, (3) the most extensive business contacts, and (4) literally centuries of aggregate investment experience?”
In the great majority of cases the lack of performance exceeding or even matching an unmanaged index in no way reflects lack of either intellectual capacity or integrity. I think it is much more the product of: (1) group decisions – my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is “safe” and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.
There is a broken incentive structure for institutional investing whereby performance is linearly rewarded to the upside, but on the downside you go out of business. Thus, the decision equilibrium is to do just enough to get by. In other words, it is better to look dumb, so long as everyone else looks dumb, than to standout and risk looking dumber. This leads to “closet indexing” and average results across the industry.
Buffett on Conservatism
Sticking with this theme of the investment management industry, Buffett explains the difference between conventionality and conservatism:
It is unquestionably true that the investment companies have their money more conventionally invested than we do. To many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative.
Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning.
We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether other conventional or unconventional – whether others agree or disagree – we feel – we are progressing in a conservative manner.
It was conventional to invest in growth stocks in 1999. It was conventional to buy a house in 2005. It was conventional to have a significant portion of your retirement account in equities in 2007. In none of these cases was it conservative. Conservatism can only be attained through an understanding of an investment. If you don’t understand the 100 or so investments in your portfolio, diversification is making you less conservative, not more.
Buffett on Strategy
Buffett again shows his ability to adapt his strategy. This year, he adds a “Generals – relatively undervalued” category and modifies the existing “Generals” category to give increased weight to qualitative factors. In Buffett’s words:
Let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management – we like a decent industry – we like a certain amount of “ferment” in a previously dormant management or stockholder group. But, we demand value.
Over the course of Buffett’s career, he slowly shifted away from the Graham “cigar butt” school of investing, to the Munger “quality at a reasonable price” school of investing. Small undervalued companies stop moving the needle after you reach a certain size, but quality companies can continue to reinvest capital in near perpetuity.
The new “relatively undervalued” category is worth quoting in it’s entirety:
This category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept. It is important in this category, of course, that apples be compared to apples – and not to oranges, and we work hard at achieving that end. In the great majority of cases we simply do not know enough about the industry or company to come to sensible judgments -in that situation we pass.
As mentioned earlier, this new category has been growing and has produced very satisfactory results. We have recently begun to implement a technique, which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g. I we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sell at 10 times.
This risk has always bothered us enormously because of the helpless position in which we could be left compared to the “Generals -Private Owner” or “Workouts” types. With this risk diminished, we think this category has a promising future.
The problem Buffett originally had with this category was that the companies were too large to be taken over. This eliminated Buffett’s “activist put” margin of safety. In these situations, Buffett was betting that the arbitrage gap in valuations between similar companies would close in his favor, i.e. 12 p/e moves up to 20 p/e rather than 20 p/e moves down to 12 p/e. This year, he was able to devise a strategy that reduced the risk of the latter.
We can reasonably guess what that strategy was. The obvious strategy would be to short the high range valuation in a classic pair trade. That way, if it drops, you are covered on the downside. However, Buffett was never comfortable with shorting as the mainstay of his strategy. Another possible strategy would be just to buy a basket of relatively undervalued securities. The chances of any one of them going against him would be diversified away.
In 2008, Buffett answered this question at the BRK Annual Meeting:
Q: From the partnership letters in 1964, you had a strategy called ‘generals relatively undervalued.’ We have recently begun to implement a technique where we buy something at 12x, when comps sell at 20x. Comps go to 10x. Is this pair trading?
WB: Yes, we didn’t know we started so early. Ben Graham did it in 1920. He did pair trading. He was right 4 out of 5, but the last one would kill him. We shorted the market to some degree. We would borrow stocks from universities. We were early in this. We wouldn’t short a stock because it was unattractive but as a general market short [hedge]. I would borrow from the Treasurer of Columbia [University], “which ones do you want”, “just give me all of them”. It provoked some odd looks when I told the universities I wanted to short all of their stocks. It was not a big deal. We might have made a little money on it in the 1960s, but it is not something we do these days. If you have good long ideas on businesses that are undervalued, it is not necessary to short. 130/30 [simultaneously holding a 130% exposure to a long portfolio; and a 30% exposure to a short portfolio] is being marketed today. Many will sell you the idea of the day. No great statistical merit.
CM: We made our money by being long wonderful businesses, not by using a long-short strategy.
Buffett on Taxes
Buffett takes this year to engage in a philosophical conversation over taxes:
More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. One of my friends – a noted West Coast philosopher maintains that a majority of life’s errors are caused by forgetting what one is really trying to do. This is certainly the case when an emotionally supercharged element like taxes enters the picture.
What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound. Quite obviously if two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other doesn’t the latter course is superior. However, we find this is rarely the case.
I have a large percentage of pragmatists in the audience so I had better get off that idealistic kick. There are only three ways to avoid ultimately paying the tax: (1) die with the asset – and that’s a little too ultimate for me even the zealots would have to view this “cure” with mixed emotions; (2) give the asset away – you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc., either; and (3) lose back the gain – if your mouth waters at this tax-saver, I have to admire you, you certainly have the courage of your convictions.
So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury -at the lowest rates the rules will allow.
Basically, seek to maximize investing profits and the tax side will take care of itself.
In 1964, Buffett began to pivot his strategy toward one that would scale in size. He began to put an emphasis on qualitative factors and to invest in large franchise companies where he had no hope of activist control. In later years, this would be apparent in his Coke, American Express, and Wells Fargo investments.