Investment Theory #10: Buffett’s 1965 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. It grew over time.

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, 1963, 1964

Historical Context

In 1965, the DJIA return 14.2%.

In January, violence broke out in Selma as state troopers attacked civil rights demonstrators. In March, the first two battalions of US combat troops arrived at the Vietnam War. In August, Singapore became an independent republic and joined the British Commonwealth. Also in August, President Johnson launched the war on poverty and signed the Voting Rights Act. Also in August, an undeclared war broke out between India and Pakistan over Kashmir. In November, a cascading failure of the power system caused the great blackout that left the entire northeastern United States dark.

Performance in 1965

In 1965, Buffett had his best year yet with an overall gain of 47.2% compared to 14.2% for the Dow. He notes that it wasn’t likely to happen again and explains:

A disadvantage of this business is that it does not possess momentum to any significant degree. If General Motors accounts for 54% of domestic new car registrations in 1965, it is a pretty safe bet that they are going to come fairly close to that figure in 1966 due to owner loyalties, dealer capabilities, productive capacity, consumer image, etc. Not so for BPL. We start from scratch each year with everything valued at market when the gun goes off. Partners in 1966, new or old, benefit to only a very limited extent from the efforts of 1964 and 1965. The success of past methods and ideas does not transfer forward to future ones.

In investing, we start from scratch everyday. Being right last year doesn’t help you be right this year. It is a very “what have you done for me lately” business. The only sustainable advantage in this industry is process. If we continually improve our process, which is all we can control, hopefully success will build upon success.

Buffett on Size

Usually, Buffett would take the next section to talk about the joys of compounding – this year he talks about the sorrows. As size increases, it becomes ever more difficult to compound at a high rate. Where do you find a 10% return on a million trillion dollars? Buffett explains:

I now feel that we are much closer to the point where increased size may prove disadvantageous. I don’t want to ascribe too much precision to that statement since there are many variables involved. What may be the optimum size under some market and business circumstances can be substantially more or less than optimum under other circumstances. There have been a few times in the past when on a very short-term basis I have felt it would have been advantageous to be smaller but substantially more times when the converse was true.

Nevertheless, as circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them. This might not be true for my own personal results, but it is likely to be true for your results.

It wouldn’t be unheard of for a manager to keep adding assets, at the expense of performance, in an attempt to boost management fees. You might think that Buffett is altruistically looking out for his partners here, which probably has some truth to it. However, Buffett is also extremely competitive and would gladly sacrifice more money in order to maintain his performance record. This becomes even more apparent when he retires the partnership later on. But we’ll get to that later.

Buffett on Strategy

Buffett takes the next section to explain trends in his strategy. He opens with a discussion on workouts:

The “Workout” business has become very spasmodic. We were able to employ an average of only about $6 million during the year in the Workout section, and this involved only a very limited number of situations. Although we earned about $1,410,000 or about 23 ½% on average capital employed (this is calculated on an all equity basis – borrowed money is appropriate in most Workout situations, and we utilize it, which improves our rate of return above this percentage), over half of this was earned from one situation. I think it unlikely that a really interesting rate of return can be earned consistently on large sums of money in this business under present conditions.

The number of workouts, at a size that would move the needle for BPL, was starting to dry up. This was another example of size hurting the firm. Buffett once said that, given a million dollars, he could easily make 50% a year. He was referring to this section of the portfolio. Other managers would come along and try to scale this strategy up by employing absurd amounts of leverage. Some would pull it off; most would blow up.

In the general and control situations, Berkshire Hathaway was the main news. We’ll get to that in the next section. Lastly Buffett makes a note about the relatively undervalued strategy:

Frankly, operating in this field is somewhat more ethereal than operating in the other three categories, and I’m just not an ethereal sort. Therefore, I feel accomplishments here are less solid and perhaps less meaningful for future projections than in the other categories. Nevertheless, our results in 1965 were quite good in the “Relatively Undervalued” group, partly due to implementation of the technique referred to in last year’s letter which serves to reduce risk and potentially augment gains.

Candor also demands I point out that during 1965 we had our worst single investment experience in the history of BPL on one idea in this group.

You may recall, Buffett was employing a pair trading strategy here. This involves buying the undervalued security and shorting the overvalued security. As with any short, a position can quickly go against you. This was probably the cause of that loss that Buffett is referring too. Buffet abandons this strategy in future years as the risk reward prospects of shorting never sat well with him.

Berkshire Hathaway Case Study Part 1

This is the beginning of what Buffett will come to know as, “the greatest mistake I ever made”, costing him upwards of 200 billion dollars. Berkshire Hathaway is the most famous case study of a value trap and is probably what put the nail in the coffin of Buffett’s “cigar butt” strategy. All of that said, Buffett was still able to salvage this investment in the end. Buffett explains:

Our purchases of Berkshire started at a price of $7.60 per share in 1962. This price partially reflected large losses incurred by the prior management in closing some of the mills made obsolete by changing conditions within the textile business (which the old management had been quite slow to recognize). In the postwar period the company had slid downhill a considerable distance, having hit a peak in 1948 when about $29 1/2 million was earned before tax and about 11,000 workers were employed. This reflected output from 11 mills.

At the time we acquired control in spring of 1965, Berkshire was down to two mills and about 2,300 employees. It was a very pleasant surprise to find that the remaining units had excellent management personnel, and we have not had to bring a single man from the outside into the operation. In relation to our beginning acquisition cost of $7.60 per share (the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965), the company on December 31, 1965, had net working capital alone (before placing any value on the plants and equipment) of about $19 per share.

This was a classic liquidation value play on a deteriorating business. As Buffett says, the working capital alone was worth more than the trading price of the stock. However, the story behind the scenes was much more interesting.

After WWII, northern textile manufacturers were in a steep decline and began to move south. In an effort to cope, two struggling textile companies combined operations to form Berkshire Hathaway. This new company would be the largest player in the troubled northern market. Seabury Stanton was charged with running the newly formed company. He hailed from a prominent textile family and had a Harvard education. Stanton stubbornly refused to change the business and quickly ran it into the ground.

Stanton eventually faced reality and began closing mills. He used the proceeds to buy back shares. This was when Buffett took notice and initiated his position in 1962. Buffett was always a fan of a shareholder friendly liquidation. In 1964, Stanton was closing two more mills and was in the process of tendering an offer to buy back more shares. At this point, Buffett was a 7% owner of Berkshire and was happily awaiting the offer. Buffett offered Stanton all of his shares for $11.50. This was about 50% higher than Buffett’s purchase price, but still far less than its book value. Still, Buffett would be happy to take the gain and move on. Stanton agreed to the terms.

This is where the story gets personal. Stanton eventually mailed Buffett a tender offer of $11.375. Buffett was furious that Stanton had shorted him an eighth of a point on what they has agreed upon. So Buffett did what any mere mortal would do when they felt slighted, he sought retribution. Buffett began aggressively buying up shares of Berkshire and in 1965 had a control position. Buffett fired Stanton and began the long journey of managing a failing textile manufacturer.

In a 2010 interview, Buffett had this to say about his spat with Stanton:

Now that sounds like a great little morality tale at this point, but the truth is, I had now committed a major amount of money to a terrible business. Berkshire Hathaway became the base pretty much for everything that I’ve done since, so in 1967, when a good insurance company came along, I bought it for Berkshire Hathaway. I really should have bought it for a new entity, because Berkshire Hathaway was carrying this anchor of all these textile assets; so, initially, it was all textile assets that weren’t any good, and then, gradually, we built more things onto it. But always we were carrying this anchor; for twenty years, I fought the textile before I gave up, and, if, instead of putting that money into the textile business originally, we just started out with the insurance company, Berkshire would be worth twice as much as it is now. This is $200 billion you can figure it comes about, because the genius here thought he’d run a textile business.

But more on that next time.

Conclusion

There are two key takeaways from this year. First, emotions can make anyone forget risk management – even the world’s greatest investor. Second, a company that has a structurally flawed business model, at almost any price, can be expensive. In Buffett’s case, he would end up paying for that emotional purchase over the next 20 years.

References:
http://www.historycentral.com/dates/1965.html#Anchor-52467

 

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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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