Investment Theory #11: Buffett’s 1966 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, 1965

Historical Context

In 1966, the DJIA returned -15.6%.

In January, a series of insurrections in Nigeria sparked a bloody civil war. In June, the Supreme Court overturned the conviction of Ernesto Miranda and established guidelines for informing suspects of their constitutional rights. In August, an undeclared war broke out between India and Pakistan over Kashmir. In September, the first episode of Star Trek debuted on NBC. In December, Walt Disney died while producing The Jungle Book.

Performance in 1966

For the tenth anniversary of the partnership, Buffett knocked one out of the park with the best relative performance in the funds history. Buffett explains:

Our advantage was 36 points which resulted from a plus 20.4% for the Partnership and a minus 15.6% for the Dow.

This pleasant but non-repeatable experience was partially due to a lackluster performance by the Dow. Virtually all investment managers outperformed it during the year. The Dow is weighted by the dollar price of the thirty stocks involved. Several of the highest priced components, which thereby carry disproportionate weight (Dupont, General Motors), were particularly poor performers in 1966. This, coupled with the general aversion to conventional blue chips, caused the Dow to suffer relative to general investment experience, particularly during the last quarter.

As always, there’s not much to gleam from the performance section other than a the amazing record. Even Buffett appears aware of the statistical improbability of his performance to date. He makes it a priority to remind everyone that future returns shouldn’t be as promising.

Hochschild Kohn Case Study

Right off the heels of what Buffett referred to as “his worse mistake ever” with Berkshire Hathaway, Buffett makes a similar mistake with Hochschild Kohn. The “cigar butt’ strategy is on life support after this one, but we are getting ahead of ourselves. In the midyear update, Buffett explains:

During the first half we, and two 10% partners, purchased all of the stock of Hochschild, Kohn & Co., a privately owned Baltimore department store.

The quantitative and qualitative aspects of the business are evaluated and weighed against price, both on an absolute basis and relative to other investment opportunities. HK (learn to call it that – I didn’t find out how to pronounce it until the deal was concluded) stacks up fine in all respects.

We have topnotch people (both from a personal and business standpoint) handling the operation. Despite the edge that my extensive 75 cents an hour experience at the Penney’s store in Omaha some years back gives us (I became an authority on the Minimum Wage Act), they will continue to run the business as in the past. Even if the price had been cheaper but the management had been run-of-the-mill, we would not have bought the business.

The argument for “cigar butt” investing goes something like this: If you buy a stock at a low enough price, chances are there will be some hiccup in the fortunes of the business that will allow you to exit the position at a decent profit. The problem, however, is timing. Unless you’re a liquidator, a mediocre business can continue to destroy value for decades without ever giving you an exit. For example, Berkshire’s textile operations would continue to destroy value for 20 years.

With Hochchild Kohn, Buffett was getting 1) a business selling for less than book value, 2) a great management team, 3) a cushion of unrecorded real estate value, and 4) a cushion of significant LIFO inventory. LIFO (last in first out) understates the value of inventory on the books, since only the low-cost inventory from years past stick around. But Hochchild Kohn was also a retailer, and that often trumps everything else.

Retail is a challenging industry, as many investors will attest too. Consider the recent value investor escapades in Sears, Target, and JC Penny. Consider the recent bankruptcies of Aeropostale, Pacsun, Quicksilver, Wet Seal, American Apparel, and Delia’s. The problem is that shopping habits and sales channels are constantly changing, making any competitive advantage impossible to maintain. For example, who was prepared for Amazon?

Over three years following Buffett’s investment, Hochchild Kohn would fall victim to those same changing preferences and technology. Buffett exits the position in 1959 for the same price he initially paid. This was a huge loss in opportunity cost terms. The main lesson was that it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Buffett on Forcasting

There is something about investor psychology, wherein every time the market ends in a down year, everyone forgets what an up year looks like. Buffett’s partners weren’t immune to this. It is the job of every professional investor to hold their clients hand at this point and stop them from doing anything foolish. Buffett explains:

We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.

I resurrect this “market-guessing” section only because after the Dow declined from 995 at the peak in February to about 865 in May, I received a few calls from partners suggesting that they thought stocks were going a lot lower.

This always raises two questions in my mind: (1) if they knew in February that the Dow was going to 865 in May, why didn’t they let me in on it then; and, (2) if they didn’t know what was going to happen during the ensuing three months back in February, how do they know in May? There is also a voice or two after any hundred point or so decline suggesting we sell and wait until the future is clearer. Let me again suggest two points: (1) the future has never been clear to me (give us a call when the next few months are obvious to you – or, for that matter the next few hours); and, (2) no one ever seems to call after the market has gone up one hundred points to focus my attention on how unclear everything is, even though the view back in February doesn’t look so clear in retrospect.

For information to be actionable, it has to be both important and knowable. What the stock market will do tomorrow is extremely important, but it is also unknowable. Instead, investors should focus on business prospects and downside protection. The market will do what it wants; the only thing we have control over is our process.

Buffett on the Partnership

As you may know, it is getting closer to the year that Buffett “retires” and liquidates the partnership. Some hints are starting to bleed through. This year, Buffett notes:

The results of the first ten years have absolutely no chance of being duplicated or even remotely approximated during the next decade. They may well be achieved by some hungry twenty-five year old working with $105,100 initial partnership capital and operating during a ten year business and market environment which is frequently conducive to successful implementation of his investment philosophy.

We now find very few securities that are understandable to me, available in decent size, and which offer the expectation of investment performance meeting our yardstick of ten percentage points per annum superior to the Dow. In the last three years we have come up with only two or three new ideas a year that have had such an expectancy of superior performance. Fortunately, in some cases, we have made the most of them. However, in earlier years, a lesser effort produced literally dozens of comparable opportunities. It is difficult to be objective about the causes for such diminution of one’s own productivity. Three factors that seem apparent are: (1) a somewhat changed market environment; (2) our increased size; and (3) substantially more competition.

These conditions will not cause me to attempt investment decisions outside my sphere of understanding (I don’t go for the “If you can’t lick ’em, join ’em” philosophy – my own leaning is toward “If you can’t join ‘em, lick ’em”). We will not go into businesses where technology which is away over my head is crucial to the investment decision. I know about as much about semi-conductors or integrated circuits as I do of the mating habits of the chrzaszcz. (That’s a Polish May bug, students – if you have trouble pronouncing it, rhyme it with thrzaszcz.)

What I do promise you, as partners, is that I will work hard to maintain the trickle of ideas and try to get the most out of it that is possible – but if it should dry up completely, you will be informed honestly and promptly so that we may all take alternative action.

A sphere of understanding (circle of competence) is a concept that will reappear in future posts, so let’s spend some time on it. In 1996, Buffett explains:

What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

Every investor has some scope of built up knowledge that they can apply towards an investment. It is fundamentally important to know when an investment falls outside of that scope. Most of us have a solid understanding of how a restaurant makes money, but a complex multinational biotech company is a different story. For Buffett, technology companies have remained mostly outside of his circle of competence.

As investors, we fall into trouble when we try to reach beyond our knowledge base. For this reason, any trend that we don’t understand, even if it is making everyone else rich, is best avoided. Otherwise we fall victim to a dot-com type mentality.

Conclusion

The partnership is edging closer to its end and Buffett is beginning to let his partners down slowly. A key takeaway this year is that, unless you’re a liquidator, a true deep value strategy is going to cause you a lot of headaches. For this reason, we should remember to always pair quantitative margins of safety with qualitative industry fundamentals.

References:
http://www.historycentral.com/20th/1966.html
http://www.wsj.com/articles/buffetts-achilles-heel-retail-investing-1405539148

 

 

 

 

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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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