Investment Theory #12: Buffett’s 1967 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, 1966

Historical Context

In 1966, the DJIA returned 19.0%.

In January, the UK Parliament nationalized 90% of the British steel industry. In April, Greece was overtaken by a military dictatorship. .In June, Israel launched the Six Day War against its Arab adversaries in the area. In August, Thurgood Marshall was confirmed as the first African-American Justice of the US Supreme Court. In October, Che Guevara was captured and executed in Bolivia. In October, tens of thousands of Vietnam War protesters marched on Washington. In December, Christiaan Barnard carried out the world’s first heart transplant.

Midyear Update

On October 9, 1967, Buffett sent out a letter to his partners explaining that the party was almost over:

Over the past eleven years, I have consistently set forth as the BPL investment goal an average advantage in our performance of ten percentage points per annum in comparison with the Dow Jones Industrial Average. Under the environment that existed during that period. I have considered such an objective difficult but obtainable.

The following conditions now make a change in yardsticks appropriate:

1. The market environment has changed progressively over the past decade, resulting in a sharp diminution in the number of obvious quantitatively based investment bargains available;
2. Mushrooming interest in investment performance (which has its ironical aspects since I was among a lonely few preaching the importance of this some years ago) has created a hyper-reactive pattern of market behavior against which my analytical techniques have limited value;
3. The enlargement of our capital base to about $65 million when applied against a diminishing trickle of good investment ideas has continued to present the problems mentioned in the January, 1967 letter; and
4. My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner.

There is a lot to dissect here. Over the previous decade, the partnership’s core competency was primarily quantitative analysis – finding undervalued securities and buying them. Over the years, as the market roared higher, statistical bargains began to disappear. Buffett would probably have welcomed another great depression coming along and making people forget about stocks again, but the next 40% plus crash wouldn’t happen until 1973.

Buffett notes that speculation was starting to dominate the market. As short-term investment tracking became widely available, investment managers needed to catch every wave of momentum or they risked being dumped for someone who did. Similarly, the general public felt a need to be invested or they risk watching their neighbors get rich from the sidelines. This was nothing new, and Buffett knew it would make the investing environment more difficult going forward.

Buffett also notes that he was far richer than when he started the partnership. Spending every waking moment in an all out effort to beat the market was starting to look less attractive than some other non-economic activities. At least this was the argument he was making to his partners. In reality, Buffett was still fiercely competitive, and knowing that under-performance was probably around the corner, he might have been looking for an out.

Performance in 1967

As always, Buffett begins the full year report with a summary of his results:

By most standards, we had a good year in 1967. Our overall performance was plus 35.9% compared to plus 19.0% for the Dow, thus surpassing our previous objective of performance ten points superior to the Dow. Our overall gain was $19,384,250 which, even under accelerating inflation, will buy a lot of Pepsi.

These results masked massive differences in the underlying strategies. The workout strategy had its worse performance in the fund’s history, basically breaking even. The control strategy was weighed down by Berkshire and Diversified Retailing. This also happened to be the year Buffett bought National Indemnity for Berkshire. The float from that insurance business would set off the second act of Buffett’s investing career, but that is a story for another day.

So how did Buffett make money this year? In the relatively undervalued strategy, Buffett managed a 72% return. This was mainly due to one very large position in American Express:

Last year I referred to one investment which substantially outperformed the general market in 1964, 1965 and 1966 and because of its size (the largest proportion we have ever had in anything – we hit our 40% limit) had a very material impact on our overall results and, even more so, this category. This excellent performance continued throughout 1967 and a large portion of total gain was again accounted for by this single security.

American Express Case Study

In 1963, a former commodities broker named Anthony De Angelis borrowed $180 million backed by 1.8 billion pounds of stored soybean oil. The problem was that he only had about 110 million pounds. De Angelis had been filling barrels with water and then topping them off with oil in an attempt to fool inspectors. When the scandal was exposed, De Angelis declared bankruptcy and left his creditors holding the $180 million bag.

American Express was one of those creditors. They would go on to lose $58 million from the scandal and their stock price would drop by 50%. In 1964, Buffett initiated a 5% position in the company. Buffett saw an out of favor company – with a sustainable and growing customer base – trading well below its earnings power as the result of a one time write-off. Not only did Buffett see this opportunity, but he bet big on it. At its height, American Express made up 40% of his portfolio.

American Express is worth looking at in greater detail. The 1964 annual report can be found here (h/t to Hurricanecaptial who did a great write-up on AMEX). In the president’s letter to shareholders, the Salad Oil Scandal was front and center:

As set forth beginning on page 18 of this report, negotiation are continuing for agreement upon the plan for the disposition of claims against our subsidiary, American Express Warehousing, Ltd., arising out of the Allied Crude Vegetable Oil Refining Corp. Fraud at Bayonne, New Jersey. Because the ultimate outcome of this matter cannot now be determined, no provision has been made in financial statements of this report for any losses which might be sustained therefrom.

It is important to remember that, at the time of Buffett’s investment, no one was sure how big the liability from the oil fraud would turn out to be. History shows time and again that investors hate uncertainty from unaccounted liabilities. After the BP oil spill in 2010, the stock crashed from $60 to $27. Two years later, it was trading back above 50. The Chemours company, weighed down by unaccounted for environmental liabilities, dropped from $20 to $3 after splitting from DuPont in 2015. Sixth months later, it was trading above $13. Volkswagon recently went through a similar scandal. Of course, there’s survivorship bias in these examples – plenty of companies facing unaccounted for liabilities end up bankrupt – but there’s still opportunity in the space.

Taking a closer look at American Express’s financials, we can come up with a quick back of the envelope valuation.

AMEX 1964.png

Before the soybean oil fiasco, American Express was trading in the 60s and had a multi-year track record of consistent growth and high returns. If you expected the oil related write-down to be a onetime none event, the stock was a clear bargain when it dropped into the 30s. Of course, everything is clear in hindsight.

Conclusion

Two main takeaways from this year: 1) as everyone else becomes less prudent with their investments (speculation run amok), we should become more prudent with ours (reduce expectations and limit exposure) and 2) when a company with a proven record of sustainable earnings power, stumbles on an event that doesn’t affect its primary business, it’s time to bet and bet big.

References:
https://en.wikipedia.org/wiki/1967
https://en.wikipedia.org/wiki/Salad_Oil_Scandal

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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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