Get the Letters: The Buffett Partnership Letters are classic reading for any value investor. Readers get an inside view of Warren Buffett’s investment philosophy — seeing where it did and did not evolve — early in his career.
The Notes
- From 1957 to 1968, the Buffett Partnership earned a 31.6% annual return (25.3% for limited partners), with no losing years, compared to 9.1% for the Dow.
- Buffett saw a satisfactory return as one that beat the Dow by 10% over the long term. And if he could not beat the Dow, it was best for the partners to invest through someone else.
- His goal was to outperform in bear markets with average performance in bull markets — targeting a half percent decline for each 1% decline in the Dow. He constantly reminded the partners of it — tempered their expectations — every time he handily beat the Dow.
- “I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%.”
- He favored a conservative approach, avoiding permanent capital loss.
- “I make no attempt to forecast the general market — my efforts are devoted to finding undervalued securities.”
- 3 years is his minimum time needed to judge good performance (5 years is better), assuming the period saw both strong and weak markets.
- “At all times, I attempt to have a portion of our portfolio in securities as least partially insulated from the behavior of the market, and this portion should increase as the market rises.”
- Buffett’s Fees: one-fourth of profits above 6% per year, with any year falling short of 6% in profits would be carried forward against future profits.
- Indexes are tough competition to beat:
- Buffett annually compared four of the largest mutual funds at the time against the Dow: “I present this data to indicate the Dow as an investment competitor is no pushover, and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.”
- The lack of outperformance from the funds was due, in his opinion, to a combination of group decisions making it harder to come to a consensus decision, desire to conform (herd mentality) to what other funds are doing, that average performance is safer than the risk of being different, broad diversification, and inertia.
- That said, Buffett does see a benefit in mutual funds despite their lack of alpha — ease of use, freedom from decision making, automatic diversification, and a better alternative than the speculative trouble an investor can get into on their own.
- “Just because something is cheap does not mean it is not going to go down.”
- “You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you… You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct.”
- The size of a portfolio can help or hurt returns depending on how its invested — helpful in control situations, hurtful in passive investments.
- A conservative portfolio is measured by how well it performs in a bear market.
- “Short periods of measurement exaggerate chance fluctuations in performance.”
- Good or bad performance should be measured against a benchmark(s), not by gains or losses in a year. Investors should objectively evaluate their performance against that benchmark.
- “What I can and do promise is that: Our investments will be chosen on the basis of value, not popularity; that we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments…”
- Joys of Compounding:
- Assume the voyage of Columbus had been underwritten with $30,000 in venture capital. Had the money been invested differently, say at 4% compounded annually to the present (i.e. 1962), Spain would have watched it grow to $2 trillion.
- Assume Francis I of France paid $20,000 for Leonardo da Vinci’s Mona Lisa in 1540. Had he instead invested the money at 6% compounded annually (after-tax, of course), his estate would worth $1 quadrillion.
- Manhattan was sold in 1626 to Peter Minuit for the rough equivalent of $24. Who got the better deal? A 1965 appraisal, at $20 per square foot puts the value at $12.5 billion. But had the Indians invested that $24 at 6.5%, it would be worth $42 billion over the same time. If they got a half point better — 7% instead — they’d have $205 billion!
- “It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years.”
- “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”
- Conservative investing is not the same as conventional investing. There are times when a conservative approach means being conventional — investing like everyone else — but there will also be times when a conservative approach means being unconventional. Conservative investing is not about seeking agreement with others but making a proper assessment of many situations while maintaining the primary goal of avoiding the temporary and permanent loss of capital.
- “If a 20% or 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments.”
- “…my own investment philosophy has developed around the theory that prophecy reveals far more of the frailties of the prophet than it reveals of the future.”
- The goal of investing is to earn the best after-tax return possible, which is not the same as paying the lowest amount of taxes. Holding on to investments to avoid paying taxes is often at odds with earning the best after-tax return.
- Investing is about probabilities and expectations which results can diverge from in the short term.
- Position Sizing: He based it on the probability that an investment might result in worse relative performance to the Dow. Given two stocks with the same expected returns, the one with the lower probability of performing worse than the Dow gets the higher weighting in the portfolio. Overall weighting is determined by how tiny the probability can get. He was willing to go as high as 40% in any one position.
- “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.”
- “The availability of a quotation for your business interest (stock) should always be an asset to be utilized if desired. If it gets silly enough in either direction, you take advantage of it. Its availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgments.”
- The beginning of 1967 was the first time Buffett complained about finding a lack of good opportunities. He questioned whether it was due to a change in the market environment, portfolio size, or more competition. He refused to invest outside his comfort zone, or chase the popular tech stock craze of the late ’60s.
- By the end of 1967, Buffett said it was no longer possible for him to beat the Dow by 10% due to the late ’60s market behavior (he changed it to 5% over the Dow or 9%, whichever is lower). He saw a “distortion of a sound idea” — a shift in focus from long term performance to short term performance, leading to speculation in order to achieve the highest returns possible in the shortest amount of time. Buffett wasn’t willing to change his strategy to something he didn’t understand just to compete against the Go-Go funds. He would rather pass on the large, easy profits because of the risk of large capital losses that came with it.
- 1967 was the first time he floated the possibility of retiring.
- On Quantitative vs. Qualitative Analysis: both approaches can be used to make money. Investors who prefer one or the other, likely combine the two to some extent. Buffett considers himself of the quantitative type, but said his best ideas were qualitative — only when he had a “high probability insight.” But those insights are rare. The quantitative side needs no insight — the numbers are either obvious or not.
- “So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”
- “My mentor, Ben Graham, used to say: ‘Speculation is neither illegal, immoral nor fattening (financially).'”
- Better to work with quality management that earn a decent return than chase a few percentage points higher returns by working with horrible management.
- Recommended partners read The Money Game in 1968.
- Go-Go Fund manager on investing in 1968: “The complexities of national and international economics make money management a full-time job. A good money manager cannot maintain a study of securities on a week-by-week or even a day-by-day basis. Securities must be studied in a minute-by-minute program.”
- Buffett announced his retirement in the May 1969 letter and offered a plan to liquate the partnership.
- Recommended partners invest with Bill Ruane — Buffett’s classmate in Ben Graham’s class at Columbia — after the partnership liquidation. He earned similar returns to the partnership with more volatility.
- “I find it much easier to think about what should develop over a relatively long period of time than what is likely in any short period. As Ben Graham said: “In the long run, the market is a weighing machine – in the short run, a voting machine.” I have always found it easier to evaluate weights dictated by fundamentals than votes dictated by psychology.”
- Buy bonds like you would stocks — only invest in what you understand.
- Bond maturity: selection should be based on the shape of yield curve, the expectation of future interest rates (most difficult to assess), and the ability to stomach price fluctuation.
- Portfolio Construction:
- Generals:
- Undervalued securities, with a wide margin of safety, no view on corporate policy or when price appreciation might occur.
- Bargain price is a must, but also good management or new management in a decent industry.
- He likes to see companies with improving earnings/increasing asset values, that the market hasn’t recognized yet.
- It’s the largest portion of the portfolio with the best total returns.
- Individual position size: 5% – 10% for each of 5 or 6 generals, with small positions in 10-15 others.
- More concerned about buying at the right price then selling at the best price — squeezing the last penny out of a deal. He was happy selling below fair value.
- Tend to move with the market — performing well in rising markets, poorly in declining markets.
- In the 1964 letter, he split Generals into two groups: “Private Owner Basis” and “Relatively Undervalued.” The “Private Owner Basis” were the typical Generals as described above. The “Relatively Undervalued” were securities selling cheap relative to other similar securities.
- Workouts (i.e. Special Situations):
- Are dependent on a specific corporate action or event in order to profit, making it easier to predict when and how much could be earned, and the risk of it falling through.
- Usually the result of corporate sales, spinoffs, mergers, liquidations, tenders, reorganizations, etc.
- The risk is that something — anti-trust issue, shareholder disapproval — causes management to abandon the planned action or event making any potential profit impossible. Misjudging the risk can be expensive.
- Tend to perform independently to the stock market.
- Workouts are used to insulate a portion of the portfolio from the short term (mis)behavior of markets. Typically, performing better in bear markets but lagging in bull markets.
- The second-largest portion of the portfolio.
- Typically in 10-15 workouts at any time.
- Buffett used borrowed money in workouts — a borrowing limit of 25% of the portfolio’s net worth — because of the higher degree of safety due to predictability of results and lower chance of short-term declines.
- Control Situations:
- The activist role: Buy a controlling interest in a company or a large enough position to influence corporate policy (he would rather others did the work).
- It requires a wide margin of safety and a large profit potential to be worthwhile.
- Each situation is expected to take several years — to gain enough shares to assume control and to realize a profit.
- Generals may become control situations if the price remains low for a long enough time.
- It can insulate the portfolio from short-term market moves, like workouts.
- Tend to move independently to the market.
- Once controlled, market price was irrelevant. Operating performance of the business was all that mattered.
- Generals:
- Mentioned Holdings:
- Commonwealth Trust Co. (1958 Letter)
- 10 to 20% position in the three partnerships at the time — at roughly 12% of outstanding shares.
- The average purchase price was $51. The intrinsic value was $125. $10/share in earnings. $50 million in assets.
- A large bank owned 25.5% of outstanding shares, with the potential to merge.
- Illiquid, inactive stock — only 300 shareholders with 2-3 trades per month.
- Buffett eventually sold it for a profit — $80/share — because he found a (better) investment in a control situation.
- Sanborn Map (1960 Letter)
- 35% position in the portfolio
- Buffett’s first attempt as an activist investor in a control situation.
- Published and revised detailed city maps — showing water mains, fire hydrants, roof types, etc. — in the U.S. mostly for fire insurance companies.
- The map was a monopoly, that eventually declined due to a new, competitive method of underwriting that didn’t require maps.
- But it also held a substantial investment portfolio.
- In 1958, shares sold at $45/share, valuing the investment portfolio at 70 cents on the dollar and getting the map business free.
- The goal was to separate the two, the portfolio from the map business, to realize the fair value of the portfolio and make the map business profitable again.
- The board objected, instead offering to exchange Sanborn stock for the securities in the investment portfolio.
- Dempster Mill Manufacturing Company (1961 Letter)
- Started as a general but took control (70%) in 1961 — started buying shares five years prior, with an average price of $28/share.
- Highly inactive market for the shares, only 15o shareholders.
- Manufuctured farm equipment and water systems.
- Had static revenue and no profits over the prior decade.
- Initially used a 40% discount on inventory and a 15% discount on receivables in estimating value.
- The goal was to sell off assets and turnaround the company by restoring earnings.
- Installed new management — Harry Bottle — after old management refused to make changes.
- Bottle exceeded expectations. He sold assets for cash and turned Dempster profitable.
- Excess cash — from asset sales and profits — was invested in undervalued securities via a portfolio within Dempster. The portfolio was initially valued at $35/share — higher than the average purchase price of Dempster stock — plus the newly profitable business.
- The business (minus the portfolio) was sold in 1963 at $80/share. The partnership retained control of the portfolio.
- Berkshire Hathaway
- Announced a controlling interest in the November 1965 letter.
- Initially bought as a General.
- Bought below net current asset value – initially valued it at 100% current assets and 50% fixed asset.
- Bought National Indemnity and National Fire and Marine through Berkshire in 1967.
- Bought Illinois National Bank and Trust Co. through Berkshire in 1969.
- Buffett had low expectations of the textile business in 1969. He was more enthusiastic about the insurance and bank businesses. He didn’t want to liquidate the textile business and put 1,100 people out of work (so long as the textile business earned a decent profit and did not need large additional amounts of capital).
- Commonwealth Trust Co. (1958 Letter)
