Buffett Partnership Letters: 1964 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Historical Performance Analysis, Process Over Outcome, Psychology

“…the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final results would have been much poorer, although still quite respectable considering market conditions during the year…In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow…Finally, in 1964 workouts were a big drag on performance.”

There is a chart in the January 18, 1965 partnership letter, in which Buffett breaks down the performance of Generals vs. Workouts for 1962-1964, and discusses the return attribution of each category in different market environments.

Most investors conduct some form of historical performance review, on a quarterly or annual basis. It’s an important exercise for a variety of reasons:

• To better understand your sources of historical return – performance analysis forces you to examine the relationship between your process vs. the outcome. Was the outcome as expected? If not, do changes need to be made to the process?
• To help you and your team become more self-aware – what you do well, badly, and perhaps reveal patterns of behavioral strength and weakness (here's an article about an interesting firm that offers this analysis)
• Team Compensation
• Highlight necessary adjustment to the portfolio and business
• Etc.

The investment management world spends a lot of time scrutinizing the operations of other businesses. Shouldn’t we apply the same magnifying glass to our own?

Sizing, Catalyst, Hedging, Activism, Control

“What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it…Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.”

“Many times…we have the desirable ‘two strings to our box’ situation where we should either achieve appreciation of market prices from external factors or from the acquisition of control positions in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don’t have.”

Buffett discusses the phenomenon known as the “two strings” on his bow which allowed for heavy concentration in a few positions. The potential to (eventually) acquire a controlling stake in the underlying company served has an “insurance policy” via the creation of a catalyst after asserting control. (Some may argue that activism is applicable here as well. However, we tread cautiously on this train of thought because activism by no means entails a 100% success rate.)

It’s important to understand that control is not an option available to all investors. Therefore, when sizing positions, one should reconsider the exact emulation of Buffett’s enthusiastic buying as price continues to decline, and concentrated approach.

Interestingly, if a controlling stake in a company serves as an insurance policy (as Buffett describes it), is ‘control’ a type of portfolio hedge?

Activism, Control

“We have continued to enlarge the positions in the three companies described in our 1964 midyear report where we are the largest stockholders…It is unlikely that we will ever take a really active part in policy-making in any of these three companies…”

Control ≠ Activism

Conservatism

“To too many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional or an unconventional approach, per se, is conservative.”

“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.”

“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 conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner.”

Ruane Cunniff Goldfarb Investor Day

The following excerpts (of Q&A) were extracted from the Ruane Cunniff Goldfarb Investor Day Transcript. For those with a little free time, I highly recommend the reading of the entire transcript. These guys are masters at dissecting businesses and identifying the heart of any topic. Psychology, Creativity

Question:

About 36 years ago, shortly before Benjamin Graham passed away, he did an interview for the Financial Analysts Journal…This is before the explosion of information, ETFs, mutual funds. Asked if he advised “careful study of and selectivity among” individual stocks in constructing a portfolio, he answered, “In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a good deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in light of the enormous amount of research now being carried on,” — 1976 we are talking about — “I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent, I'm on the side of the ‘efficient market’ school of thought now generally accepted by the professors.” I'm just wondering if you would comment on that and how the investment industry has changed over that period of time.

Greg Alexander:

...I would add — that it is a funny thing — I have kids 14 and 11, and I think that the next generation will go about their decision making maybe differently than us. They have every expectation that they can go and spend an hour on the Internet and become semi-expert on anything that they are interested in, whether it is figuring out how to do a Rubik’s cube, which I remember looking at and not having the least idea. But with all the information, the timeless human struggle remains judgment, the ability to think long term when there are problems that are short term, and whether we see something solid where everyone perceives uncertainty — many factors of that nature. Looking in new areas where people have not thought so much, there are many factors like that, that are timeless. I always tell people there will be men and women on the moon but we still will not understand the guy next door.

Activism

Question:

Would you be kind enough to share with us the philosophy of some of your adventures in corporate governance?

David Poppe:

I think as we said in the letter that we wrote to clients a few weeks ago, the goal is really to own best-of-breed world-class companies and to be positive and passive shareholders. Ideally for us we are going to spend a lot of time on research on the front end. We are going to identify a business that we love and a management team that we think is really strong. Then we are going to make an investment. Afterwards, I would not say we are going to go away, but we are going to be quiet. We are going to own it and if we get everything right, we are going to own it for a really long time. Where you have to get involved, you really need sharp elbows and you need a different kind of personality than we have. It's a different — I don't want to say effort level — but different relationship…So hopefully we are not going to have a lot of adventures in corporate governance if we are doing our jobs really well.

Team Management

David Poppe:

We do allow the analysts to trade in their own accounts; they do have personal accounts. They can buy things that we do not own in Sequoia, but I do not think they do so often. The only time that really comes up is when Bob and I reject something for Sequoia and the analyst strongly believes that it was a great idea, and he did a lot of work on it and feels good about it. We think that is an appropriate outlet for frustration.

Buffett Partnership Letters: 1963 Part 3

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: When To Buy, When To Sell, Activism, Catalyst, AUM When To Buy, Activism, Catalyst, Control

“…controls develop from the general category. They results from situations where a cheap security does nothing price-wise for such an extended period of time that we are able to buy a significant percentage of the company’s stock…Whether we become active or remain relatively passive at this point depends upon our assessment of the company’s future and the management’s capabilities.”

“We do not want to get active merely for the sake of being active. Everything else being equal I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.”

“Active or passive, in a control situation there should be a built-in profit…Our willingness and financial ability to assume a controlling position gives us two-way stretch on many purchases in our group of generals. If the market changes its opinion for the better, the security will advance in price. If it doesn’t, we will continue to acquire stock until we can look to the business itself rather than the market for vindication of our judgment.” 

Warren Buffett is renowned for his strong stomach, and willingness to continuously purchase and ingest increasing stakes as falling prices deter others. I believe the quote above holds the rationale behind this courageous behavior.

I think it's important to point out, that for each purchasing quest as the price falls, there exists a tipping point – the point at which Buffett obtains a controlling position – such that if the market continues to undervalue the asset, he will “look to the business itself rather than the market for vindication,” thus unlocking value by enacting his own catalyst as a control/majority investor.

Many investors attempt to emulate Buffett’s strong-stomach approach. However, I would advise caution to those investors with limited cash resources or asset under management, without which investors could end up with too much of his/her portfolio in a minority stake of an asset that remains perpetually undervalued.

AUM

“Our rapid increase in assets always raises the question of whether this will result in a dilution of future performance. To date, there is more of a positive than inverse correlation between size of the Partnership and its margin over the Dow…Larger sums may be an advantage at times and a disadvantage at others. My opinion is that our present portfolio could not be improved if our assets were $1 million or $5 million. Our idea inventory has always seemed to be 10% ahead of our bank account. If that should change, you can count on hearing from me.”

I have heard it remarked that capital is the enemy of return. This is true under many circumstances, however in some instances, as Buffett outlines above, a large capital base has its benefits. For example, see our discussion above on When To Buy, Activism, Catalyst, and Control.

When To Sell

“Our business is making excellent purchases – not making extraordinary sales.”

Buffett Partnership Letters: 1959 & 1960

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. Benchmark

“My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average…Unless we do achieve this superior performance there is no reason for existence of the partnerships.”

The term “benchmark” is often associated with relative performance. I believe that “benchmark” has a much wider definition and purpose – as a goal of sorts for each portfolio manager.

Early on, Buffett recognized the importance of identifying a benchmark and set investor expectations accordingly. Without a proper benchmark and reasonable investor expectations, there exists greater risk for potential discord and misunderstanding, as well as the risk of a portfolio manager shooting the proverbial arrow and painting the bull’s eye around where the arrow lands.

Separate Accounts, Time Management

“…the family is growing. There has been no partnership which has had a consistently superior or inferior record compared to our group average, but there has been some variance each year despite my efforts to keep all partnerships invested in the same securities and in about the same proportions. This variation, of course, could be eliminated by combining the present partnerships into one large partnership. Such a move would also eliminate much detail and a moderate amount of expense…Frankly, I am hopeful in doing something along this line in the next few years…”

Buffett grappled with the issue of having separate accounts versus a single pooled vehicle. A pooled vehicle would have eliminated investor questions about discrepancies in partnership returns. It also would have saved a great deal of time and effort in dealing with the operational details of having to oversee multiple accounts vs. the ease of managing one single vehicle. Given the scarcity of time each day, the topic of effective time management is one that will continue to receive coverage in future posts at PM Jar.

Activism

“Last year mention was made of an investment which accounted for a very high and unusual proportion (35%) of our net assets along with the comment that I had some hope this investment would be concluded in 1960…Sanborn Map Co. is engaged in the publication and continues revision of extremely detailed maps of all cities in the United States…”

Today, Buffett no longer discusses individual ideas or the rationale behind his thesis and analysis. This was not the case back in the Partnership days. In the 1960 Letter, there is a very detailed account of an activist position he took in Sanborn Map Co. which accounted for ~35% of the NAV of the partnerships and involved contentious negotiations with the Board of Directors.

Buffett Partnership Letters: 1958 Part 1

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. Volatility

“…widespread public belief in the inevitability of profits from invest in stocks will led to eventual trouble…prices, not intrinsic value in my opinion, of even undervalued securities can be expected to be substantially affected.”

Price does not always equal intrinsic value, and the resulting impact is volatility due to price, not intrinsic value, movement. Unlike some value investors today, Buffett (especially in the Partnership days) never ignored volatility because he recognized the impact of this phenomenon on his performance return stream. Instead, he anticipated sources of possible price volatility and stood with cash or “work-outs” ready to deploy in case price, not intrinsic value, declined. Please see the 1957 Part 1 and 1957 Part 2 commentary for more details on “work-outs.”

Diversification, Liquidity, Catalyst, Activism

“Commonwealth only had about 300 stockholders and probably averaged two trades or so per month…”

“Over a period of a year or so, we were successful in obtaining about 12% of the bank at a price averaging about $51 per share…our block of stock increased in value as its size grew, particularly after we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal.”

“This new situation is somewhat larger than Commonwealth and represents about 25% of the assets of the various partnerships. While the degree of undervaluation is no greater than in many other securities we own…we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation.”

“To the extent possible…I am attempting to create my own work-outs by acquiring large positions in several undervalued securities.”

Not surprisingly, Buffett was never one to preach the merits of diversification or liquidity, even in the pre-Berkshire days when he did not have permanent capital. (Side Note: At the 2012 DJCO Shareholders’ Meeting, Charlie Munger stated that the Volcker Rule would actually improve the markets by decreasing trading liquidity.) He seemed unafraid of liquidity constraints created by little/no trading activity, holding 12% of total shares outstanding of a company, or making a single position 25% of portfolio NAV.

In the Partnership days, Buffett conducted some degree of shareholder activism (this was to change down the road). In certain instances, he held the belief that the value of a holding increased once a large enough stake was accumulated due to the intangible control premium and higher potential to create your own catalyst, thereby controlling the expected annualized return.

And it begins...with Michael F. Price

Michael F. Price is going to kick off our inagural post. Well, sort of. I'd like to share the summary (mainly the categorized juicy portfolio management bits) of an interview with MFP in Peter J. Tanous' book Investment Gurus.

Sourcing, Creativity: Price discusses how competitive the traditional bankruptcy and restructuring game has become (this was 1997 folks, think of how much more competitive it must be today). As a creative way to deploy capital into distressed situations, he would do “standby purchaser” deals, in which companies would do a rights offering to raise additional capital and reserve a certain % of the deal for Mutual Series, as well as whatever % existing shareholders didn’t want. These “standby purchaser” deals required him to keep an eye out for companies near liquidity crunches, and meet with them beforehand to offer his assistance, thereby requiring more work and proprietary sourcing, but involved far less competition than traditional bankruptcy/restructuring situations. Reminds of the recent Buffett deals (convertible preferred + warrants) with GE, Goldman Sachs, Bank of America.

Risk: “Risk is not the same as volatility. It’s very hard to measure risk. It’s very simple to measure return. You can’t model it.” He also discusses how earnings and asset value both help mitigate risk.

Cash / Special Situations / Volatility: Cash is ~5-25% of his portfolio “always.” Special situations (bankruptcy, arbitrage, tender offer, merger, buyback, liquidation, etc.) positions don’t move with general market but more with progress of individual situation. Cash + Special Situation is ~40% portfolio. The remaining ~60% consists of POCS (Plain Old Common Stock, value ideas trading below “intrinsic value”) which should theoretically go down less than the market. Therefore his portfolio beta is ~0.6.

Catalyst, Activism: “We perform well because some of our stocks have these catalysts. You asked why do we spend our time going around to shake some cages? It’s because a lot of times you can buy good values. But until there’s a catalyst, the value is not going to get realized.”

Turnover: Portfolio turnover is in mid-70s, skewed upwards by Special Situations basket.

Capital Preservation: “My mission isn’t to make money in bull markets. My mission is to preserve capital.”

Foreign Exchange: “Foreign positions are hedged perfectly every day so currency movements don’t affect our fund price.”

So there you have it: a little sample to whet your appetite! I'll be posting more summaries from other great investors in the weeks and months ahead, be sure to check back for updates.