Buffett Partnership Letters: 1965 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Control, Volatility

“When such a controlling interest is acquired, the assets and earnings power of the business become the immediate predominant factors in value. When a small minority interest in a company is held, earning power and assets are, of course, very important, but they represent an indirect influence on value which, in the short run, may or may not dominate the factors bearing on supply and demand which result in price.”

“Market price, which governs valuation of minority interest positions, is of little or no importance in valuing a controlling interest…When a controlling interest is held, we own a business rather than a stock and a business valuation is appropriate.”

Today, people often reference Buffett’s advice about owning a “business,” not just a “stock.” It’s interesting to note that a prerequisite, at the origin of this advice, involves having a “controlling interest.”

Only to investors with control, do earnings power and assets become the predominant determinants of value. Otherwise, for minority investors, outside factors (such as supply and demand) will impact price movement, which in turn will determine portfolio value fluctuations.

This is strangely similar to Stanley Druckenmiller’s advice: “Valuation only tells me how far the market can go once a catalyst enters the picture...The catalyst is liquidity.” Druckenmiller’s “catalyst” is Buffett’s “factors bearing on supply and demand which result in price.”

Control, Liquidity

“A private owner was quite willing (and in our opinion quite wise) to pay a price for control of the business which isolated stock buyers were not willing to pay for very small fractions of the business.

There’s a (theoretical) Control Premium. There’s also a (theoretical) Liquidity Premium. So (theoretically) the black sheep is the minority position that’s also illiquid.

Then again, all this theoretical talk doesn’t amount to much because investment success is price dependent. Even a minority illiquid position purchased at the right price could be vastly profitable.

Mark to Market, Subscriptions, Redemptions

“We will value our position in Berkshire Hathaway at yearend at a price halfway between net current asset value and book value. Because of the nature of our receivables and inventory this, in effect, amounts to valuation of our current assets at 100 cents on the dollar and our fixed assets at 50 cents on the dollar. Such a value, in my opinion, is fair to both adding and withdrawing partners. It may be either higher or lower than market value at the time.”

We discussed in the past the impact of mark to market decision, and why it’s relevant to those seeking to invest/redeem with/from fund vehicles that contain quasi-illiquid (or esoteric difficult to value) investments yet liquid subscriptions and redemption terms (e.g., hedge funds, certain ETFs and Closed End Funds). Click here, and scroll to section at bottom ,for more details.

Benchmark, Clients

“I certainly do not believe the standards I utilize (and wish my partners to utilize) in measuring my performance are the applicable ones for all money managers. But I certainly do believe anyone engaged in the management of money should have a standard of measurement, and that both he and the party whose money is managed should have a clear understanding why it is the appropriate standard, what time period should be utilized, etc.”

“Frankly I have several selfish reasons for insisting that we apply a yardstick and that we both utilize the same yardstick. Naturally, I get a kick out of beating part…More importantly, I ensure that I will not get blamed for the wrong reasons (having losing years) but only for the right reasons (doing poorer than the Dow). Knowing partners will grade me on the right basis helps me do a better job. Finally, setting up the relevant yardsticks ahead of time insures that we will all get out of this business if the results become mediocre (or worse). It means that past successes cannot cloud judgment of current results. It should reduce the chance of ingenious rationalizations of inept performance.”

Time Management, Team Management, Clients

“…our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business. This, of course, is the result of really outstanding personnel and cooperative partners.”

The skill set required for client servicing is completely different from the skills required for investment management. But unfortunately, most investors/funds have clients that require servicing.

Some are fortunate enough to have team resources that shoulder the majority of client obligations. Yet, the client component never disappears completely. Disappearance may be wishful thinking, though minimization is certainly a possibility.

Reflect upon your procedures and processes – what changes could you implement in order to make a claim similar to the one that Buffett makes above?

Buffett Partnership Letters: 1962 Part 2

This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. Slightly off tangent random fact: in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”

Volatility

“It should be pointed out that Dempster last year was 100% an asset conversion problem and therefore, completely unaffected by the stock market and tremendously affected by our success with the assets. In 1963, the manufacturing assets will still be important, but from a valuation standpoint it will behave considerably more like a general since we will have a large portion of its money invested in generals pretty much identical with those in Buffett Partnership, Ltd…Therefore, if the Dow should drop substantially, it would have a significant effect on the Dempster valuation. Likewise, Dempster would benefit this year from an advancing Dow which would not have been the case most of last year…”

In a previous article (1961 Part 2), we discussed the topics of expected return and expected volatility, where we made the assertion that Buffett was ever conscious of how each security would behave relative to overall markets and in the long-run, and on a forward looking basis.

His comments above on Dempster again demonstrate this, by focusing on the underlying drivers of price movement, not just categorical surfaces. Because the name of a security hasn’t changed, doesn’t mean that everything about it stays the same.

As background, in 1962, Buffett installed as the new CEO of Dempster (a control position where Buffett owned a majority stake) Harry Bottle who successfully transformed the assets of Dempster from Inventory, Receivables, and PPE into mostly Cash and Marketable Securities.

In 1962, the valuation of Dempster was mostly unaffected by the bear market that year since the assets consisted of inventory, receivables, etc. With the asset conversion, in 1963 and beyond, the valuation of Dempster would be far more sensitive to market swings since “a large portion of its money” was “invested in generals pretty much identical to those in” the Partnership.

“Our target is an approximately ½% decline for each 1% decline in the Dow, and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative.”

Here we see an explicit goal outlined for portfolio downside volatility. Notice, this is only a downside volatility goal, with no stipulations about upside volatility.

Everyone talks about volatility as a bad, bad thing. In truth, people really only hate portfolio downside volatility, and welcome extreme high upside volatility in their portfolios.

Liquidity, Mark to Market, Volatility

“The figures for our performance involve no change in the valuation of our controlling interest in Dempster Mill Manufacturing Company, although developments in recent months point toward a probable high realization.” (As of 6/30/1962)

“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate). Last year, our Dempster holding was valued by applying what I felt were appropriate discounts to the various assets.”

Control of Dempster was achieved in 1961, therefore, the mark to market on Dempster (at year-end 1961) was based on balance sheet liquidation of assets (marked at discounts to face value) and liabilities (100% face value), not market quotations.

During the first six months of 1962, the Dow returned -21.7%, while the Partnership outperformed substantially returning -7.5%.

At the end of 1961, Dempster was ~22% of Partnership NAV, which no doubt helped bolster performance when the market took a nosedive. However, had the market taken off for the moon instead, Buffett’s position in Dempster would have negatively impacted performance.

Illiquid positions can decrease portfolio volatility on both the upside and the downside, thus be sure to utilize securities of this breed (the proverbial double-edged sword) with caution.

Buffett Partnership Letters: 1961 Part 4

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. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.

Conservatism

“Many people some years back thought they were behaving in the most conservative manner by purchasing medium or long-term municipal or government bonds. This policy has produced substantial market depreciation in many cases, and most certainly has failed to maintain or increase real purchasing power.”

“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 hypothesis is correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

“I might add that in no way does the fact that our portfolio is not conventional provide that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results. I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets.”

Conservatism ≠ Buying “Conservative” Securities

Food for thought: currently (today’s date is 6/23/12), millions of retirees and older individuals in America hold bonds and other fixed income securities believing that they are investing “conservatively.” In light of current bond market conditions, where the 10-Year Treasury and 30-Year Treasury yields 1.67% and 2.76% respectively, is it time for people to reconsider the traditional definition of conservatism and conservative allocation? The bond example recounted by Buffett sounds hauntingly familiar. According to history, it ended badly for bond holders the last time around.

Buffett also highlights the importance of focus on conservatism inherent in the investment process, that of objective fact gathering and interpretation “through knowledge and reason.”

Interestingly, the last quote above implies that Buffett believed “evaluation of performance in down markets” an adequate measure of conservatism. Another name for this measurement is called drawdown analysis, and drawdown analysis is very much a measure of volatility (i.e., temporary impairment of capital). How then, does this view reconcile with his later comments about temporary vs. permanent impairments of capital?

Clients, Benchmark

“The outstanding item of importance in my selection of partners, as well as in my subsequent relations with them, has been the determination that we use the same yardstick. If my performance is poor, I expect partners to withdraw…The rub, then, is in being sure that we all have the same ideas of what is good and what is poor. I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.”

“While the Dow is not perfect (nor is anything else) as a measure of performance, it has the advantage of being widely known, has a long period of continuity, and reflects with reasonable accuracy the experience of investors generally with the market…most partners, as an alternative to their investment in the partnership would probably have their funds invested in a media producing results comparable to the Dow, therefore, I feel it is a fair test of performance.”

For any business, tapping the right client base and keeping those clients happy is crucial. Buffett advises the establishment of a mutually agreed upon objective (i.e., benchmark), so that the client and portfolio manager can mutually agree whether performance during any given period is “good” or “poor.” Coincidentally, this is similar to what Seth Klarman advises during an interview with Jason Zweig.

This is why the benchmark is so important – it is the mechanism through which clients can decide if a portfolio manager is doing a good or bad job. Picking the right benchmark is the tricky part…

Clients

“With over 90 partners…”

For those of you wondering how many clients Buffett had in his partnerships at the end of 1961, there you go!

Trackrecord, Mark To Market, Liquidity

“Presently, we own 70% of the stock of Dempster with another 10% held by a few associates. With only 150 or so other stockholders, a market on the stock is virtually non-existent…Therefore, it is necessary for me to estimate the value at yearend of our controlled interest. This is of particular importance since, in effect, new partners are buying in based upon this price, and old partners are selling a portion of their interest based upon the same price…and at yearend we valued our interest at $35 per share. While I claim no oracular vision in a matter such as this, I believe this is a fair valuation to both new and old partners.”

With such a large, illiquid controlling stake, Buffett had difficulty determining the “fair” mark to market for Dempster. Dilemmas such as this are still commonplace today, especially at funds that invest in illiquid or private companies.

As Buffett points out, the mark directly impacts new and old investors who wish to invest or redeem capital from the fund. Anyone who invests in a fund of this type should carefully diligence the mark to market methodology before investing (and redeeming) capital.

There’s another more murky dimension, the investment management industry’s dirty little secret: difficulty in determining an accurate mark makes it possible for funds to “jimmy” the mark and therefore influence the performance trackrecord / return stream reported to investors.