Buffett Partnership Letters: 1961 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. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The summary below is derived from the first of two letters written about the results of 1961.

Separate Accounts, Fee Structure

The business underwent conversion from multiple separately managed accounts to a pooled partnership vehicle. Buffett grappled with housekeeping issues such as proper allocation of “future tax liability due to unrealized gains” during the transition process since all the different partnerships would contribute different tax liabilities to the new pooled vehicle.

More interesting is the fee structure of the Buffett Partnerships. The new pool vehicle would charge 0% management fees, 25% incentive fee above a 6% hurdle, and “any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.”

Previously, the multiple partnerships had a number of different fee structures including:

1. 6% Hurdle, 33.33% incentive fee
2. 4% Hurdle, 25.00% incentive fee
3. 0% Hurdle, 16.67% incentive fee

Additionally, Buffett provides his clients with a unique liquidity mechanism to supplement the annual redemption window:

“The right to borrow during the year, up to 20% of the value of your partnership interest, at 6%, such loans to be liquidated at yearend or earlier. This will add a degree of liquidity to an investment which can now only be disposed of at yearend…I expect this to be a relatively unused provision, which is available when something unexpected turns up and a wait until yearend to liquidate part or all of a partner’s interest would cause hardship.”

AUM

“Estimated total assets of the partnership will be in the neighborhood of $4 million, which enables us to consider investments such as the one mentioned earlier in this letter, which we would have had to pass several years ago.”

Buffett was cognizant of the relationship between AUM and his fund’s investment strategy. I suspect the investment “mentioned earlier in this letter” was an activist situation which required him owning an influential or controlling stake in the company – therefore requiring a minimum amount of capital commitment, now made possible by the higher total partnership assets of $4 million.

Portfolio managers are not the own ones who should monitor the AUM figure. The relevance of the relationship between AUM and a fund’s investment strategy has wider implications. For example, investors who allocate capital to funds should also be monitoring AUM and asking whether the changes in AUM impact a fund’s ability to generate returns due to sizing, strategy shift / drift, changing opportunity sets, etc.

Expected Return, Catalyst, Risk

“We have also begun open market acquisitions of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year. Such a commitment may be a deterrent to short range performance but it gives strong promise of superior results over a several year period combined with substantial defensive characteristics.

The above quote highlights two important portfolio management topics.

First: the concept of “yield to catalyst.” Similar in concept to yield to call or maturity for bonds, it’s the annualized return between today to until the catalyst or price target occurrence – a sort of expected annualized return figure. In this situation, the price target was high enough that even if the security “does nothing for at least a year,” the “superior results over a several year period” was enough to make the investment worthwhile. For his basket of “work-outs” (see our 1957 Part 1 post for more details on this), the price target was usually lower, but the catalyst was usually not far away, therefore the yield to catalyst was still adequately high to justify an investment.

Second: the concept of risk-adjusted return. This one is slightly more difficult to estimate since “risk” is a squishy term and difficult to quantify. In the quote above, Buffett references the “substantial defensive characteristics” of the investment. This indicates that he is measuring the return against the risk profile. Unfortunately, he does not give any details as to how he defines risk, or does that math.

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: 1957 Part 2

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. Cash, Special Situations

“…if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio.”

His describes the “general issues” basket – mostly undervalued securities with no catalyst – in greater detail in later letters.

Interestingly, the quote implies that Buffett used his “work-out” basket as a quasi-cash equivalent. Theoretically, when a security has little/no downside capture, assuming there’s enough trading volume and liquidity, it can be utilized in a portfolio context as a quasi-cash equivalent with upside potential. This allows the portfolio manager to decrease exposure as underlying markets get expensive, while squeezing out some return potential greater than pure cash yields. Should the underlying market decline, accumulated performance is preserved as the “work-out” basket does not decline, and could be sold to serve as a source of liquidity to purchase other (now cheap) securities that have declined with the market.

A useful tactic for investors who wish to decrease exposure when markets get frothy, but don't want to blatantly lag if the rally continues. Of course, this is all predicated upon one's ability to identify "work-out" securities with 1957 attributes. Please see our 1957: Part 1 discussion for more details.

Sizing, Expected Return, Hurdle Rate

“One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%...will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return…”

“Earlier I mentioned our largest position which comprised 10% to 20% of the assets of the various partnerships. In time I plan to have this represent 20% of the assets of all partnerships but this cannot be hurried.”

“Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages…Our performance, relatively, is likely to be better in a bear market than in a bull market…In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.”

Buffett left nothing to hope or chance, and thought very strategically about position sizing, the annualized expected return of these positions, and the estimated hurdle rate required to outperform his benchmarks by a margin of 10% annually.

Too often, investors are anchored to certain return figures (e.g., 8-15%+ for equities, etc.) regardless of current market conditions and entry price. Unpleasant negative surprises would occur less often if investors followed Buffett’s approach in examining portfolio holdings, percentage exposures, and assigning realistic expected returns based on present market conditions.

I do not wish to imply that the expected return of a portfolio can be extracted via a scientific formula involving the calculation of a weighted average return figure – false precision is equally as dangerous as false expectations. However, I do believe that knowing the general direction of potential future portfolio returns can be helpful in setting realistic expectations for portfolio managers, external fund investors, and assist with other portfolio related decisions such as fundraising, headcount expansion, etc.

Separate Accounts

“All three of the 1956 partnerships showed a gain during the year amounting to about 6.2%, 7.8%, and 25% on yearend 1956 net worth. Naturally a question is created as to the vastly superior performance of the last partnership, particularly in the mind of the partners of the first two. This performance emphasizes the importance of luck in the short run, particularly in regard to when funds are received. The third partnership was started in the latest in 1956 when the market was at a lower level and when several securities were particularly attractive. Because of the availability of funds, large positions were taken in these issues. Whereas the two partnerships formed earlier were already substantially invested so that they could only take relatively small positions in these issues.”

For those who manage separate accounts and have received inquiries from clients regarding performance discrepancies related to fund flow / timing differences, feel free to tell them that this would happen even if Buffett managed their account. Perhaps not in those exact words, but I thought to include this quote in case a Reader finds it useful.