My examination of the 1957 partnership letter will be broken up into two different articles (or parts). This first article (Part 1) deals with “The General Stock Market Picture in 1957.” The second article (Part 2) will deal with the partnership’s activities and results for 1957.
For your reference, all indented/italicized text below is a direct quote from the 1957 partnership letter.
With that out of the way, let’s get started.
The General Stock Market Picture in 1957
In last year's letter to partners, I said the following:
My view of the general market level is that it is priced above intrinsic value. This view relates to blue-chip securities. This view, if accurate, carries with it the possibility of a substantial decline in all stock prices, both undervalued and otherwise. In any event I think the probability is very slight that current market levels will be thought of as cheap five years from now. Even a full-scale bear market, however, should not hurt the market value of our work-outs substantially.
If the general market were to return to an undervalued status our capital might be employed exclusively in general issues and perhaps some borrowed money would be used in this operation at that time. Conversely, 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.
All of the above is not intended to imply that market analysis is foremost in my mind. Primary attention is given at all times to the detection of substantially undervalued securities.
The past year witnessed a moderate decline in stock prices. I stress the word "moderate" since casual reading of the press or conversing with those who have had only recent experience with stocks would tend to create an impression of a much greater decline. Actually, it appears to me that the decline in stock prices has been considerably less than the decline in corporate earning power under present business conditions. This means that the public is still very bullish on blue chip stocks and the general economic picture. I make no attempt to forecast either business or the stock market; the above is simply intended to dispel any notions that stocks have suffered any drastic decline or that the general market, is at a low level. I still consider the general market to be priced on the high side based on long term investment value.
There are a number of interesting points in the above section:
1. Buffett attempted to value the general market level as it related to blue-chip securities.
2. Buffett mentioned that there was a possibility of a substantial decline in all stock prices, “both undervalued and otherwise.” Thus, in a general market decline, all stocks can get cheaper – even those that were undervalued/cheap before the decline.
3. Buffett is always thinking in terms of probabilities. For example, in the first paragraph, he talks about “the possibility of a substantial decline in all stock prices,” and he writes that “the probability is very slight that current market levels will be thought of as cheap five years from now.”
4. Buffett mentions that: “Even a full-scale bear market... should not hurt the market value of our work-outs substantially.” (Note: A little later in the 1957 letter, Mr. Buffett defines a work-out as follows: “A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.”)
5. Buffett states: “Primary attention is given at all times to the detection of substantially undervalued securities.” Thus, first and foremost, Buffett focuses on finding undervalued securities. This means that his portfolio is not driven by market analysis. However, having said that, Buffett has probably recognized a pattern over time: When the general market is undervalued, his portfolio seems to contain more “general issues” (i.e. generally undervalued securities); and when the market is higher (or overvalued), his portfolio seems to contain more work-outs. (Note: This is probably not due to some grand design on Buffett’s part. It’s probably just where he’s finding the most value at different levels of the market.) This makes intuitive sense from an investor’s standpoint: When the market is low, owning “general issues” is probably more attractive (from a risk-reward standpoint) than owning work-outs; and when the market is higher, owning work-outs probably becomes more attractive relative to owning “general issues.”
6. Buffett might consider using borrowed money to buy “general issues” if the general market were to become undervalued. (I find it very interesting that Buffett would entertain the idea of using borrowed money to buy “general issues,” even though that could subject him to price fluctuation risk. However, it probably doesn’t make sense to read too much into this statement, as Buffett doesn’t say at what level of undervaluation, or under what conditions, he would use leverage.)
7. Buffett characterizes the previous year’s decline in stock prices by comparing the decline in stock prices versus the decline in corporate earning power under present business conditions. He states “…it appears to me that the decline in stock prices has been considerably less than the decline in corporate earning power under present business conditions. This means that the public is still very bullish on blue chip stocks and the general economic picture.” For this reason, he characterized the previous year’s decline in stock prices as “moderate.” However, interestingly enough, the press and other individuals new to the stock market “would tend to create an impression of a much greater decline.”
8. Buffett makes “no attempt to forecast either business or the stock market.” While Buffett doesn’t attempt to forecast business or the stock market (because he doesn’t know exactly how the future is going to play out), he still tries to roughly value the underlying businesses that make up the stock market (based on his assessment of possible outcomes and probabilities). Then, he takes this rough valuation and compares it to the current stock market level in order to make a general determination as to whether the market is overvalued, undervalued or fairly valued. For example, Buffett states in the last line of the above section: “I still consider the general market to be priced on the high side based on long term investment value.”
Thanks for reading my thoughts on Part 1 of the 1957 Buffett partnership letter. Stay tuned for my thoughts on Part 2 of this letter.
Links to other articles in the Buffett Partnership Series:
Next article: Buffett Partnership Letter Series – 1957 (Part 2)
Previous (introductory) article: Buffett Partnership Letter Series