This article (Part 2) will deal with the partnership’s activities and results for 1957. Part 1 dealt with “The General Stock Market Picture in 1957.”
Activities in 1957
Here are a few highlights/thoughts about this section of the partnership letter.
1. A market decline can create “greater opportunity among undervalued situations” such that “general issues” (i.e. generally undervalued securities) can become more attractive relative to “workouts.” (Note: A definition of the term “work-out” was provided in my previous article, 1957 (Part 1).) This is what happened in 1957. Thus, Buffett took advantage of this market decline, and increased the amount of general issues in the partnership’s portfolio relative to work-outs: “At the end of 1956, we had a ratio of about 70-30 between general issues and work-outs. Now it is about 85-15.”
However, just prior to this section, Buffett stated: “I still consider the general market to be priced on the high side based on long term investment value.” So, Buffett increased the percentage of general issues in his portfolio, even though he considered the market to be overpriced.
2. Buffett was not afraid to take large positions in undervalued businesses. This statement seems to be true both in terms of portfolio concentration (percentage of portfolio allocated to a specific investment) and percentage ownership of a business (percentage of business owned/controlled by the partnership). Buffett states “During the past year we have taken positions in two situations which have reached a size where we may expect to take some part in corporate decisions. One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%.”
3. In the aforementioned two larger positions, Buffett expected to “take some part in corporate decisions.” Buffett was willing to put “three to five years of work” into these situations because they appeared to have “potential for a high average annual rate of return with a minimum of risk.” I think it’s interesting that Buffett, as an investment manager, was willing to get actively involved in these businesses and that he characterized this period of his involvement as “work.”
4. Buffett notes that these two larger positions “have very little dependence on the general action of the stock market. Should the general market have a substantial rise… I would expect this section of our portfolio to lag behind the action of the market.” It was probably somewhat comforting to Buffett that these positions had very little dependence on the performance of the stock market, as he considered the market overvalued at the time of writing this letter. It seems that Buffett was okay with the trade-off of having these two positions lag if the market had a large rise because they carried a “minimum of risk.” In other words, he was primarily focused on minimizing the downside and not just capturing the speculative upswings in the market.
Results for 1957 & Interpretation of Results
Here are some highlights and notes from these sections of the partnership letter:
1. The partnerships that were formed in 1956 did much better in 1957 than the general market. The overall loss for the Dow Jones Industrial Average was 8.47% for the year. To Buffett’s knowledge, “no investment fund invested in stocks showed a gain for the year.”
2. The three partnerships that were formed in 1956 showed gains during the year of “about 6.2%, 7.8% and 25% on yearend 1956 net worth.” Buffett then goes on to explain that the last partnership vastly outperformed the first two because it “was started 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.” Buffett also mentions that “this performance emphasizes the importance of luck in the short run, particularly in regard to when funds are received.”
He goes on to say: “Basically, all partnerships are invested in the same securities and in approximately the same percentages. However, particularly during the initial stages, money becomes available at varying times and varying levels of the market so there is more variation in results than is likely to be the case in later years.”
3. Buffett’s goal is to beat the Dow each year by 10% or more. He states: “Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages, so in respect to these three partnerships [formed in 1956], 1957 was a successful and probably better than average, year.”
4. Two partnerships were started in the middle of 1957, and their results for the remainder of the year were approximately the same as the “performance of the Averages, which were down about 12% for the period since inception of the 1957 partnerships.” However, he goes on to say that the portfolios of the 1957 partnerships are now starting to approximate those of the 1956 partnerships and that the “entire group should be much more comparable in the future.”
5. The partnership did better than the Averages in 1957 because “it was a generally poor year for most stocks.” Buffett states that the partnership’s performance relative to the Averages is “likely to be better in a bear market than in a bull market.” He then goes on to say: “In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.” This performance profile, described by Warren Buffett, matches that of value investing in general. You buy with a margin of safety, and then, if the stock market takes a beating, you should take less of a beating. Essentially, the value investing discipline should help you to outperform on the downside, and then hopefully match the Averages on the upside. By doing this, you can substantially beat the Averages.
6. Buffett states that the portfolio at the end of 1957 represents better value than it did at the end of 1956. He attributes this to two things: 1) “generally lower prices,” and 2) the partnership “had more time to acquire the more substantially undervalued securities which can only be acquired with patience.” He goes on to state that he hoped to take the partnership’s largest position (which represented around 10% to 20% of partnership assets) to 20% of partnership assets. However, he says, “This cannot be hurried. Obviously, during any acquisition period, our primary interest is to have the stock do nothing or decline rather than advance. Therefore, at any given time, a fair proportion of our portfolio may be in the sterile stage. This policy, while requiring patience, should maximize long term profits.” Buffett was willing to take his time to acquire these (perhaps, somewhat illiquid) securities so that his purchasing wouldn’t push up prices. He knew that this method of acquisition “should maximize long term profits.”
7. Finally, Buffett mentions that he has tried to “disclose as much of our philosophy as may be imparted without talking of individual issues.” I take this to mean that he doesn’t discuss current/potential investments, as it may harm the partnership if someone were to go off and bid up these securities (and essentially make it so the partnership could not get a full allocation).
Thanks for reading my thoughts on Part 2 of the 1957 Buffett partnership letter.
Next up is the 1958 partnership letter.
Links to other articles in the Buffett Partnership Series:
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Introductory article: Buffett Partnership Letter Series