Buffett Partnership Letter Series – 1958 (Part 2)

The main focus of the second part of the 1958 partnership letter is a case study: Commonwealth Trust Co. of Union City, New Jersey.


The second part of the 1958 partnership letter also contains some thoughts from Warren Buffett on the “current” investment environment (note: the 1958 letter is dated Feb. 11, 1959).


To jog your memory, the first part (Part 1) of the 1958 letter dealt with “The General Stock Market in 1958” and “Results in 1958.”


A Typical Situation


In this section, Buffett puts forth a case study of a typical investment situation. The full text of this section is reproduced below (with some portions bolded, by me, for emphasis):

So that you may better understand our method of operation, I think it would be well to review a specific activity of 1958. Last year I referred to our largest holding which comprised 10% to 20% of the assets of the various partnerships. I pointed out that it was to our interest to have this stock decline or remain relatively steady, so that we could acquire an even larger position and that for this reason such a security would probably hold back our comparative performance in a bull market.


This stock was the Commonwealth Trust Co. of Union City, New Jersey. At the time we started to purchase the stock, it had an intrinsic value of $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend at all despite earnings of about $10 per share, which was largely responsible for a depressed price of about $50 per share. So here we had a very well managed bank with substantial earning power selling at a large discount from intrinsic value. Management was friendly to us as new stockholders and risk of any ultimate loss seemed minimal.


Commonwealth was 25 1/2% owned by a larger bank (Commonwealth had assets of about $50 million – about half the size of the First National of U.S. National in Omaha), which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely. Thus we had a combination of: (1) Very strong defensive characteristics; (2) Good solid value building up at a satisfactory pace and; (3) Evidence to the effect that eventually this value would be unlocked although it might be one year or ten years. If the latter were true, the value would presumably have been built up to a considerably larger figure, say $250 per share.


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. Obviously it was definitely to our advantage to have the stock remain dormant in price. 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.


Commonwealth only had about 300 stockholders and probably averaged two trades or so per month, so you can understand why I say that the activity of the stock market generally has very little effect on the price movements of some of our holdings.


Unfortunately we did run into some competition on buying, which raised the price to about $65 where we were neither buyers nor sellers. Very small buying orders can create price changes of this magnitude in an inactive stock, which explains the importance of not having any “Leakage” regarding our portfolio holdings.


Late in the year we were successful in finding a special situation where we could become the largest holders at an attractive price, so we sold our block of Commonwealth, obtaining $80 per share although the quoted market was about 20% lower at the time.


It is obvious that we could still be sitting with a $50 stock patiently buying in dribs and drabs, and I would be quite happy with such a program although our performance relative to the market last year would have looked poor. The year when a situation such as Commonwealth results in a realized profit is, to a great extent, fortuitous. Thus, our performance for any single year has serious limitations as a basis for estimating long term results. However, I believe that a program of investing in such undervalued well protected securities offers the surest means of long term profits in securities.


I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with intrinsic value of $135 is quite different from a price of $50 with an intrinsic value of $125, and it seemed to me that our capital could best be employed in the situation which replaced it. 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 (or even less than some) we are the largest stockholder and this has a substantial advantage many times in determining the length of time required to correct the undervaluation. In this particular holding we are virtually assured of performance better than that of the Dow-Jones for the period we hold it.

If you’ve made it this far, you probably realize why I didn’t summarize this section. There’s just too much good information to summarize, and Buffett states everything so well. So, I thought I would just let you hear it from Buffet directly.


I don’t plan to cover all of the statements that were bolded in this section (although I urge you to read these bolded statements with care in order to understand what Warren Buffett is saying), as this article would get even longer than it is right now.


I’ll highlight some things from this section, and then we’ll dig into some numbers.

• Portfolio Concentration: Commonwealth was a large holding of the partnership. Therefore, Buffett must have had a good amount of confidence in this investment.
  
  

• Intrinsic Value: At the time the Buffett partnership started purchasing the stock, it had an “intrinsic value of $125 per share computed on a conservative basis.” Additionally, Buffett states that if it took 10 years for Commonwealth to realize its intrinsic value, it “would presumably have been built up to a considerably larger figure, say $250 per share.” (Note: Intrinsic value is usually best thought of as a range of values. So, I assume that the values mentioned in this section represented the low end of the intrinsic value range.)
  
  

• Earnings, Dividends and Share Price: Commonwealth had earnings of about $10 per share when the partnership began to purchase the stock. Commonwealth didn’t pay a dividend, and this was probably the reason behind the depressed share price of $50 per share.

• Purchase and Sale Details: It took the Buffett partnership a year or so to obtain around 12% of the bank at an average price of $51 per share (Commonwealth only had about 300 stockholders and averaged about two trades per month – this was an inactive stock). When the Buffett partnership sold its block of Commonwealth, they received $80 per share, although the quoted market was around $64 per share (20% lower). (Note: This must have been a negotiated transaction. It doesn’t state who the buyer was.)
  
  

• Relative Undervaluation: Buffett mentions that the buyer of the stock at “$80 can expect to do quite well over the years. However, the relative undervaluation at $80 with intrinsic value of $135 is quite different from a price of $50 with an intrinsic value of $125, and it seemed to me that our capital could best be employed in the situation which replaced it.”

So, now, let’s look at some numbers and do some math (using the initial purchase price of $50 per share).

• The P/E ratio at purchase was 5 ($50/$10), and the equivalent earnings yield was 20% ($10/$50).
  
  
• The discount to conservative intrinsic value at purchase was 60% (1 – $50/$125).
  
  
• The earnings-to-conservative intrinsic value at purchase was 8% ($10/$125).
  
  
• Growth in intrinsic value over 10 years was 7.18% ((($250/$125)^(1/10)) – 1).

Note: While I can’t be positive of this, it almost seems like Buffett assumed that Commonwealth’s intrinsic value, earnings, equity, and assets would all double over 10 years. This would seem to indicate that he believed the bank’s return on assets, return on equity, and asset-to-equity ratio would all stay about the same over 10 years, and that the earnings-to-conservative intrinsic value in 10 years would still be around 8%. But this is all conjecture….


Possible Return Scenarios


Here are two possible return scenarios that Buffett may have thought about when purchasing Commonwealth stock (note: calculations use the purchase price of $50 per share):

• If Buffett sold all of the partnership’s Commonwealth stock after approximately one year at intrinsic value (assumed to be $135), the total return would be 170% ($135/$50 - 1). The annual return would also be 170%.
  
  
• If Buffett sold all of the partnership’s Commonwealth stock after 10 years at intrinsic value, the total return would be 400% ($250/$50 - 1), and the annual compound rate of return would be approximately 17.5% (using a financial calculator: I/YR = 17.5, where N=10, PV= -50, FV=250 and PMT=0).

Obviously, either scenario would be very attractive. Thus, Buffett could do well if the discount to intrinsic value closed either quickly (1 year) or slowly (over 10 years). This was a classic win-win situation (assuming his facts and reasoning were correct).


Relative Undervaluation Calculations (using a purchase price of $50 per share)

• At the time of purchase, the discount to intrinsic value was 60% (1 - $50/$125). Thus, price to intrinsic value was 40% ($50/$125).
  
  
• At around one year or so after purchase, the discount to intrinsic value was approximately 41% (1 - $80/$135). Thus, the price to intrinsic value was 59% ($80/$135).

So, Buffett started buying into Commonwealth at a price to intrinsic value of 40% and sold at a price to intrinsic value of around 59%.


The situation that replaced Commonwealth was somewhat larger than Commonwealth – and the Buffett partnership was able to become the largest stockholder at an attractive price. The letter does not directly state whether this larger situation was more or less undervalued than the 59% price to intrinsic value that Commonwealth sold at. However, we do know that the larger situation was more attractive than Commonwealth when all factors were taken into account (control, price to intrinsic value, etc.).


The Current Situation


In this section of the 1958 partnership letter, Warren Buffett had this to say:

The higher the level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.


To the extent possible, therefore, I am attempting to create my own work-outs by acquiring large positions in several undervalued securities. Such a policy should lead to the fulfillment of my earlier forecast – an above average performance in a bear market or neutral market, and a normal performance in a bull market. It is on this basis that I hope to be judged…

Thus, the current situation (as of the writing of this letter) was that it was somewhat difficult to secure “an adequate number of attractive investments.” With the market level higher, there were fewer undervalued securities. Buffett wanted to increase the percentage of work-outs in the partnership’s portfolio, but he said “these are very difficult to find on the right terms.”


At this point, Buffett could have sat back and just waited for another opportunity to come his way. But he didn’t – he was proactive. He states, “To the extent possible… I am attempting to create my own work-outs by acquiring large positions in several undervalued securities.” Translation: Buffett started buying large positions in certain securities so that he could influence the corporate decision-making process and the timeline for realizing underlying value.


Finally, Warren Buffett reiterates that he expects that, based on the above policy of trying to create his own work-outs, the partnership would probably outperform in down or flat markets, but it would barely keep pace in up markets.


Thanks for reading my thoughts on Part 2 of the 1958 partnership letter. I hope you found them useful.


Next time, we’ll look at the 1959 partnership letter.



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Introduction: Buffett Partnership Letter Series