In contrast to the DJIA’s loss in 1960, the Dow Jones Utility Average showed “a good gain,” and Buffett guessed that perhaps “90% of all investment companies out-performed the Industrial Average.” He went on to say that the “majority of investment companies appear to have ended the year with overall results in the range of plus or minus 5%.” Buffett also wrote that “on the New York Stock Exchange, 653 common stocks registered losses for the year while 404 showed gains.”
Results in 1960
Buffett said that his objective in managing the funds of the partnership was to achieve “a long-term performance record superior to that of the Industrial Average.” He went on to state that “unless we do achieve this superior performance there is no reason for existence of the partnerships.” What a true statement. If an investment fund or partnership can’t beat the market average over time, an individual investor would be better off simply owning the companies that make up the market average. Today, this is easy to do by purchasing a low cost ETF or index fund.
Buffett goes on to say that if the partnership was to achieve a superior record against the DJIA, it would probably “be through better-than-average performance in stable or declining markets and average, or perhaps even poorer-than-average performance in rising markets.”
He went on to say:
I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s."The important thing is to be beating par” means the important thing is to be beating the performance of the DJIA.
In this passage, he also says that he would “consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%.” In other words, a strong performance relative to the DJIA was what constituted superior performance for the partnership.
Something else that’s interesting in this passage: “Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur.” What he’s talking about here is path independence of returns: If you know the returns that will occur over future time periods, you can apply these returns in any order to a common starting point and always end up at a common ending point.
For example, assume that over the next five years the Dow will have returns of 5%, 42%, -6%, -18% and 3%. As shown in the picture below (Scenario 1), if we start with $100 at year zero, and apply these returns in years one through five, we end up with $118.37. If we re-order these same returns (as shown in Scenario 2), such that the year-one-through-five returns are -6%, 3%, 5%, 42% and -18%, respectively, and we again start with $100 at year zero, we still end up with $118.37. (Note: You can play around with this spreadsheet through an interactive version.)
Thus, regardless of the order of these returns (i.e. regardless of the path we took), we end up at the same place. This demonstrates the path independence of returns, and I believe that is what Buffett was referring to in the above passage.
Buffett didn't seem to care about the sequence of DJIA returns — just that he was beating the DJIA by at least 10% per year over time (see the 1957 letter). This implies he believed that 1) the DJIA would achieve at least moderately positive returns over time, and 2) the partnership would still be around over time (and not be prematurely shut down due to redemptions, etc.).
Continuing with the 1960 letter, Buffett said that it should come as no surprise that the partnership outperformed in 1960. The seven partnerships operating throughout the year had a 22.8% gain, versus the 6.3% overall loss for the DJIA.
Below are the partnership’s “results for the four complete years of partnership operation after expenses but before interest to limited partners or allocation to the general partner.”
|Year||Partnerships Operating Entire Year||Partnership Gain||Dow-Jones Gain|
Buffett said that the partnership’s “overall gain or loss is computed on a market to market basis.” He said, “After allowing for any money added or withdrawn such a method gives results based upon what would have been realized upon liquidation of the partnership at the beginning of the year and what would have been realized upon liquidation” at the end of the year.
Using Buffett’s yardstick of performance (i.e. relative gains over the DJIA), it would appear that the partnership’s “best” year in terms of performance was 1960, as it gained approximately 29 percentage points higher than that of the DJIA (see table below).
|Year||Partnerships Operating Entire Year||Partnership Gain||Dow-Jones Gain||Partnership Gain minus Dow-Jones Gain|
The partnership’s cumulative results on a compounded basis (both in tabular and graphical formats) are below:
|Year||Partnership Gain||Dow-Jones Gain|
The above results show that the Buffett partnership achieved the greatest relative advantages against the Dow during the years the Dow was declining. Along these lines, Buffett said:
Although four years is entirely too short a period from which to make deductions, what evidence there is points toward confirming the proposition that our results should be relatively better in moderately declining or static markets. To the extent that this is true, it indicates that our portfolio may be more conservatively, although decidedly less conventionally, invested than if we owned ‘blue-chip’ securities. During a strongly rising market for the latter, we might have real difficulty in matching their performance.
Multiplicity of Partnerships
In this section, Buffett explained that “…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.”
Buffett adds that he was hopeful that in the near future he might have been able to combine the present partnerships into one large partnership. He wrote that this “move would… eliminate much detail and a moderate amount of expense.” However, said that “various partners have expressed preferences for varying partnership arrangements” and that “nothing will be done without unanimous consent of partners.”
Buffett here mentioned that some of the partners asked about putting additional money into the partnership during the year. Buffett responded that, although an exception was made in the past, it was too hard to amend the partnership agreements during the middle of the year when there were multiple partners in the limited partnership. In these “mixed partnerships,” money could only be added at the end of the year.
But, he said, the partnership would accept “advance payments during the year toward partnership interest and pay interest at 6% on this payment from the time received until the end of the year. At that time, subject to amendment of the agreement by the partners, the payment plus interest is added to the partnership capital and thereafter participates in profits and losses.”
Buffett must have seen the situation as a win-win, in that: 1) the limited partners could earn a decent rate of return on their advance payments until these payments (and associated interest) became part of their capital account at the end of the year, and 2) the partnership could make some additional money by investing the advance payments and achieving rates of return above 6%.
That concludes the first part of the 1960 partnership letter. Next time, we’ll look at the second part.
Other articles in the Buffett Partnership Series:
Next article: Buffett Partnership Letter Series – 1960 (Part 2)
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Introduction: Buffett Partnership Letter Series