Buffett Partnership Letter Series – 1961 (Part 3)

In this article, we will take a look at the third part of Warren Buffett’s 1961 partnership letter.


Dempster Mill Manufacturing Company


In the next section of the 1961 letter, Buffett describes a control investment that the partnership is currently involved in: Dempster Mill Manufacturing Company of Beatrice, Neb.


Buffett gives a quick run down of the investment:


· First stock was purchased as a general five years ago. A block later became available, and four years ago Buffett became a board member. In August 1961, the partnership obtained majority control.


· The partnership owns 70% of Dempster’s stock and a few associates own another 10%. Buffett goes on to say that “with only 150 or so other stockholders, a market on the stock is virtually non-existent, and in any case, would have no meaning for a controlling block. Our own actions in such a market could drastically affect the quoted price.” For this reason, it is necessary for Buffett to “estimate the value at yearend of our controlling interest” because new partners are going to buy in at this price and old partners are going to be selling at this price. Buffett further states that this price should be an estimate or what “our interest would bring if sold under current conditions in a reasonably short period of time.”


· “Dempster is a manufacturer of farm implements and water systems with sales in 1961 of about $9 million.”


· Dempster’s operations only produced “nominal profits in relation to invested capital during recent years” for a number of reasons (“poor management situation, along with a fairly tough industry”). At yearend 1961, consolidated net worth (book value) of Dempster was $4.5 million ($75 per share), consolidated working capital was about $50 per share, and Buffett valued the partnership’s interest at $35 per share. Buffett believe this was a fair valuation for both new and old partners.


· The partnership’s “controlling interest was acquired at an average price of about $28, and this holding currently represents 21% of partnership net assets based on the $35 value.”


· Finally, Buffett mentions that “In a raging bull market, operations in control situations will seem like a very difficult way to make money, compared to just buying the general market. However, I am more conscious of the dangers presented at current market levels that the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.”


There are a couple of noteworthy items in this section on Dempster Mill. First, this investment occurred over a number of years – Buffett patiently bought up stock in Dempster as a general until the partnership ended up with majority control.


Second, Buffett purchased the partnership’s controlling interest at a low price. The average purchase price was about $28 per share – and this represented a 44% discount to consolidated working capital of $50 per share and an almost 63% discount to book value of $75 per share in a company that was still producing “nominal profits in relation to invested capital during recent years.”


Third, Buffett must have had faith that value would be realized at Dempster, as the partnership had 21% of its net assets in Dempster based on the $35 per share value. Fourth, and finally, Buffett is “more conscious of the dangers presented at current market levels than the opportunities,” and notes that control situations and work-outs provide a way to insulate “a portion of our portfolio from these dangers.”


The Question of Conservatism


In this section Buffett addresses the meaning of conservatism. Here are a few classic quotes:

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you.”


“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”


“I might add that in no way does the fact that our portfolio is not conventional prove that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results.”

There isn't anything that I could add to Buffett’s description of conservatism. Next, Buffett states that he feels the “most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow.” He then states that the partnership’s performance during the “mild declines of 1957 and 1960” would indicate that the partnership invests conservatively.


It’s interesting that Buffett chooses down periods in the markets to evaluate how conservative the partnership invests. In up markets, returns take care of themselves and everyone looks like a genius. However, down markets expose the weak. I believe Buffett chooses market downturns to measure conservatism because that is when many investment funds or vehicles seem to break down. High fliers have their wings clipped, easy money isn’t so easy any more, greed turns to fear, people get margin calls and are forced to sell, flighty investors flee investment funds requiring fund managers to sell investments at the wrong time, etc. By taking a look at whose standing after a downturn, one can get a good idea of which investment managers and funds are “conservative.”


Buffett concludes this section by noting that “We have never suffered a realized loss of more than 1/2 of 1% of total net assets, and our ratio of total dollars of realized gains to total realized losses is something like 100 to 1. Of course, this reflects the fact that on balance we have been operating in an up market. However, there have been many opportunities for loss transactions even in markets such as these… so I think the above facts have some significance.”


Wow. That kind of record makes you think about just how selective Buffett was with his investments (even if he did achieve this record in an up market). His realized losses were minimal. To me, one of the main takeaways from this last paragraph is that aspiring value investors need to be rigorous in their screening and research process, and then be very selective about the investments that they acquire for their portfolio.


The Question of Size


In this section, Buffett addresses the question of how the increased size of the partnership would affect performance.


Buffett states: “Larger funds tug in two directions. From the standpoint of ‘passive’ investments, where we do not attempt by the size of our investment to influence corporate policies, larger sums hurt results….” Buffett goes on to say, “For a portion of our portfolio, larger sums are definitely disadvantageous. For a larger portion of the portfolio, I would say increased sums are only slightly disadvantageous. This category includes most of our work-outs and some generals.”


I want to insert a thought here. If increased size is at least somewhat disadvantageous in many work-outs and some generals, perhaps those of us working with smaller sums of money may have an advantage in the areas of work-outs and some generals. Just a thought. Now, back to the matter at hand – the question of size.


After addressing the disadvantages of size, Buffett extols the virtues of size:

“However, in the case of control situations increased funds are a definite advantage. A ‘Sanborn Map’ cannot be accomplished without the wherewithal. My definite belief is that the opportunities increase in this field as the funds increase. This is due to the sharp fall-off in competition as the ante mounts plus the important positive correlation that exists between increased size of a company and lack of concentrated ownership of that company’s stock.”

Finally, he comes to the relevant question from the perspective of the limited partners: “Which is more important – the decreasing prospects of profitability in passive investments or the increasing prospects in control investments?” He responds to his question as follows: “I can’t give a definite answer to this since to a great extent it depends on the type of market in which we are operating. My present opinion is that there is no reason to think these should not be offsetting factors; if my opinion should change, you will be told.”


So, it sounds like, as long as Buffett can find attractive control situations, the larger size of the partnership does not have to be a drag on performance (i.e. Buffett believes that it is possible to replace some outperformance in smaller-sized work-outs and generals with outperformance in control situations).


And a Prediction


In this section, Buffett states that he is not going to make a prediction in the “normal sense.” He states:

I am certainly not going to predict what general business or the stock market are going to do in the next year or two since I don’t have the faintest idea.


I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor.


Over any long period of years, I think it likely that the Dow will probably produce something like 5% to 7% per year compounded from a combination of dividends and market value gain. Despite the experience of recent years, anyone expecting substantially better than that from the general market probably faces disappointment.


Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%.... It is most important to me that you fully understand my reasoning in this regard and agree with me not only in your cerebral regions, but also down in the pit of your stomach.

I’ll pause here and just summarize what I think Buffett is saying and insert a couple of thoughts:


· Buffett is not capable of making short-term predictions about general business or the stock market.


· However, over 10 years or so, he thinks there will be a few good years, a few bad years and a majority of in-between years. Buffett doesn’t know which order these years will come in, but he thinks the Dow will produce something like “5% to 7% per year compounded.” (This idea goes along with Buffett’s 1960 partnership letter and my thoughts on path independence of returns.)


One additional thought here: If the Dow were to experience a number of 20% or higher years in a row after this letter was written, I think Buffett may be skeptical of that type of performance going forward. He may actually view that strong advance in the market as stealing returns from future years and set his expectations accordingly. Of course, I don’t believe Buffett would come to this conclusion before first weighing the stock market’s performance against actual business performance.


· Buffett sees his job as one of racking up “yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus.” He gives an example of this, stating: “I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%.”


It is very important to Buffett that his partners understand how Buffett operates and thinks, as well as how he gauges performance. I think Buffett knows that if he can get partners to think about performance like he does, he is less likely to have partners redeem their investments in down markets (which might force the partnership to sell investments when they are too cheap) and keep them as partners long term. If he can do that, he won’t have as many redemptions at the wrong time and can invest when markets and securities are dirt cheap (whereas other investment funds may not be able to take advantage of bargains to the same degree).


Stated differently, Buffett is trying to indoctrinate his partners to his way of investing so that he can take full advantage of future opportunities. This will benefit his partners as well as himself (as Buffett gets a 25% cut of the profits above a 6% yearly return).


Buffett continues his letter with these words:

Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring one year in the next ten – no one know which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much. The consequence of performance such as this over a period of years would mean that if the Dow produces a 5% to 7% per year over-all gain compounded, I would hope our results might be 15% to 17% per year."

So, the way Buffett will achieve a 10% per year advantage over the Dow is by trying to: 1) obtain a 20% advantage in large down years, 2) obtain a 10% advantage in flat years and 3) just stay even with the market in large up years.


Buffett concludes this section by stating that his thoughts and expectations may be wrong, but that he felt that “the partners are certainly entitled to know what I am thinking in this regard even though the nature of the business is such as to introduce a high probability of error in such expectations.” He notes that yearly variations are quite substantial; however, fortunately, the 1961 “variation was on the pleasant side,” but they “won’t all be.” This is another example of Buffett setting expectations and trying to under-promise/over-deliver.


Miscellaneous


In this final section of his letter, he notes that the partnership has moved offices to 810 Kiewit Plaza, and now has a secretary (Beth Henley) and an associate (Bill Scott). Buffett also notes that his father is sharing office space with him and running a brokerage business in securities. However, he assures his partners that none of the partnership’s brokerage business is done through his father.


Buffett mentions that he expects the partnership’s “overhead, excluding interest on borrowing and Nebraska Intangibles Tax, to run less than .5 of 1% of net assets.”


Buffett states that “with 90 partners and probably 40 or so securities, you can understand that it is quite a welcome relief to me to shake loose from some of the details.”


Finally, Buffett provides some partnership statistics. He states:

We presently have partners residing in locations from California to Vermont, and net assets at the beginning of 1962 amounted to $7,178,500.00. Susie and I have an interest in the partnership amounting to $1,025,000.00, and other relatives of mine have a combined interest totaling $782,600.00. The minimum for new partners last year was $25,000, but I am giving some though to increasing it this year.

Appendix


I am also going to reproduce the appendix to the 1961 letter, as it is interesting to compare the performance of the various partnerships (for the time periods listed) against the performance of the Dow. To refresh your memory, in the first half of 1961 the Dow returned 13% including dividends; and for full year 1961, the Dow returned 22.2% including dividends.









* Gain in net assets at market values plus payments to limited partners during year.


Thanks for reading my thoughts on the 1961 partnership letter. Next time, we’ll take a look at the partnership letter for the first half of 1962.


Links to other articles in the Buffett Partnership Series:


Previous article: Buffett Partnership Letter Series – 1961 (Part 2)


Introduction: Buffett Partnership Letter Series