The Ground Rules
To start this letter off, Buffett lays down the ground rules for the partnership. He emphasizes these rules quite a bit, as he wants all partners “entirely clear” on how the partnership operates and its goals.
I have reproduced these ground rules below:
1. In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that – withdrawing. If we earn more than 6% per annum over a period of years the withdrawals will be covered by earnings and the principal will increase. If we don’t earn 6%, the monthly payments are partially or wholly a return of capital.These ground rules do a good job of laying out the important principles of the partnership and setting limited partner expectations. The rules explain the mechanics of withdrawals and investment performance, measurement of partnership performance against an appropriate yardstick, minimum time for judging investment performance, lack of predictions regarding stock market/business fluctuations, partnership investment philosophy, and Buffett’s alignment of interests with limited partners.
2. Any year in which we fail to achieve at least a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered.
3. Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at yearend against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.
4. Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
5. While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
6. I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership.
7. I cannot promise results to partners. What I can and do promise is that:
a. Our investments will be chosen on the basis of value, not popularity;
b. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and
c. My wife, children and I will have virtually our entire net worth invested in the partnership.
By putting these ground rules front and center in the 1962 letter, I believe Buffett was trying to ensure that his investor base understood and agreed with the investment philosophy and operating principles of the partnership. This was important because it probably allowed Buffett to make longer-term investments and commitments (knowing that his investor base was aware of and probably agreed with his method of operation).
Our Performance in 1962
The Dow began 1962 at 731. In June, it dipped to 535. And the Dow closed the year at 652. The overall result from the Dow for 1962 (including dividends) was minus 7.6%. The Buffett partnership’s overall result was positive13.9%. So, the relative outperformance by the partnership was 21.5 percentage points. Not too shabby.
In this section, Buffett then presents the standard performance tables (i.e. year-by-year and cumulative performance of the Dow vs. the partnership and limited partners).
Buffett then notes, “My (unscientific) opinion is that a margin of ten percentage points per annum over the Dow is the very maximum that can be achieved with invested funds over any long period of years, so it may be well to mentally modify some of the above figures” (i.e. the ones shown in the performance tables).
Buffett then addresses a concern brought up by some partners regarding the effect of size on performance. He states: “At the beginning of 1957, combined limited partnership assets totaled $303,726 and grew to $7,178,500 at the beginning of 1962. To date, anyway, our margin over the Dow has indicated no tendency to narrow as funds increase.”
In addition to the performance of the Dow, Buffett included in this letter the 1962 performance of the “two largest open-end investment companies (mutual funds) following a common stock policy, and the two largest diversified closed-end investment companies.” These four companies – Massachusetts Investors Trust, Investors Stock Fund, Tri-Continental Corp. and Lehman Corp. – performed worse than the Dow in 1962. The performance of these four companies ranged from -9.8% to -13.4%. Buffett’s intent with this section was to point to the fact that the “Dow is no pushover as an index of investment achievement.”
The Joys of Compounding
In this section, Buffett illustrates how compounding your money at a good clip for a long time can be a wonderful thing.
Specifically, he gives the example of Isabella underwriting Christopher Columbus’ voyage to theAmericas. Buffett states that he has it from “unreliable” sources that this endeavor cost approximately $30,000. He states that while some have considered this “at least a moderately successful utilization of venture capital… the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962... Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate.”
Then, to show just how much difference a few percentage points each year can make over a long period of time, Buffett presents the following table, which “indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20, and 30 years.”
Buffett notes, regarding this table: “It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.”
I couldn’t have said it any better. If you ever wonder why money managers and finance types obsess over a few extra percentage points of return, this is the reason. It can mean big bucks over a long time period. Also, another takeaway from this table is that investors should try to have their money compound for them over the longest time period possible. Thus, it makes sense to start saving and investing prudently as early in life as one can. A few extra years of investing and compounding can make a big difference in the number of dollars one ultimately has.
Thanks for reading along. Next time, we’ll take a look at Part 2 of the 1962 partnership letter.
Links to other articles in the Buffett Partnership Series:
Previous article: Buffett Partnership Letter Series – December 24, 1962
Introduction: Buffett Partnership Letter Series