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Reverse Engineering Two of Buffett’s Earliest Investments

Below are excerpts from the 1958-1960 partnership letters explaining two investments (Commonwealth Trust Co. and Sanborn Map) as they occur each year. Buffett does a great job explaining why he does not “talk his book”, the valuation of the businesses and parameters of his investment thesis behind both. I have bolded key phrases or words throughout the writing but have not elaborated on any of the original writing. The second investment was an alternative to the first and was partially the reason for selling before intrinsic value was achieved, explains Buffett. On both investments roughly 57% and 50% cumulative gains were made. Buffett very rarely needs to be clarified and does a wonderful job of simplifying, thus I included it all. Enjoy!

[/b] [b]TYPICAL SITUATION (1958 Shareholder Letter)

(Commonwealth Trust Co.)

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 $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 earnings 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 25.5% owned by a larger bank (Commonwealth had assets of about $50 Million – about half the size of the First National in Omaha), which had desired a merger for many years. Such a merger was prevented for persona1 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 proposa1. 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 had very little effect on the price movement of some of our holdings.

Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller. 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 holder 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 $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 at 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 an intrinsic value $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better 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 than some) we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation. In this particular holding we are virtually assured of a performance better than that of the Dow-Jones for the period we hold it.

(1959 Shareholder Letter)

Last year, I mentioned a new commitment, which involved about 25% of assets of the various partnerships. Presently this investment is about 35% of assets. This is an unusually large percentage, but has been made for strong reasons. In effect, this company is partially an investment trust owing some thirty or forty other securities of high quality. Our investment was made and is carried at a substantial discount from asset value based on market value of their securities and a conservative appraisal of the operating business. We are the company’s largest stockholders by a considerable margin, and the two other large holders agree with our ideas. The probability is extremely high that the performance of this investment will be superior to that of the general market until its disposition, and I am hopeful that this will take place this year.

(1960 Shareholder Letter) [/b](Sanborn Map)[b]

Last year mention was made of an investment, which accounted for a very high and unusual proportion (35%) of our net assets along with the comment that I had some hope this investment would be concluded in 1960. This hope materialized. The history of an investment of this magnitude may be of interest to you. Sanborn Map Co. is engaged in the publication and continuous revision of extremely detailed maps of all cities

of the United States. For example, the volumes mapping Omaha would weigh perhaps fifty pounds and provide minute details on each structure. The map would be revised by the paste-over method showing new construction, changed occupancy, new fire protection facilities, changed structural materials, etc. These revisions would be done approximately annually and a new map would be published every twenty or thirty years when further paste overs became impractical. The cost of keeping the map revised to an Omaha customer would run around $100 per year. This detailed information showing diameter of water mains underlying streets, location of fire hydrants, composition of roof, etc., was primarily of use to fire insurance companies. Their underwriting departments, located in a central office, could evaluate business by agents nationally.

The theory was that a picture was worth a thousand words and such evaluation would decide whether the risk was properly rated, the degree of conflagration exposure in an area, advisable reinsurance procedure, etc. The bulk of Sanborn's business was done with about thirty insurance companies although maps were also sold to customers outside the insurance industry such as public utilities, mortgage companies, and taxing authorities. For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort. In the earlier years of the business, the insurance industry became fearful that Sanborn's profits would become too great and placed a number of prominent insurance men on Sanborn's board of directors to act in a watch-dog capacity.

In the early 1950’s a competitive method of under-writing known as "carding" made inroads on Sanborn’s business and after-tax profits of the map business fell from an average annual level of over $500,000 in the late 1930's to under $100,000 in 1958 and 1959. Considering the upward bias in the economy during this period, this amounted to an almost complete elimination of what had been sizable, stable earning power. However, during the early 1930's Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.

Let me give you some idea of the extreme divergence of these two factors. In 1938 when the Dow-Jones Industrial Average was in the 100-120 range, Sanborn sold at $110 per share. In 1958 with the Average in the 550 area, Sanborn sold at $45 per share. Yet during that same period the value of the Sanborn investment portfolio increased from about $20 per share to $65 per share. This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions. In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing. How could this come about?

Sanborn in 1958 as well as 1938 possessed a wealth of information of substantial value to the insurance industry. To reproduce the detailed information they had gathered over the years would have cost tens of millions of dollars. Despite “carding” over $500 million of fire premiums were underwritten by “mapping” companies. However, the means of selling and packaging Sanborn’s product, information had remained unchanged throughout the year and finally this inertia was reflected in the earnings. The very fact that the investment portfolio had done so well served to minimize in the eyes of most directors the need for rejuvenation of the map business. Sanborn had a sales volume of about $2 million per year and owned about $7 million worth of marketable securities. The income from the investment portfolio was substantial, the business had no possible financial worries, the insurance companies were satisfied with the price paid for maps, and the stockholders still received dividends. However, these dividends were cut five times in eight years although I could never find any record of suggestions pertaining to cutting salaries or director's and committee fees. Prior to my entry on the Board, of the fourteen directors, nine were prominent men from the insurance industry who combined held 46 shares of stock out of 105,000 shares outstanding. Despite their top positions with very large companies, which would suggest the financial wherewithal to make at least a modest commitment, the largest holding in this group was ten shares. In several cases, the insurance companies these men ran owned small blocks of stock but these were token investments in relation to the portfolios in which they were held.

For the past decade the insurance companies had been only sellers in any transactions involving Sanborn stock. The tenth director was the company attorney, who held ten shares. The eleventh was a banker with ten shares who recognized the problems of the company, actively pointed them out, and later added to his holdings. The

next two directors were the top officers of Sanborn who owned about 300 shares combined. The officers were capable, aware of the problems of the business, but kept in a subservient role by the Board of Directors. The final member of our cast was a son of a deceased president of Sanborn. The widow owned about 15,000 shares

of stock. In late 1958, the son, unhappy with the trend of the business, demanded the top position in the company, was turned down, and submitted his resignation, which was accepted. Shortly thereafter we made a bid to his mother for her block of stock, which was accepted. At the time there were two other large holdings, one of about 10,000

shares (dispersed among customers of a brokerage firm) and one of about 8,000. These people were quite unhappy with the situation and desired a separation of the investment portfolio from the map business, as did we. Subsequently our holdings (including associates) were increased through open market purchases to about 24,000

shares and the total represented by the three groups increased to 46,000 shares.

We hoped to separate the two businesses, realize the fair value of the investment portfolio and work to re-establish the earning power of the map business. There appeared to be a real opportunity to multiply map profits through utilization of Sanborn's wealth of raw material in conjunction with electronic means of converting this data to the most usable form for the customer. There was considerable opposition on the Board to change of any type, particularly when initiated by an outsider, although management was in complete accord with our plan and a similar plan had been recommended by Booz, Allen & Hamilton (Management Experts). To avoid a proxy fight (which very probably would not have been forthcoming and which we would have been certain of winning) and to avoid time delay with a large portion of Sanborn’s money tied up in blue-chip stocks which I didn’t care for at current prices, a plan was evolved taking out all stockholders at fair value who wanted out. The SEC ruled favorably on the fairness of the plan. About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value. The map business was left with over $l,25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated. The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.

Necessarily, the above little melodrama is a very abbreviated description of this investment operation. However, it does point up the necessity for secrecy regarding our portfolio operations as well as the futility of measuring our results over a short span of time such as a year. Such control situations may occur very infrequently. Our bread- and-butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action. To the extent that partnership funds continue to grow, it is possible that more opportunities will be available in “control situations.”

In both cases Buffett was emulating the classic Graham and Dodd approach. Sanborn Maps had earnings power through a near monopoly of the market, a margin of safety through investment portfolio asset values, and a market to continually sell their maps in the coming years. Although Sanborn Maps had deteriorating profit, Buffett knew by gaining control and a position as a director he would have much more pull on strategic direction. If worst came to worst, Buffett could have realized the value by liquidating assets, as was the case with his next famous investment in 1961, Dempster Mill Manufacturing.

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


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Comments

The Science of Hitting
The Science of Hitting premium member - 5 months ago
I never realized that Sanborn was such a sizable position at one point (35% of assets); great commentary from Warren.

"However, these dividends were cut five times in eight years although I could never find any record of suggestions pertaining to cutting salaries or director's and committee fees."

And he was quite funny even back at the ripe age of 29! :)

Thanks for posting!

TannorP
TannorP premium member - 5 months ago
Thanks Science,

The concentration was surprising to me as well, as this was only a few years after studying under Graham and Dodd, although I assume he elected for concentration over diversification from the get-go.

Very humorous indeed, especially in regards to speaking his mind & crying foul for shareholders on managements self centred incentive process.

vgm
Vgm - 5 months ago
Fascinating Tannor. Thanks.

It was mighty impressive to see the depth of Buffett's analysis as well as his insights into the businesses themselves - enough in fact to decide on strategy in one case. Furthermore he was informed on who owned what. It seemed a huge amount of work for a relatively modest return.

I can see why he was very willing to adopt Munger's 'great business at a good price and wait out the long term' philosophy.
TannorP
TannorP premium member - 4 months ago
No problem and thanks! - Warren is very much an iconoclast and I have a great time trying to put myself in his shoes, guessing what he may have thought. The great business philosophy from Fisher & Munger I believe to be a strategy of "watering the flowers and picking the weeds" instead of the more common approach of "watering the weeds and picking the flowers."

I believe this to be the case for various reasons but the largest weighting I believe to be taxes, alternative investments (opportunity cost), risk of permanent capital impairment, and his pavlovian association to his holdings.

I believe this to be one of the main reasoning behind the acquisition of Sees Candy, Warren and Munger knowing the effects of compound interest and the media to become a self fulfilling prophecy of fame. The chocolate then being associated with them would enjoy outsized sales growth in comparison to competitors not due to volume but due to the price increase they are able to exercise due to the pavlovian effect.

These are two very smart men and psychology is a wonderful thing.

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