Every serious value investor is aware of the above famous rules from the Oracle of Omaha. These two seemingly simple rules require considerably more than mere memorization. In practice, never lose money is almost impractical, especially in a full-blown bear market. No one does a better job than the rule setter himself in achieving the above goals. So when reading through Warren Buffett's letters to partners from 1957 to 1969 again, I set up the goal to analyze how did Mr. Buffett generate gains during the down years in 1957, 1960, 1962 and 1966.
First of all, let's take a look at the performances of the Buffett Partnership during the down years against the Dow. Below is the performance of the Dow Jones and the Buffett Partnership during the aforementioned periods:
In all four years, the Dow suffered from mild to severe declines while the Buffett Partnership generated gains. The out-performance is nothing short of spectacular. In order to analyze how Mr. Buffett achieved the above results, I read the annual letters of these four years, the preceding years if available (1956, 1959,1961 and 1965) as well as the succeeding years (1958, 1961, 1963 and 1967). I also read "Snowball" by Alice Schroeder for supplemental information if needed.
This article series will start with the year of 1957. Here is an excerpt from the 1956 letter that explains his view of the general market of 1957:
"My view of the general market level is that it is priced above intrinsic value. This view relates to blue-chip securities. This view, if accurate, carries with it the possibility of a substantial decline in all stock prices, both undervalued and other wise. In any event I think the probability is very slight that current market level will be thought of as cheap five years from now. Even a full-scale bear market, however, should not hurt the market value of our work-out substantially."
With this view that the market is priced above intrinsic value, Buffett's adjusted the ratio of general issues and work-outs to 70-30, meaning that 30% of his portfolio should not be impacted by market moves. Naturally one may ponder how Buffett came to the view that the market is priced above intrinsic value. In order to answer that question, ideally one should find the market cap as a percentage of GNP for the year 1956 because that is Buffett's favorite metric to use when valuing the overall market. However, I was not able to find such data for 1956. As an alternative, I gathered the Shiller P/E information for the S&P index until 1956. Assuming the data I gathered is correct, the pre-1956 average Shiller P/E for the S&P is just over 14 times. Here is the monthly Shiller P/E ratio for 1956:
On average, S&P had a Shiller P/E of 18.3 during 1956. Although based on the ratio itself the market was not terribly expensive, the ratio was still much higher than the pre-1956 historical average of a little over 14 times.
Now that we know the market was expensive, the next question becomes what stocks did Buffett buy? I could not find the answer I wanted in the 1957 letter to partners. However, a careful read of Chapter 22 of "Snowball" reveals that at least one of the stocks he bought was National American.
According to Schroeder, this is the story between the Oracle and National American:
"Monen had joined Warren on a personal side project that he had been pursuing for some time: buying the stock of an Omaha-based insurer, National American Fire Insurance. This company’s worthless stock had been sold to farmers all over Nebraska in 1919 by unscrupulous promoters in exchange for the Liberty Bonds issued during World War I. Since then, its certificates had lain crumbling in drawers, while their owners gradually lost hope of ever seeing their money again.
Warren had discovered National American while working at Buffett-Falk, flipping through the Moody’s Manual.
The company was headquartered only a block away from his father’s office. William Ahmanson, a prominent Omaha insurance agent, had originally been sucked into it unawares, set up as a local front man for what had started out as a fraud. But the Ahmanson family had gradually turned it into a legitimate company. Now, Howard Ahmanson, William’s son, was feeding top-drawer insurance business into National American through Home Savings of America, a company he had founded in California, which was becoming one of the largest and most successful savings-and-loan companies in the United States?
The defrauded farmers had no idea that their moldering paper was now worth something. Howard had been quietly buying the stock back from them on the cheap for years through his younger brother Hayden, who ran National American. By now the Ahmansons owned seventy percent of the company.
Warren admired Howard Ahmanson.' Nobody else was quite as audacious at managing capital as Howard Ahmanson. He was very shrewd in a lot of ways. Formerly, a lot of people came in to Home Savings and paid their mortgages in person. Howard put the mortgage at the farthest branch away from where you lived so that you paid by mail and didn’t spend half an hour of one of his guys’ time telling them about your kids. Everybody else had been to see It’s a Wonderful Life and felt that you should do this Jimmy Stewart stuff, but Howard didn’t want to see his customers. His operating costs were way under anybody else’s.'
National American was earning $29 per share, and Howard’s brother Hayden was buying its stock for around $30 per share. Thus, as with the rarest and most attractive of the cheap stocks that Warren stalked, the Ahmansons could pay virtually the entire cost of buying a share of stock out of one year’s profits from that single share. National American was the cheapest stock Warren had ever seen—except for Western Insurance. And it was a nice little company, too, not a soggy cigar butt.
'I tried to buy the stock for a long time. But none of it was getting to me, because there was a security dealer in town and Hayden had given this guy the shareholders list. This stockbroker—he regarded me as a punk kid. But he had the list. And I didn't have the list. So he was buying the stock at thirty for Hayden’s account.'
Cash on the barrel from Hayden Ahmanson sounded good to some of the farmers compared to their worthless certificates. Though they had paid around $100 per share many years before and were only receiving $30, many of them had gradually convinced themselves that they were better off without the stock.
Warren was determined. 'I looked it up in some insurance book or something. If you went back to the twenties you could see who were the directors. They made some of these bigger stockholders the directors from the towns they worked the hardest for sales. There was a town called Ewing, Nebraska, which has got no population at all. But somebody sold a lot of stock out there. And that’s how they probably got the local banker on the board thirty-five years earlier.'
So Dan Monen, Warren’s partner and proxy, went off to the countryside carrying wads of Warren’s money and some of his own. He cruised around the state in a red-and-white Chevrolet, showing up in rural county courthouses and banks, casually asking who might own shares of National American. He sat on front porches, drinking iced tea, eating pie with farmers and their wives, and offering cash for their stock certificates.
'I didn’t want Howard to know because I was topping his price. He had been picking it off at thirty bucks, and I’d had to raise the price some. The shareholders had been listening for probably ten years at thirty bucks, so it was the first time the price moved.'
The first year Warren paid $35 each for five shares of the stock. The farmers’ ears pricked up. Now they realized that buyers were competing for the stock; they began to think maybe they weren't better off without it. The price had to keep moving up.
'Finally, toward the end, I paid a hundred. That was the magic number, because it was what they’d paid in the first place. A hundred bucks, I knew, would bring out all the stock. And sure enough, one guy came in when Dan Monen was doing this and he said, ‘We bought this like sheep, and we’re selling it like sheep.’
That they were. Many had sold at less than three times the $29 a year the company was earning. Monen eventually accumulated two thousand shares, ten percent of National American’s stock. Warren kept it in the original shareholders’ names, with a power of attorney attached that gave him control, rather than transferring it into his name. 'That would have tipped Howard off to the fact that I was out there competing with him. He didn’t know. Or, if he did, he had insufficient information. I just kept collecting shares. Then, the day I walked into Hayden’s office, I plopped them all down and said I wanted to transfer them to my name. And he said, ‘My brother’s going to kill me.’ But in the end, he transferred the stock.'
The brainstorm behind Warren’s National American coup had been more than just the price. He had learned the value of gathering as much as possible of something scarce."
Here we have a high-quality insurance company whose stocks are very illiquid. The stock price has basically not moved in 10 years. We have a manager who is very shrewd at capital allocation. We also have some hidden assets value that requires more than sheer intelligence to discover. At first, Buffett tried buying around $35 a share, or a little more than 1 times earning and less than 30% of the book value. Eventually, he offered $100 a share or 3.5 times earning per share and 75% of book value per share for a premium insurance company. I don't know the rate of return Buffett achieved for this investment but all the information above shapes up pretty well for a great investment.
To be continued...