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A Few Takeaways from Revisiting Munger's Partnership

June 04, 2014 | About:
Grahamites

Grahamites

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I was rereading "Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger (Trades, Portfolio)" last night and the chapter on Munger’s partnership drew great attention from me. I was familiar with Munger’s partnership’s performance, which was outlined in Buffett’s famous 1984 article The Superinvestors of The Graham-and-Doddsville. However, I never bothered to dig deeper into Munger’s portfolio in 1974. When I did, I found something incredibly interesting. Here is what I found followed by the original description from Jane Lowe’s book.

1. Munger’s portfolio was extremely concentrated. At the end of 1974, his largest two holdings accounted for a whopping 84% of the portfolio. Blue Chip Stamps, the largest holding alone, accounted for 61%. New America Fund, the second largest holding, accounted for 23% of the fund. These two holdings caused great pains for Munger during the 1973 to 1974 bear markets but he held them through and in the end, they worked out really well.

2. Munger used leverage in the limited partnership structure. The amount of leverage was not disclosed in the book. However, the use of leverage certainly greatly exacerbated Munger’s pain during the bear market.

3. New America Fund, Munger’s second largest holding, was a Graham-type net-net play. Munger tweaked Graham’s approach by taking control of the business and compound the money on his own. By doing this, he was able enjoy the double joy of deep discount to asset value and increase of intrinsic value.

4. “When dealing only with his own money, investment losses never bothered Munger much. To him it was like a losing night in a regular poker game where you knew you were one of the best players - you’d make up the difference later. But he now found that reported, temporary quotational losses in the Wheeler, Munger limited partnership accounts gave him tremendous pain.”

The lesson here is more relevant to wanna-be hedge fund managers. If you manage your own money, you may not care about the yearly fluctuation at all but if you manage other people’s money, you are very likely to be greatly disturbed by the vicissitudes of the market. Even a person as great as Munger is not immune from this psychological pain. One approach is simply to follow Buffett and Munger: Take control of a business and compound the free cash flow generated by the business. This way you are investing your own money and your investors' money but you are less subject to the psychological pain caused by market folly. I suspect this is one of the reasons why Buffett uses book value per share growth as a proxy: It is much less volatile than the market price of Berkshire and both shareholders and Buffett and Munger would be exempted from the illusionary but psychological pain caused by steep decline in Berkshire’s shares in extreme market conditions.

The above are my major takeaways. I’ve also included the following paragraphs from Lowe’s book for readers' reference.

“Munger and Guerin stayed in longer (than Buffett), especially with a large investment that was made late in 1972, a registered investment company named Fund of Letters.

Bob Denham had arrived at Munger, Tolles and part of his early work for Munger was the acquisition of the Fund of Letters. The stock market in the late part of the 1960s - the go-go years - had been torrid. A popular investment at the time was “letter stock,” a security sold without SEC registration and therefore not saleable for an extended period of time in ordinary stock market transactions. Under the securities laws, it was necessary to put a rider on the stock saying that the investor was not allowed to sell until an SEC registration or some other key event had occurred.

The Fund of Letters was a venture capital fund that its founders had formed in a highly touted initial public offering allowing liberal sales commissions to stockbrokers. When it was first organized, the fund raised $60 million, but when underwriting fees and other costs were subtracted, only $54 million remained for investment purposes.

“It was as if,” said Charlie “the customers had asked their brokers ‘what shall I do with my money?’ and the brokers had responded:’ First, give 10 percent of it to me.’ ”

Because the fund was a closed-end registered investment company, no new shares were sold once it was established. The Fund grew only if its money was invested wisely and its asset value increased. As typically is the case with a closed-end fund, the Fund of Letters soon traded well below its net asset value. Moreover, when the market went into a prolonged decline, the Fund tanked with it.

After Guerin and Munger bought control of the troubled Fund of Letters, they changed almost everything about it. They renamed it the New American Fund, reorganized board, and redirected the investment style to a value approach. They quickly liquidated assets chosen by former managers. Guerin was the chairman, but Munger’s investment philosophy was written all over the New America Fund and, as might be expected, the philosophy ran against the pack. In 1979, Business Week published an article entitled “Shareholder Heaven at New America Fund.”

“New America eschews the common industry practice of paying fat fees to outside investment advisors,” wrote Business Week, “Instead, the work is done internally under Guerin’s supervision. What’s more, the latest fiscal year, directors fees were only $25,000, and remuneration for all officers and directors came only to $59,450.”

New America Fund exhibited “a propensity for publishing and broadcasting investments,” continued the article. “In recent years its record has been outstanding: The net asset value per share increased from $9.28 in October 1974 to $29.28 on September 30,1979. Like most closed-end funds, New America sells at a discount to net asset value. On November 16, shares closed at $18.25, a 25.9% discount from net asset value of $24.64.”

Among New America Fund’s holdings were Capital Cities Communications and 100% of the Daily Journal Corporation, publisher of a Los Angeles legal newspaper. Regardless of how wonderful New America Fund looked to Business Week in 1979, its purchase by Wheeler, Munger caused many sleepless nights.

In the first eight years, Wheeler, Munger had a stunning performance, although, said Munger, “We never did get a large amount of money under management. I never did manage a lot of other people’s money on a compensated basis.”

When the years 1962 to 1969 are measured together, Wheeler, Munger’s average annual return, before the general partner’s override, was 37.1% per annum which beat performance of the Dow Jones Average by a large margin. Then, in the three-year period ending with 1972, Wheeler, Munger’s return dropped to only 13.9%, barely topping the Dow’s 12.2%.

Discouraged by market conditions, Buffett liquidated his partnership at the end of 1969. Within a few years, Munger probably wished he’d followed suit. But Munger did not follow Buffett’s example, and 1973 and 1974 were a nightmare.

“We got drubbed by the 1973 to 1974 crash, not in terms of true underlying value, but by quoted market value, as our publicly traded securities had to be marked down to below half of what they were really worth,’’ said Munger. “It was a tough stretch - 1973 to 1974 was a very unpleasant stretch.”

The main cause of Wheeler, Munger’s poor relative performance was its ownership of big blocks of common stock in New America Fund and Blue Chip Stamps. They had purchased New America’s predecessor, the Fund of Letters, during a time of stock market exuberance at the end of 1972, paying $9.22 per share, substantially under liquidation value, for their controlling block.And even after the great stock market decline, as Business Week noted in October 1974, Fund shares had an asset value of $9.28, a little higher than Munger and Guerin had paid in 1972. So why Munger’s agony? After all, Munger and Guerin had made a big investment at an unpropitious time but had dodged the natural consequences, mostly because of the “margin of safety” of the purchase as required by the principles of Benjamin Graham. Moreover, the Fund possessed a tax loss carryforward that would enable it to make large gains for many future years with no income taxes due.

Munger’s distress was caused by limited partnership’s structure, the fact that some borrowed money had been used in buying Fund stock, increasing declines in partnership net worth, and the fact that by 1974, Fund shares had a market price very much lower, indeed over 50 percent lower, than the asset value per share that could have been paid out in a Fund liquidation. Like it or not, Munger had to report results to his limited partners at the end of 1974 valuing the partnership’s large block of Fund stock at only $3.75 per share.

In addition, Wheeler, Munger was in a similar position with respect to its substantial block of Blue Chip Stamps. This stock had been purchased at an average price of $7.50 per share, had a market price of $15.37 per share at the end of 1972, yet a market price of only $5.25 per share at the end of 1974. Munger believed that Blue Chip Stamps stock was virtually certain, “not too far ahead and regardless of what the stock market did, or whether any more trading stamps were sold,” to reach a value much higher than $15.37 per share. Yet at the end of 1974, Munger faced a stubborn fact: the market price of Blue Chip Stamps stock was then only $5.25, intrinsic value be damned.

As Wheeler, Munger’s investment numbers went to hell, Charlie realized that some partners would suffer hard-to-bear distress. After all, an investment of $1,000 on January 1,1973, would have shrunk to $467 by January 1,1975, if the partner had never taken any money out during the period. In contrast, a similar $1,000 investment that performed in line with the Dow Jones Industrial Average over the same period would have shrunk much less, leaving $688. Moreover, following precedents in the Graham and Buffett partnership, all Wheeler, Munger partners drew cash from their partnership accounts at one half a percent per month on start-of-the-year value. Therefore, after regular monthly distributions were deducted, limited partners’ accounts in 1973 to 1974 went down in value even more than 53 percent.

At the end of 1974, after the big stock market crunch, the net asset value of the entire Wheeler, Munger Partnership was only $7 million. Of this, $4.3 million or 61%, was in 505,060 shares of Blue Chip Stamps, selling at $5.25 per share, plus 427,630 shares of New America Fund selling at $3.75 per share.

“Over the course of Wheeler, Munger’s first 13 year of life, ending with 1974, an investment mimicking performance of the Dow Jones Industrial Average, after counting all dividend received, would have produced a nominal return just above zero,” explained Munger. After the ravages of taxes, inflation, and withdrawals of funds for use, the real return would have been embarrassingly negative. Wheeler, Munger, during its entire lifetime, did much better. Limited partners who stayed the course after 1973 and 1974 fared exceptionally well and 95 percent of the partners did stay the course. For instance, Otis Booth stood pat after 1973 to 1974, and stood pat again with securities distributed in Wheeler, Munger’s liquidation at the end of 1975.”

There was one major, galling exception. A new limited partner had put in $350,000 just before the 1973 and 1974 crash and panicked out at the bottom. For this partner more than half the funds vanished. Charlie could not talk the partner out of the decision to withdraw. “ A lawyer is supposed to be an expert in persuasion, and I flunked a persuasion test that I think I should have passed,” said Munger. “There was something in the mix of personalities, including a low pain threshold and a strong will in the limited partner, that somehow made me fail.”

When dealing only with his own money, investment losses never bothered Munger much. To him it was like a losing night in a regular poker game where you knew you were one of the best players - you’d make up the difference later. But he now found that reported, temporary quotational losses in the Wheeler, Munger limited partnership accounts gave him tremendous pain. And so, by the end of 1974, he had resolved, like Buffett, to stop managing money for others in a limited partnership format. He would liquidate Wheeler, Munger after its asset value made a substantial recovery. And he would liquidate soon enough so that he would not take any general partner’s override when the main investment positions were distributed.”


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