When problems strike investors, they tend to look for ways to enhance their knowledge and regain their confidence. Recently, I got stuck in what I consider to be a value trap – James River Coal. I purchased the stock because smart money (activist Pirate Capital) was getting involved, the stock looked cheap on my projections and the company looked like it stood to benefit from the cyclical upswing occurring coal. It turns out smart money can wrong, management severely cut guidance and, in doing so, destroyed my projections, and the cyclical upswing in coal swung downward.
I believe I learned many things from this investment and I’m pretty glad it happened. Sure I lost money, but I’m happy that I lost money at this stage in my investing career (if you could call it that), rather than when it really matters.
One thing I did to regain knowledge and confidence was read all of Warren Buffett’s publicly available letters to investors in his BPL partnership. The letters can be found at http://tinyurl.com/zcqon.
Buffett’s returns for the partnership, adjusted on the basis of 1/4 of profits above 6% (For the first few years he had a few different fee structures), annualized at 25.3% per year versus just 9.1% for the Dow. Every dollar invested in Buffett’s partnership at inception yielded roughly $12 when it was closed. This compares to only $2.60 for every $1 invested in the Dow. The power of compounding is truly wonderful.
Although this is not the first letter to partners (this is the 3rd year in operations), it is the first letter available on the website listed above. Buffett begins the letter by informing investors of a situation he spoke of in the 1958 letter. He says:
“Last year, I referred to our largest holding which comprised of 10% to 20% of the assets of the various partnerships…it was in our interest to have this stock decline or remain relatively steady, so that we could acquire an even larger position.”
This quote is testament to two things: 1) Buffett’s remarkable understanding of how to use Mr. Market to his advantage; and 2) Buffett’s committment to focusing large percentages of the partnership’s assets on the ideas in which he has the most confidence.
Buffett reveals that this idea was Commonwealth Trust Co., a bank with an “intrinsic value” of $125 per share but trading at only $50 per share. The discount, according to Buffett, was due to the fact that the bank paid none of its $10 per share in earnings out in the form of dividends. Buffett also found a catalyst — the bank was 25.5% owned by a larger bank which, according to Buffett, had already tried to buy the bank out.
While Buffett found the intrinsic value to be $125, Buffett agreed to sell his 12% position in the company to another buyer for $80 per share. In my opinion, Buffett decided to sell shares at a large discount to their intrinsic value because 1) the shares were illiquid and there was a chance they wouldn’t reach his intrinsic value estimate for a long time; and 2) the bank being bought out by the 25.5% holder was not definitive occurrence, especially at his $125/share estimate of intrinsic value.
In this letter Buffett reveals that he has 35% of the partnership’s assets in one stock (which is revealed in the 1961 letter to partners). Buffett described this business as an investment trust “owning some thirty to forty other securities of high quality…[the investment] is carried at a substantial discount from asset value based on the market value of their securities and a conservative appraisal of the operating business.”
Buffett reveals that the large position aforementioned in the 1960 letter to partners is Sanborn Map Co.
According to Buffett this company had been earning roughly $500,000 during the late 1930s, but this figure fell below $100,000 in 1958/1959. That said, Sanborn started an investment portfolio in the late 1930s because there were no capital requirements in the map business. Over time, Sanborn invested about $2.5 million in about 50% bonds and 50% stocks.
Buffett went on to say, “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 the 1958, the same map business was evaluated at minus $20 [per share] with the buyer of the stock unwilling to pay more than 70 cents on the dollar for an investment portfolio with the map business thrown in for nothing.”
Buffett then reveals that he earned a spot on the company’s board. Prior to his entry to the board, nine of the fourteen directors were prominent men of the insurance industry. The startling fact is that these men, combined, owned 46 shares of stock when there were 105,000 shares outstanding.
The tenth director was an attorney owning 10 shares. The eleventh was a banker with 10 shares who “recognized the problems of the company, actively pointed them out, and later added to his holdings,” according to Buffett. The last two directors were top officers at the company with about 300 shares combined. These officers were “capable [and] aware of the problems of the business but kept in a subservient role by the Board of Directors,” in Buffett’s opinion. The final member was a son of the deceased president with about 15,000 shares of stock.
In late 1958, the son of the deceased president was unhappy with the business and demanded the top position of the company. When he was rejected he resigned from the company.
After he resigned, Buffett bought the family’s block of stock.
Buffett and two other major holders (who owned 18,000 shares of the company) thought that the business should be separated from the investment portfolio.
Buffet then instituted changes at the company. “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 $1.5 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.”
Note: Buffett begins writing semi-annual letters to partners. In his second letter in 1961 he comments on the dangers of short-term reporting:
“One year is far too short a period to form any kind of an opinion as to investment performance, and measures based upon six become even more unreliable. One factor that has caused some reluctance on my part to write semi-annual letters is fear that partners may begin to think in terms of short term performance which can be most misleading. My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets.”
This is very interesting especially when considering the short-term focused environment we live in today. For example, hedge funds report returns quarterly, monthly, weekly and even daily! For excellent thoughts on maintaining a long term focus in this world read Mauboussin’s take: http://tinyurl.com/ez27u
Buffett goes through his three different categories of investing - generals, work-outs and controls. According to Buffett, generals tend to do better in up market environments while work-outs and controls tend to do better in down market environments.
Buffett defines generals as stocks where he has no criticisms of corporate policies nor does he hold a timetable as to when he expects the value of the stock to be realized. He describes work-outs as “securities whose financial results depend on corporate action rather than supply and demand factor created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart.” In my opinion, the most important part of that is where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. These days, work-outs are more commonly called special situations. Some special situations in today’s environment include spin-offs, reorganizations, risk arbitrage, and liquidations. Joel Greenblatt is an expert in special situations. He had used them achieve 40%+ returns since his hedge fund’s inception 20 years ago. Greenblatt considers special situations “value with a catalyst,” and he wrote an excellent book, You Can Be a Stock Market Genius (available at http://tinyurl.com/hllcx), which explains how to play many of these situations. Lastly, Buffett describes control situations as a position when he would “either take control of the company or take a very large position and attempt to influence policies of the company…these situations have relatively little in common with the behavior of the Dow.” It is interesting to note the striking resemblance to this strategy and the activist strategies of today.
Buffett goes on to explain one of his control situations: Dempster, a manufacturer of “farm implements and water systems with sales in 1961 of about $9 million.” According to Buffett the company had $50/share in working capital (current assets-current liabilities) and a $75/share book value. Buffett tells the partners that new partners are receiving the position at $35/share - his estimation of current value (a 25% premium to where original partners received the stock on the position sheet).
Later in the letter Buffett tells investors several tenants of a Graham investing style:
“You will not be right simply because a large number of people monentarily 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 reasoning.”
There are two other interesting things in this letter. First, Buffett predicts long term growth in the Dow of “5-7%.” This is interesting because Buffett continues to use this forecast when investors ask for his estimate while he has been completely wrong in this estimate so far. Next, Buffett mentions the portfolio holds “40 or so securities.” This is interesting because while Buffett is a believer in concentration (30%+ of assets in one position), he holds many stocks compared to modern day focus investors such as Joel Greenblatt, Whitney Tilson or Mohnish Pabrai (5-15 names).