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The Buffett Partnership Letters (Part II)

October 03, 2006
Kevin Kelly

Kevin Kelly

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1963

Buffett begins the letter by telling partners to focus on relative performance rather than absolute performance: “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 by the Dow-Jones Industrial Average…if our record is better than these yardsticks we consider it a good year whether we are plus or minus. If we do poorer we deserve the tomatoes.”

Buffett revisits this point in Berkshire Hathaway’s 2001 Letter to Shareholders. Inside he says, “some people disagree with our focus on relative figures, arguing that “you can’t eat relative performance.” But if you expect ¾ as Charlie Munger, Berkshire’s Vice Chairman, and I do ¾ that owning the S&P 500 will produce reasonably satisfactory results over time, it follows that, for long-term investors, gaining small advantages annually over that index must prove rewarding. Just as you can eat well throughout the year if you own a profitable, but highly seasonal, business such as See’s (which loses considerable money during the summer months) so, too, can you regularly feast on investment returns that beat the averages, however variable the absolute numbers may be.”

Buffett goes on to make several promises to partners:

  • “Our investments will be chosen on the basis of value, not popularity”
  • “We will attempt to bring risk of permanent capital loss (not short-term quotation loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments”
  • “My wife, my children and I will have virtually our entire net worth invested in the partnership”

In addition, Buffett starts a section entitled the Joys of Compounding. In this letter he considers Columbus’ Isabella voyage a “moderately successful utilization of venture capital.” The voyage was underwritten for $30,000 and Buffett annotates this figure is would be $2,000,000,000,000 (that’s trillion) in 1963 dollars if the initial $30,000 had been compounded at 4% per annum. With this said he presents a table presenting $100,000 compounded at 5%, 10% and 15% for 10, 20 and 30 years, respectively.

Buffett also tells investors that he is not hesitant to use leverage in work-out situations saying, “I believe in using borrowed money to offset a portion of our work-out portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.”

Buffett moves on to a specific company — Dempster. This company was partially covered in Part I. As of its mention in Pat I, Buffett had not instituted any significant changes, however in this letter Buffett notes he has hired Harry Bottle to run the company. “Harry is unquestionably the man of the year. Every goal we set for Harry has been met, and all the surprises have been on the pleasant side…our breakeven point has been virtually cut in half, slow-moving or dead merchandise has been sold or written off, marketing procedures have been revamped, and unprofitable facilities have been sold.” As a result of Bottle’s actions (primarily, quickly converting unneccessary “assets” into cash), Buffett’s adjusted value per share moved up to $51. Why is this? Because Buffett values cash at 100% stated value vs. just 60 cents on the dollar for inventory, 85 cents on the dollar for accounts receivable and prepaid expenses at 25 cents on the dollar.

After explaining the Dempster situation Buffett tells partners that one of the cornerstones of his investing philosophy: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.” Essentially, valuation should be performed so conservatively that any upside from the original valuation is merely a bonus.

In his 2nd letter of 1963 Buffett informs partners that his adjusted book value per share for Dempster has moved up again due to Bottle’s continued rapid conversion of assets to cash. Buffett’s adjusted net worth figure not stands at $64 per share.

Additionally, Buffett uses a very commonsense approach to look at the current situation in Dempster: “On June 30, 1963 Dempster had a small safe deposit box at the Omaha National Bank containing securities worth roughly $2,000,000 the partner’s 72% share of this amounts to roughly $1,450,000.” The cost of acquisition for the partners totaled $1,260,000, thus any continued upside in the company is pure profit. Buffet notes, while this may be a “primitive” valuation method for the educated readers, Buffett finds it contains “a bit more substance…rather than in prayerful reliance that someone will pay me 35 times next year’s earnings.”

1964

In this letter’s The Joy of Compounding, Buffett notes the two determinants of compounding are length of life and rate of compounding.

Interestingly, Buffett remarked he doesn’t take a control position “to get merely active for the sake of being active. Everything else equal I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.” This is an interesting point, especially when considering many modern day activists disclose a new 13D filing practically every other week.

In the appendix on the first letter Buffett elaborates on Texas National Petroleum and revisits Dempster. TNP was an oil sellout work-out situation in which Buffett claimed, “the risk of stockholder disapproval was nil. The deal was negotiated by the controlling stockholders, and the price was a good one. Any transaction such as this is subject to title searches, legal opinions, etc., but this risk could also be appraised at virtually nil. There was no anti-trust problems…the only fly in the ointment was the obtaining of the necessary tax ruling.” The partnership ended up making 20%+ annualized returns on the company’s bonds, stock and warrants.

When Buffett revisits Dempster he says, “Experience shows you can buy 100 situations like this and have perhaps seventy or eighty work out to reasonable profits in one to three years,” in reference to control situations. Regarding Dempster specifically, Buffett comments that under Harry the company:

  • Has invested $2,050,000 in marketable securities and made about $400,000 in profits
  • Cut administration and selling expenses costs
  • Closed five branches operating unprofitably
  • Converted some PP&A (property, plant and equipment) into cash

We also learn something very interesting – Buffett’s positions are audited at net asset value, rather than share price. Essentially, he could choose his returns for the year (as he created the adjusted book value figures), a system that seems like it would be extremely impractical in today’s environment.

In his second letter for the year Buffett speaks about companies where the fundamentals continue to improve yet the share prices don’t go up (or even fall):

“What we really like to see in situations like the three mentioned above [generals in which BPL is the largest shareholder] is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values etc., but where the price of the stock is doing very little while we continue to acquire it.”

About the author:

Kevin Kelly
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Comments

vooch
Vooch - 7 years ago
The November 6, 1963 Buffett Partnership letter references "The Ground Rules", which consequently, took me a long time to locate that document. It is below.

- Vooch

=====

January 18, 1963

The Ground Rules

Some partners have confessed (that's the proper word) that they sometimes find it difficult to wade through my entire annual letter. Since I seem to be getting more long-winded each year, I have decided to emphasize certain axioms on the first pages. Everyone should be entirely clear on these point To most of you this material will seem unduly repetitious, but I would rather have nine partners out of ten mildly bored than have one out of ten with any basic misconceptions.

1. In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that--with drawing. If we earn more than 6% per annum over a period of year 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.

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 measure( 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.



kfh227
Kfh227 premium member - 7 years ago
Where are these letters located?
vooch
Vooch - 7 years ago

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