Buffett Partnership Letter Series – First Half of 1962

In this article, we will take a look at the Buffett partnership letter covering the first half of 1962.

In the first part of this letter, dated July 6, 1962, Buffett reprints an entire a section of his 1961 letter. This section is entitled “And a Prediction.” My summary and commentary on this section is shown in my previous article covering the 1961 letter.

The First Half of 1962

After his reprinting of the “And a Prediction” section, Buffett discusses investment results for the first half of 1962. Below I have reproduced the important parts of this section.

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Between yearend 1961 and June 30, 1962, the Dow declined from 731.14 to 561.28. If one had owned the Dow during this period, dividends of approximately $11.00 would have been received so that over-all a loss of 21.7% would have been the result of investing in the Dow…..

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…a declining Dow gives us our chance to shine and pile on the percentage advantages which, coupled with only an average performance during advancing markets, will give us quite satisfactory long-term results. Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative.

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…during the first half of 1962 we had one of the best periods in our history, achieving a minus 7.5% result before payments to partners, compared to the minus 21.7% over-all result on the Dow. This 14.2 percentage points advantage can be expected to widen during the second half if the decline in the general market continues, but will probably narrow should the market turn upward. Please keep in mind my continuing admonition that six-months’ or even one-year’s results are not to be taken too seriously. Short periods of measurement exaggerate chance fluctuations in performance. While circumstances contributed to an unusually good first half, there are bound to be periods when we do relatively poorly. The figures for our performance involve no change in the valuation of our controlling interest in Dempster Mill Manufacturing Company, although developments in recent months point toward a probable higher realization.

Here are a couple of important points regarding this section:

· During the first half of 1962, the Buffett partnerships achieved “a minus 7.5% result before payments to partners, compared to the minus 21.7% over-all result on the Dow.” First off, it is rare that the Buffett partnerships turn in a negative result in any time period – so, that is definitely noteworthy. Secondly, Buffett mentions that this was “an unusually good first half” even though the partnerships were actually down by 7.5%. Of course, he means that the performance of the partnership compared to the Dow was unusually good (14.2 percentage point advantage). Remember that partnership performance relative to the Dow is Buffett's yardstick for performance.

· Buffett states, as he has in letters past, that “a declining Dow gives us our chance to shine and pile on the percentage advantages which, coupled with only an average performance during advancing markets, will give us quite satisfactory long-term results.” In past articles, Buffett has discussed how the partnerships should do better than the Dow in down and flat markets, and would just hope to keep up in strongly advancing markets. The partnerships’ results versus the Dow’s in the first half of 1962 seem to confirm that the partnership does decrease less than the Dow in a down market. Buffett goes further and says that his target for the partnership is “approximately 1/2% decline for each 1% decline in the Dow.” Obviously, the Buffett partnerships, during the first half of 1962, performed better than this target. The Dow declined by 21.7% and thus Buffett’s target performance would have been an approximate decline of 10.9% or less. As the partnership only declined by 7.5% in the half, the partnership declined less than 1/2% for each 1% decline in the Dow. However, please note that this 7.5% decline involves “no change in the valuation of our controlling interest in Dempster Mill Manufacturing Company.” So, this valuation assumption definitely helped the partnership beat the Dow for the first half of 1962. (Remember that Dempster was a large holding for the partnership – i.e., it represented approximately 21% of partnership net assets at the end of 1961.) However, it may have actually been conservative for Buffett not to change the valuation of Dempster during the half because he states “developments in recent months point toward a probable higher realization.”

· Finally, I think it’s important to highlight the following sentence: “Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative.” So, stated another way, Buffett is saying that if the partnership declines by only about half as much as the Dow in downturns, it would mean that the partnership is “a considerably more conservative vehicle for investment in stocks than practically any alternative” (i.e., reduced downside = conservative). And of course, we know that the partnership would also hope to beat the Dow in flat markets and keep pace with the Dow in rapidly rising markets.

Investment Companies During the First Half

In this section, Buffett discusses the performance of investment companies versus the Dow in the first half of 1962. I’ll highlight some interesting thoughts from this section.

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“Past letters have stressed our belief that the Dow is no pushover as a yardstick for investment performance.”

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“…to the extent that funds are invested in common stocks…our belief is that the overwhelming majority will achieve results roughly comparable to the Dow. Our opinion is that the deviations from the Dow are much more likely to be toward a poorer performance than a superior one."

To illustrate this point, Buffett provides a tabulation in Appendix C of the letter that shows five-years’ results of the Dow and the limited partners against the results of the “two largest open-end investment companies (mutual funds) following a program of common stock investment and the two largest closed-end investment companies.” This tabulation is reproduced at the end of this article.

Buffett then notes that many other large common stock funds also had results worse than the Dow for various time periods. Buffett writes that the so-called “growth” funds were particularly hard hit in the first half of the year and, “almost without exception, were down considerably more than the Dow.” However, then Buffett makes the following astute observation regarding these growth funds:

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It is only fair to point out that because of their excellent records in 1959-61, their over-all performance to date is still better than average, as it may well be in the future. Ironically, however, this earlier superior performance had caused such a rush of new investors to come to them that the poor performance this year was experienced by very many more holders than enjoyed the excellent performance of earlier years. This experience tends to confirm my hypothesis that investment performance must be judged over a period of time with such a period including both advancing and declining markets. There will continue to be both; a point perhaps better understood now than six months ago.

To me, this is a clear warning not to chase performance. Also, it is helpful to remind myself that there will continue to be both advancing and declining markets – it is never just one or the other.

Buffett concludes this section of his letter with the following words:

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In outlining the results of investment companies, I do so not because we operate in a manner comparable to them or because our investments are similar to theirs. It is done because such funds represent a public batting average of professional, highly-paid investment management handling a very significant $20 billion of securities. Such management, I believe, is typical of management handling even larger sums. As an alternative to an interest in the partnership, I believe it reasonable to assume that many partners would have investments managed similarly.

Asset Values

In this section, Buffett notes that “whenever the over-all results for the year are not plus 6% on a market value basis (with deficiencies carried forward) there is no allocation to the General Partner.” He also notes what happens to limited partner capital accounts and monthly payments when partners experience a decrease in the market value of their equity. Buffett also reminds his limited partners that advance payments during 1962 “do not participate in profits or losses, but earn a straight 6%.”

Year-end Amendments

In this final section, Buffett deals with some housekeeping items:

· He notes that “All partners have the right to withdraw or add any amount (rounded to even $100’s) at year- end.” (Partners could amend their agreements up to December 31st.)

· Buffett writes that “Our attorneys have advised us to admit no more than a dozen new partners (several of whom have already expressed their desire) and accordingly, we have increased the minimum amount for new names to $100,000. This is a necessary step to avoid a more cumbersome method of operation.”

· Buffett states that “During July and August I expect to be in the metropolitan New York area except for a trip or two back to Omaha. Therefore, you can get in touch with me either through our office in the Kiewit Plaza, or more directly, in care of Tweedy, Browne & Reilly, 52 Wall Street, New York 5, N.Y. (Value investors probably recognize the name Tweedy, Browne – it appears that Buffett would be using their offices during these trips to New York.)

Appendices A, B, and C to the letter follow:

APPENDIX A:

DOW-JONES INDUSTRIAL AVERAGE



APPENDIX B

PARTNERSHIP PERFORMANCE



(1) For 1957-61 consists of combined results of all predecessor limited partnerships operating throughout entire year after all expenses but before distributions to partners or allocation to the general partners.

(2) For 1957-61 computed on basis of preceding column of partnership results allowing for allocation to general partner based upon present partnership agreement.

APPENDIX C

YEARLY RESULTS



(1) Computed from changes in asset value plus any distributions to holders of record during year.

(2) From Moody’s Bank & Finance Manual – 1962.

CUMULATIVE RESULTS



Thanks for reading my thoughts on the first half of 1962. Next time, we’ll take a look at the partnership letter dated December 24, 1962.

Links to other articles in the Buffett Partnership Series:

Previous article: Buffett Partnership Letter Series – 1961 (Part 3)

Introduction: Buffett Partnership Letter Series