I have come across one of the largest compendiums of the early Buffett partnership letters, with letters from 1957 to 1970. It is important to remember that Buffett was investing smaller sums of money, and that he was able to reap his largest returns during this tenure. Among the letters, it is remarkable the amount of wisdom and insight that we can get, not only on investment strategy, but on the feel of the market and how to seize opportunities as they approach. In this article, I will comment on the overall expectations of a true value-investing strategy during both bull and bear markets.
What to expect during a bear market
"Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring one year in the next ten--no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much. The consequence of performance such as this over a period of years would mean that if the Dow produces a 5% to 7% per year over-all gain compounded, I would hope our results might be 15% to 17% per year."
"Our performance, relatively, is likely to be better in a bear market than in a bull market so that deductions made from the above results should be tempered by the fact that it was the type of year when we should have done relatively well. In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages."
As Buffett mentions, it is during bear markets that value investors get a significant alpha spread against the most common averages. Why? Because of the insistence on investing with a margin of safety, which limits the downside. This is not to be confused with not suffering any losses, which, as Buffett mentions, are just in a minor proportion. However, if we think about the compounding effects of 500 basis points or more over the long term, this advantage gained during bear markets will make a huge difference. During a bull market, the point was made that matching the advance of averages is a satisfactory result.
What to expect during a bull market
"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 otherwise. In any event I think the probability is very slight that current market levels 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-outs substantially. If the general market were to return to an undervalued status our capital might be employed exclusively in general issues and perhaps some borrowed money would be used in this operation at that time. Conversely, if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio."
"I make no attempt to forecast the general market - my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, prices, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected."
Generally, a bull market makes a value investor's job harder. Since our job is to allocate capital among investments, higher prices during bull markets make it harder to find bargains or an adequate margin of safety to invest. It is very interesting to note that Buffett employed three main strategies during the tenure of the partnerships: generals (stocks), controls (significant majority positions) and workouts (on expectations of corporate activity such as M&A). These strategies allowed Buffett to make money on a less-dependent way to market conditions. He also mentions that if the value of the averages goes higher, it might be a good time to reduce the exposure to stocks, given that the taking of profits eventually can lead to trouble.
There is a lot to learn from these partnership letters, which cover a broad range of topics. As I make my way through them, I will classify and comment them by topic, which I believe would be very useful for all investors.
