Saturday, December 28, 2013

2013 Year End Reflections

As the year 2013 draws to a close, it is time to sit down and reflect upon the investment mistakes that I’ve committed during the year. In doing so, I am immediately reminded of an excerpt from Warren Buffett’s 1989 letter to shareholders.

“To quote Robert Benchley, ‘Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down.’ Such are the shortcomings of experience. Nevertheless, it's a good idea to review past mistakes before committing new ones.”

Alas, how I wish I had a magic dog to teach myself to avoid soggy cigar butts on the street. The biggest mistake I made this year unmistakably falls under this “cigar butt” category. In a year where S&P advanced more than 30%, I’ve brilliantly managed to invest in a company whose share price has sunk over 50% since the beginning of the year. It is certainly not fun to slip up but getting up and learn from the fall has proved to be extremely rewarding. Heck, in fact, I consider this the best investing lesson that I have ever learned because as a result of the mistake, I now have a much better understanding of the shortcomings of the cigar butts approach to investment.

This cigar butt is called JC Penney. The mistake I made is a multifaceted one that involves analytical errors, human psychological biases, and a horrible purchase price.

To be clear, I don’t think buying JC Penney is a mistake per se. I’ve bought JC Penney in 4 tranches, the lowest at $8 and the highest at $17.Whether it is a mistake depends on the price paid. As Howard Marks has said before:

“In investing there is no such thing as a good or bad idea. Only a good idea at a price. Anything can be a good idea at one price and time, and a bad one at another. There is no investment idea so good that it can not be ruined by a too-high entry price. And there are few things that can not be attractive investments if bought at a low-enough price.

It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.”

I have certainly paid too much for JC Penney and that was a huge mistake that has cost me dearly. At the time I bought the first tranche of JC Penney, it was around $17 per share. In an article I wrote called “JC Penney – Maximum Pessimism,” I laid out my thesis based on JCP was trading around the liquidation value estimated to be between $13 to $16 per share. One of the readers made the following great comment: Liquidation value is one of those things with a big range of possibilities IMO. In a bankruptcy preceding, I doubt current shareholders will get even $9 per share or even $5 for that matter. Although I don’t know this member personally, I can tell he is without a doubt a much better investor than I am.

I’ve learned the hard way that liquidation value is as real as a mirage. First of all, the liquidation value is very likely to evaporate like liquid left in the sun if the business is not improving. JC Penney’s book value dropped almost by half within a relative short period of time. Therefore, using the present liquidation value was very foolish. Had I extrapolated the liquidation value for JC Penney based on the speed at which the business was deteriorating, I would have come up with very different scenarios. Secondly, as I have learned through studying Buffett’s partnership letters, liquidation value itself provides very limited downside protection unless you can accumulate a controlling position and even if you can end up controlling the business, the liquidating process is likely to be very painful.

Given the inadequacy of liquidating value, it is not surprising that my worst case scenario was way too optimistic, which leads to another lesson – risk means worst case scenario can happen more often and can be more severely than you think. Frankly, I did not think JC Penney was going to drop to merely $6 per share. Mark Twin said “a man who carries a cat by the tail learns something he can learn in no other way.” My experience with JC Penney has certainly proved his point. Almost everything that could go wrong did go wrong. Sales dropped precipitously; the board room was full of dramas; drastic leadership turnovers; solvency issues; liquidity crunch; massive equity dilution. Even when sales are improving, no one seems to care because everyone is now concerned that margin will stay low forever. I would be lying if I tell you that all the negativity did not bother me one bit. It was unpleasant mentally to go through the turmoil but I am also fully aware that I deserve such agitation. However, without such agitation, I probably won’t be able to fully appreciate the beauty of “it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

I wish I could stop right here and tell everyone that’s all the mistakes I’ve made about JC Penney. Unfortunately, the dimension of this flub extends beyond sheer analytical flounder. I also failed utterly to recognize the human psychological forces that were in play.

At the time I made my purchase decision, JC Penney had a very promotional CEO and a promotional activist, Bill Ackman, who I actually admire a lot. Looking back, my analysis was heavily influenced by the way Ron Johnson and Bill Ackman presented information (framing bias) and the ease at which the information can be recalled (availability bias). What initially got me really interested in JC Penney were a few articles on gurufocus and Bill Ackman’s presentation. Unfortunately, the presentation served as my initial anchor. Below are the slides that got the neurons in the nucleus accumbens part of my brain fired like wild.

Upon deep reflection, I think the root of my mistake lies in the part of my brain that handles anticipation for rewards. In Chapter 3 of the great book “Your Money or Your Brain” by Jason Zweig, the author noted that “Making money feels good, all right; it just doesn’t feel as good as expecting to make money. In a cruel irony that has enormous implications for financial behavior, your investing brain comes equipped with a biological mechanism that is more aroused when you anticipate a profit than when you actually get one. The arousal piece is actually the main component of euphoria, and it’s expectation- not satisfaction – that causes most of that arousal. When rewards are near, the brain hates to wait. Neurons in the caudate nucleus, a region in the center of the primate brain, become active even before the predictive cue is presented.” Now I can imagine that the neurons in the caudate nucleus must have been fired up when I saw Mr.Ackman’s base case offered a 6.5 times upside when JC Penney was trading at $17 per share.

Fixating on the upside made me overlook the magnitude of the downside. Under influence, my calculated risk reward ratio seemed favorable: using 20 year low of $10 as worst case and $39 - only half of Mr. Ackman’s base case, at $17 per share, the downside was $7 and upside was $22 with. For every dollar of risk, I thought I was getting 3 dollars of rewards. The odds were favorable.

The reward seemed so real and the anticipation was so exciting. There was only one little problem – in reality, it doesn’t work that way. The rewards are imaginary while the risks are real.

I had the fortune to talk about JC Penney with a few renowned investors including Arnold Van Den Berg, Stephen Yacktman and Michael Shearn. All of them have considered investing in JC Penney yet all passed. Among the reasons they ultimately did not invest are promotional management, too hard to figure out and too much downside. None of them even mentioned the upside during our conversations. This is the difference between a wise man and a fool when it comes to investing. The wise man knows that if you take care of the downside, the upside will take care of itself. Now I realize that even though the risk reward was favorable, the downside of 40% was too much and because the uncertainty was so high, one should pay a lot less for taking on the risks, not more.

The above may all seem very obvious to most of the readers but I had to learn it the hard way over and over.The confluence of the framing bias, the availability bias and the anchoring has been skewed my reasoning in the past to the more euphoric side of the pendulum. It was not until the second half of this year did I recognize the power of the lollapalooza effect, which Charlie Munger has warned us. But better late than never. The JC Penney experience will definitely serve me as a reminder going forward.
The last mistake I made with the JC Penney investment is related to portfolio sizing. It had been a 15% position in my portfolio. I am still debating whether this is as huge as a mistake as the analytical error and the lollapalooza effect. After all, I resonate with the idea of concentration unless everything gets cheap like the experience of 2008. Nevertheless, a 15% position in a struggling retailer does seem too high with the benefit of hindsight.

Now that I have finally listed out all the mistakes I’ve made with JC Penney, I feel obligated to apologize for having rambled so much on an investment that has been discussed very extensively on gurufocus. Of all the mistakes I have made and believe me, there are a lot, the JC Penney blunder is by far my favorite because I have learned tremendously from a multidisciplinary approach.

Charlie Munger once said “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.

Therefore, at the end of 2013, I’d like to admit that I was a complete stupid horse’s ass but I’ve learned to rub my nose in my mistakes.

Thanks for reading and happy new year!

Thursday, December 19, 2013

A Great Lesson From Todd Combs

I was reading the notes I took from this year’s Berkshire meeting today. One of the things that stood out was an article on Todd Combs from the World Herald.

This article came out on the Monday of the Berkshire Hathaway Shareholder Meeting. I remember reading it right before I went to the shareholder meeting. It was certainly not the fanciest article but absolutely one of my all-time favorites. I want to share with the readers the part I enjoy the most because I found it extremely inspiring and illuminating. Below is an excerpt from the article:

“One of the students asked what he could do now to prepare for an investing career. Buffett thought for a few seconds and then reached for the stack of reports, trade publications and other papers he had brought with him."

“Read 500 pages like this every day,” said Buffett, or words to that effect. “That's how knowledge works. It builds up, like compound interest. All of you can do it, but I guarantee not many of you will do it.”

"Remarkably, Combs began doing just that, keeping track of how many pages and what he read each day. Eventually finding and reading productive material became second nature, a habit. As he began his investing career, he would read even more, hitting 600, 750, even 1,000 pages a day.Combs discovered that Buffett's formula worked, giving him more knowledge that helped him with what became his primary job — seeking the truth about potential investments.”

Let’s do a simple math here. Assuming the average number of words per page is 250, then 500 pages means 125,000 words. The amount of time it takes to read 100,000 words depends on your reading speed. I don’t know how fast Warren Buffett reads but if I have to guess, I would say at least 1,000 words per minute, compared to the average of say 300 words per minutes. At 1,000 words per minute, it takes Buffett a little over 2 hours to read 500 pages whereas at 300 words per minute, it takes an average adult almost 7 hours to read 500 pages. This is based on the assumption that one actually reads 500 pages per day. Like Buffet said, all of us can do it, but not many of us will do it. Out of all the students Buffett talked to in Combs’ class, he is probably the only one who listened to Buffett’s advice and practiced the daily 500 pages drill. This is truly remarkable! No wonder Buffett eventually hired him as one of Berkshire’s investment managers.

I have been keeping track of the number of pages and what I read consistently since I got back from Omaha this year. With a very busy full time work schedule, I can only manage to read between 200-300 pages per day. This mostly includes books, annual reports, magazines, periodicals, articles, and industry surveys. Although 200-300 pages are nothing compared Combs and Buffett’s 1000 pages per day, I am starting to feel the power of compounding knowledge. The first time I read an annual report of a crude oil shipper, I have to spend so much time understanding the terms. I may still spend a good amount of time refreshing my memories on the shipping terms the second time I read it. By the time I read it for the third time, it may take me 70% less time and the knowledge applies to all other crude oil shippers. I know I am not a prodigy like Buffett so the process of repetition is inevitable. I think the key is to be consistent and persistent. My goal is to reach 500 pages per day in the next year or two.

Of course reading 500 pages every day almost sounds brutal. But as Albert Gray shrewdly observed in book The Common Denominator of Success, “The common denominator of success – the secret of success of every man who has ever been successful – lies in the fact that he formed the habit of doing things that failures don’t like to do.”

Combs did just that. As such, he rightly deserved the job offer from Warren Buffett.

Tuesday, December 17, 2013

1998 - When Buy And Hold The Greatest Business Did Not Work

Here is a question: If you had bought equity ownership interests in the Coca-Cola Company on July 15th 1998, what would your return be for the next 13 years excluding dividends?

Many readers may have guessed the answer: not much. In fact, the return from price appreciation is almost negligible if you bought KO at the high point in July 1998.

This is a discovery I was lucky enough to stumble on when speaking to Stephen Yacktman and Jason Subotky from Yacktman Asset Management.

Although I am not surprised by the fact that an investor could lose money in a wonderful business like Coca Cola, I have been pondering the implication of stagnant KO’s share price during that 13 year period. After all, Coca Cola probably has the widest moat among all wonderful businesses. We all know that Warren Buffett has repeatedly said “buying a wonderful business at a fair price is far better than a fair business at a wonderful price.”  However, the Oracle did not disclose what his definition of fair price is. Obviously in this case, the market was not offering Coca Cola at a fair price during July 1998. And no one knows for sure what the exact fair price for Coca Cola was in 1997, but that’s probably out of my current circle of competence anyway. Instead, to practice reverse thinking advocated by Charlie Munger, I would like to analyze the reasons why one should not buy Coca Cola during July 1998.

Let’s look at the reported numbers first. Here is the 5 year summary up until 1997. These are numbers from audited financial statements.

The average closing price for Coca Cola during July 1998 is about $85 per share. Assuming an investor purchased KO at the average closing price, he or she was paying a hefty 51 times unadjusted earnings. And if we refresh our memories from the Yachtman Asset Management interview, Jason and Stephen had said that the earnings in 1997 were of lower quality compared to previous years. Shrewd readers may have already observed from the above table, 1996 and 1997 earnings include unusually large other incomes. A careful read of the 1997 annual form 10k shows that these are mostly made up of gain on sales of non-core assets and gain on issuance of stock by equity investees, both non-recurring in nature. The details are disclosed in the footnotes:

Furthermore, the 1996 income tax rate includes a one-off settlement benefit that lowered the tax rate to 24% for 1996 only. Without this benefit, Coke’s 1996 income tax rate should have been 31%. This is also disclosed in the footnote:

After adjusting for the non-recurring items and tax rates, Coca Cola’s earnings in 1996 and 1997 are much worse than they appear to be. The following table summarizes the result of the adjustments.

Reported Pre Tax Income$     4,596.00$        6,055.00
Adjustments for Non-Recurring Item -
Gain on Sales of Non-Core Assets

Adjustments for Non-Recurring Item -
Gain on Issuance of Stock by Equity Investee
        (413.00)           (343.00)
Adjusted Pre Tax Income        4,183.00           5,204.00
Adjusted Tax Rate              31%             31.80%
Adjusted Net Income$     2,886.27$          3,549.13
Shares Outstanding- Diluted            2,523                2,515
Adjusted Diluted EPS          $  1.14              $  1.41
Reported Diluted EPS          $  1.40              $  1.67
Difference%             -18%                  -15%
If we use the adjusted EPS for 1997, Coca Cola was trading at more than 60 times trailing 12 months' earnings at $85 per share. This is almost priced into perfection.  

Out of curiosity, I pulled a few sell side analyst reports on Coca Cola from June 1998 to July 1998. Not surprisingly, almost all the analyst reports have buy ratings on KO:

“Our 12-month target price range is of $88-90. We feel that it is important to note that our confidence and conviction in The Coca-Cola business model and its long-term growth opportunities have never been stronger.”  -July 1998 Donaldson, Lufkin & Jenrette Analyst Report

“The long-term story for Coke remains a very strong one. Coke appears capable of achieving a high-teens rate of EPS growth longer term, driven by 8-10% annual volume growth overseas, a 5% increase in weighted concentrate price overseas, a 2-3 percentage point increase in volume driven unit profitability, and continued share repurchase (another 1-2 percentage points). Our 12-month target price for Coke is $90. Coke’s P/E multiple is at approximately 47x this year’s earnings, and holding that multiple would result in a $90 price by next year.” –June 1998 Paine Webber Analyst Report
"We continue to believe KO shares could trade to the $85–86 level over that next 12–18 months, or at roughly 46–47 times our 1999 EPS estimate of $1.84." - June Morgan Stanley Analyst Report
None of the analyst report I read adjusted 1997’s earnings for the non-recurring items, let along the 1996 earnings for the tax rate effect. Interestingly enough, almost all the analyst whose reports I read did a good job compiling the fundamental information and business updates of Coca Cola. It is the almost-ridiculous multiples they used and the EPS figure that left unadjusted that reflect poor and shallow thinking, albeit likely caused by institutional imperative.

Now I have a much better understanding of the situation of Coke in 1998. Low quality earnings combined with a high multiple and human euphoria created a classic example of “don’t just buy a wonderful business and hold it.”  

The lesson is pretty clear. History rhymes. There are a few times in Coca Cola’s history where an investor can get stuck with a stagnant stock price for an extended period of time. Human nature guarantees that this will be a repeating theme in the future as well. How to avoid the mistake of paying too much for a wonderful business?  Fortunately, Warren Buffett has laid out the ground rule for us:

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”

And I have nothing to add.

Thursday, December 12, 2013

Revisit The Buffett Partnership In 1957, 1960, 1962 And 1966 - After Thoughts

Although I have read Buffett’s early partnership letters a few times, I had never really done the “behind the scene” research prior to embarking on this journey. After all, the Oracle has certainly made it look like it was not that hard to beat the Dow. By now, it is safe to say that his writings have vastly understated the amount of effort he spent on each investment, either intentionally or by accident.

Now, I have a confession to make: I had originally started writing this article series a few months ago. I was not expecting this to be an easy task but certainly did not think it would be too hard either. However, after hours and hours of frustration, I was still stuck with the very first part because neither could I find the definitive evidence why Buffett thought the market was “priced above its intrinsic” value in 1956 nor did I have the slightest idea on how did he achieved the results in 1957. Therefore, the project was put on hold and almost obliterated. I was going to miss out on some great learning opportunity just because it might also be too hard.

Fortunately, I decided to carry on, and this was without a doubt one of the best investment decisions I have ever made.

Although it is clear to me that his record running the partnership is almost impossible to replicate, I have learned tremendously just by doing the research and reverse engineering his decision making. In this epilogue, I want to share with the readers my personal favorites. As a relatively inexperienced value investor, I had thought Buffett bought cigar butts type of investments in his early career and passively waited until they reached their fair value. This has been proved to be a ridiculously naïve and ignorant assessment. Buffett was not a passive investor when it comes to cigar butts. He would keep buying the stock as long as it continued to be a cigar butt. If the price rose, he would sell out for a profit. But if the price did not rise, he would accumulate enough shares to gain control of the company so he could liquidate its assets. He was essentially a liquidator-type of activist. This approach has worked out well with him, although it did come with a lot of pain, especially in the case of Dempster Mills.

I see many amateur investors enamored by the cigar butts approach by buying companies on a purely quantitative basis. This could work out well and there is a sound logic behind it:

“By buying assets at a bargain price, we don't need to pull any rabbits out of a hat to get extremely good percentage gains. This is the cornerstone of our investment 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.’” - 1962 Letter

This may be a very controversial opinion, but I think for small investors, a pure cigar butts approach will likely to yield unsatisfactory results. There are two main reasons for this. First of all, the value of the cigar butt business is often decreasing day by day, week by week. Such is the case for Dempster Mill and Berkshire Hathaway. Without dramatic changes, both businesses were facing the possibility of going bankruptcy. Secondly, when you invest in a cigar butt, you never know how long will your money be tied up for. Such is the case for Sanborn Map and National American. National American was dirt cheap, yet the farmers who held the shares had seen their shares stagnant for more than 10 years. Sanborn Map was even cheaper. However, had Buffett not gained a controlling position, those directors may keep smoking cigars at the board meeting and leave the shareholders helplessly disgruntled. Buffett’s cigar butt approach is different in that he can actually liquidate the assets to realize value, something a small investor is not able to do.

The above discussion leads to my next favorite part of this article series:

“Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess - I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a "high-probability insight". This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side - the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” – 1967 Letter

The big money is made by buying wonderful businesses at wonderful prices. The investments that made Buffett big fortunes — GEICO, American Express, Coke Cola, Washington Post and See’s Candy — all fall under this category.

This approach sounds too good and too obvious to be true. In theory it may be easy, but in practice it is hard. The easy part is to diligently build up the knowledge base of as many wonderful businesses as one can. This takes time and effort but will prepare an investor when opportunities come. The hard part, which arguably cannot be learned, is to have the right temperament. Buying on the way down when temporary problems happen so fast and furious is almost against human nature. One need both the knowledge-based conviction and the innate fortitude.

My own experiences have reinforced the merits of this approach. At least I have never lost any money buying wonderful businesses, and my biggest winners were mostly wonderful businesses bought at wonderful prices.

In the end, I want to thank Mr. Buffett for the wonderful lessons he has imparted through his ageless writings. I hope the readers find this article series somewhat helpful.

Revisit The Buffett Partnership In 1957, 1960, 1962 And 1966 - Part IV

The Buffett Partnership had its 10th anniversary in 1966, a year during which the Dow had declined 15.6% whereas the partnership gained 20.4% and the limited partners gained 16.8%. This year also set the record relative performance for the Buffett Partnership since its inception with an astounding 36% outperformance for the partnership and a 32.4% outperformance for the limited partners.

Let’s take another look at Buffett’s spectacular performance from 1957 to 1966:
[ Enlarge Image ]

The Dow, since the 1962 decline, had advanced significantly by the end of 1965. Accompanying the advance in the market is the diminished number of undervalued securities. Furthermore, by the end of 1965, the Buffett Partnership has reached a size that the Sanborn Maps and the Dempster Mills would not have that much of an impact on the returns. Buffett admitted that he had a harder time finding bargains through the mid-1960s in his 1966 letter:

Although the amount of opportunities have shrunk over time, Buffett did not sit on cash. Instead, the partnership was again very concentrated with a few positions making up of about more than half of the portfolio. One was disclosed in the 1966 first half letter - Hochschild Kohn. Here is what Buffett wrote in the first half 1966 letter.

“During the first half (of 1966) we, and two 10% partners, purchased all of the stock of Hochschild, Kohn & Co., a privately owned Baltimore department store. This is the first time in the history of the Partnership that an entire business has been purchased by negotiation, although we have, from time to time, negotiated purchase of specific important blocks of marketable securities. However, no new principles are involved. The quantitative and qualitative aspects of the business are evaluated and weighed against price, both on an absolute basis and relative to other investment opportunities. HK (learn to call it that - I didn't find out how to pronounce it until the deal was concluded) stacks up fine in all respects.

We have topnotch people (both from a personal and business standpoint) handling the operation. Despite the edge that my extensive 75 cents an hour experience at the Penney's store in Omaha some years back gives us (I became an authority on the Minimum Wage Act), they will continue to run the business as in the past. Even if the price had been cheaper but the management had been run-of-the-mill, we would not have bought the business.”

From the above language, it appears that HK was more like a cigar butt-type investment, but it was not as cheap as Dempster Mills because at the time of the purchase, “both quantitative and qualitative aspects of the business were evaluated and weighted against price.” HK was, to quote Buffett, a "second class department store at a third class price.” So this seems like a fair business at a wonderful price. He ended up roughly breaking even for this investment three years later.

Another large position in Buffett’s portfolio was Berkshire Hathaway. He took control of Berkshire in 1965, and it was also a fair business at a wonderful price. As the textile business kept deteriorating, so did Berkshire’s business value. Although Buffett may have paid a wonderful price for Berkshire, the return on investment was likely not satisfactory. 

At this point we may wonder if Berkshire Hathaway and Hochschild Kohn were mediocre investments to say the best, how did Buffett achieve the superior return in 1966? Buffett analysis of 1966 results gave me some clue.

[ Enlarge Image ]

The controls category (mostly Berkshire and HK) and the workouts category had a decent year, but the big gain was made in the generals – Generals - Relatively Undervalued. This comes as a surprise as in 1957, 1960 and 1962, it was the controls or the workout category that contributed the most to Buffett’s outperformance. The Generals - Relatively Undervalued category tends to correlate with the market performance.

Buffett did not disclose the investments in the Generals - Relatively Undervalued category in the letter, so a little guess work is required. Here is what he wrote:

“Our relative performance in this category was the best we have ever had - due to one holdingwhich was our largest investment at yearend 1965 and also yearend 1966. This investment has substantially out-performed the general market for us during each year (1964, 1965, 1966) that we have held it. While any single year's performance can be quite erratic, we think the probabilities are highly favorable for superior future performance over a three or four year period. The attractiveness and relative certainty of this particular security are what caused me to introduce Ground Rule 7 in November, 1965 to allow individual holdings of up to 40% of our net assets. We spend considerable effort continuously evaluating every facet of the company and constantly testing our hypothesis that this security is superior to alternative investment choices. Such constant evaluation and comparison at shifting prices is absolutely essential to our investment operation.

It would be much more pleasant (and indicate a more favorable future) to report that our results in the Generals -Relatively Undervalued category represented fifteen securities in ten industries, practically all of which outperformed the market. We simply don't have that many good ideas. As mentioned above, new ideas are continually measured against present ideas and we will not make shifts if the effect is to downgrade expectable performance. This policy has resulted in limited activity in recent years when we have felt so strongly about the relative merits of our largest holding. Such a condition has meant that realized gains have been a much smaller portion of total performance than in earlier years when the flow of good ideas was more substantial.

The sort of concentration we have in this category is bound to produce wide swings in short term performance –some, most certainly, unpleasant. There have already been some of these applicable to shorter time spans than I use in reporting to partners. This is one reason I think frequent reporting to be foolish and potentially misleading in a long term oriented business such as ours.

Personally, within the limits expressed in last year's letter on diversification, I am willing to trade the pains (forget about the pleasures) of substantial short term variance in exchange for maximization of long term performance. However, I am not willing to incur risk of substantial permanent capital loss in seeking to better long term performance. To be perfectly clear - under our policy of concentration of holdings, partners should be completely prepared for periods of substantial underperformance (far more likely in sharply rising markets) to offset the occasional over performance such as we have experienced in 1965 and 1966, and as a price we pay for hoped-for good long term performance.

All this talk about the long pull has caused one partner to observe that “even five minutes is a long time if one's head is being held under water." This is the reason, of course, that we use borrowed money very sparingly in our operation. Average bank borrowings during 1966 were well under 10% of average net worth. 

One final word about the Generals - Relatively Undervalued category. In this section we also had an experience which helped results in 1966 but hurt our long term prospects. We had just one really important new idea in this category in 1966. Our purchasing started in late spring but had only come to about $1.6 million (it could be bought steadily but at only a moderate pace) when outside conditions drove the stock price up to a point where it was not relatively attractive. Though our overall gain was $728,141 on an average holding period of six and a half months in 1966, it would have been much more desirable had the stock done nothing for a long period of time while we accumulated a really substantial position.”

A little extra research reveals that this one holding is American Express (AXP). I will spare the readersthe excruciating details of the American Express story as many of us should be very familiar with what happened in 1964. Buffett loaded up American Express for the partnership at the depressed price and eventually made a $13 million bet which more than doubled in three years.

The other idea in 1966 that falls into the Generals – Relatively Undervalued category was the Walt Disney Company (DIS). Here is what Buffett told the Notre Dame students about the Walt Disney investment:

“We bought 5% of the Walt Disney Company in 1966. It cost us $4 million dollars. $80 million bucks was the valuation of the whole thing. 300 and some acres in Anaheim. The Pirate’s ride had just been put in. It cost $17 million bucks. The whole company was selling for $80 million. Mary Poppins had just come out. Mary Poppins made about $30 million that year, and seven years later you’re going to show it to kids the same age. It’s like having an oil well where all the oil seeps back 1966 they had 220 pictures of one sort or another. They wrote them all down to zero – there were no residual values placed on the value of any Disney picture up through the ‘60s. So (you got all of this) for $80 million bucks, and you got Walt Disney to work for you. It was incredible. You didn’t have to be a genius to know that the Walt Disney company was worth more than $80 million. $17 million for the Pirate’s Ride. It’s unbelievable. But there it was. And the reason was, in 1966 people said, ‘Well, Mary Poppins is terrific this year, but they’re not going to have another Mary Poppins next year, so the earnings will be down.’ I don’t care if the earnings are down like that. You know you’ve still got Mary Poppins to throw out in seven more years…I mean there’s no better system than to have something where, essentially, you get a new crop every seven years and you get to charge more each time…I went out to see Walt Disney (he’d never heard of me; I was 35 years old). We sat down and he told me the whole plan for the company – he couldn’t have been a nicer guy. It was a joke. If he’d privately gone to some huge venture capitalist, or some major American corporation, if he’d been a private company, and said ‘I want you to buy into this’...they would have bought in based on a valuation of $300 or $400 million dollars. The very fact that it was just sitting there in the market every day convinced (people that $80 million was an appropriate valuation). Essentially, they ignored it because it was so familiar. But that happens periodically on Wall Street.”

Buffett’s initial investment on Disney was 31 cents and he sold it for 48 cents for a quick gain.

Now it is clear that the big bucks in 1966 were made from buying two wonderful businesses at wonderful prices. Instead of going through the painful exercises as he did with Sanborn Map and Dempster Mill, Buffett just picked up American Express and Disney’s shares and decided to “sit on his ass” with equally satisfactory results. This is absolutely a much more enjoyable experience. 

Buffett would later write to the partners that buying “the right company (with the right prospects, inherent industry conditions, management, etc.)” means “the price will take care of itself…. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions.”

Here goes the lesson from 1966: It is far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. However, the best is to buy a wonderful business at a wonderful price!

Revisit Whe Buffett Partnership In 1957, 1960, 1962 And 1966 - Part III

The year of 1962 marked another spectacular outperformance of the Buffett Partnership. The Dow was down 7.6% and the partnership was up 11.9%, resulting in a 19.5% out-performance.

If we recall from the prior articles, before the 1957 market decline, Buffett stated that the market was expensive:

"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 other wise. In any event I think the probability is very slight that current market level 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-out substantially.”

Before the 1960 decline, he observed the divergence in the stock market:

“The Dow-Jones Industrial Average, undoubtedly the most widely used index of stock market behavior, presented a somewhat faulty picture in 1959. This index recorded an advance from 583 to 679, or 16.4% for the year. When the dividends which would have been received through ownership of the average are added, an overall gain of 19.9% indicated for 1959.

Despite this indication of a robust market, more stocks declined than advanced on the New York Stock Exchange during the year by a margin of 710 to 628. Both the Dow-Jones Railroad Average and Utility Average registered declines.”

However, in his 1961 letter, the Oracle did not make similar statements about the general market as he did in 1956 and 1959. Instead, he laid out his expectation in terms of annual returns of the Dow for the long term:

“I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few when it is minus on the same order, and a majority when it is in between. I haven't any notion as to the sequence in which these will occur. Nor do I think it is of any great importance for the long-term investor.

Over any long period of years, I think it likely that the Dow will probably produce something like 5% to 7% per year compounded from a combination of dividends and market value gain. Despite the experience of recent years, anyone expecting substantially better than that from the general market probably faces disappointment.”

If we use a 3% dividend rate for the Dow and strip that out from the 5% to 7% Buffett expected, his price return for the Dow in the long run was 2% to 4% per year, which was conservatively pessimistic. If we repeat the Shiller P/E exercise we did for 1957, we can see that the market was mildly expensive at the end of 1961 based on the Shiller P/E. Below is the table of the Shiller P/E of the S&P for 1960 and 1961:


The decline in 1960 brought the Shiller P/E down to as low as 16.61. As the market advanced significantly in 1961, the Shiller P/E rose to 22 at the end of 1961, much higher than the historical average of 14.5 up to 1961.

Another indication that Buffett thinks that the market was not cheap comes from this video:

In this video, Buffett said although the stock market had been rising at a rather rapid rate for some time, corporate earnings and dividends had not been increasing. Therefore, a correction was expected.
Buffett’s portfolio, incidentally, included a position that was usually large just as it did in 1956 and 1959. This time, it was Dempster Mill, a windmills and water irrigation systems maker in Beatrice, Neb. To be clear, Buffett started purchasing the stocks of Dempster Mill back in 1958. It was a classic Graham-style cheap the stock had book value of $72 per share and price of $18 per share. Over the next few years, Buffett continued to accumulate shares at prices significantly below book value and eventually he owned 70% of the stock with another 10% held by a few associates by August 1961. At the end of 1961, Dempster Mill represented more than 20% of the Buffett Partnership’s portfolio. In his letter dated November 1962, Buffett mentioned that the outperformance up until Oct. 31 was about 40% due to Dempster Mill if valued at $50 per share. Although we can’t tell how much Dempster Mill contributed to 1962 full year’s outperformance, an educated guess would suggest a 40% to 50% range.
What happened next to Dempster Mill was very interesting. First of all, in the 1962 annual report, the Dempster Mill position was not valued using quoted prices. Instead, it was valued using Buffett’s own intrinsic value estimate, which is based on liquidation value. In today’s accounting lingo, this investment would be classified as a Level III asset, which means the value of the assets are estimated using unobservable inputs. Although $35 per share does look like a very conservative estimate of liquidation value, for a declining business, I doubt that Dempster Mill could be traded at $50 per share if it were listed on NYSE in today’s market environment.

The second interesting point about the Dempster Mill investment was that Buffett was in serious trouble with this investment at one point in 1962. This was skillfully depicted by Alice Schroeder in "Snowball":
“Since Dempster was just another cigar butt, Warren applied his cigar-butt technique, which was to keep buying a stock as long as it continued to sell below book value. If the price rose for any reason, he could sell out at a profit. If it didn’t, and he ended up buying until he owned so much stock that he controlled the company, he could sell off—that is, liquidate—its assets at a profit.
Buffett was looking at only a few months before it all caved in and he would have to report to the partners that a business into which he had sunk a million dollars of their money was broke. He tried to recruit his old Columbia friend Bob Dunn to leave his job at U.S. Steel, move to Beatrice, and run Dempster. Dunn actually made a trip out to Beatrice but in the end wasn’t interested. Buffett rarely asked advice, but finally that April he took the situation up with his friend Munger while he and Susie were visiting Los Angeles.

‘We were going to dinner with the Grahams and the Mungers, Susie and I. We met them at the Captain’s Table on El Segundo in L.A. During the dinner, I’m telling Charlie, ‘I’m in this mess with this company; I’ve got this jerk running Dempster, and the inventories keep going up and up.’”
So the situation at Dempster Mill was awful and if the current manager kept messing up the company, it was likely that Dempster Mill would go bankruptcy eventually. Buffett had to talk to Munger and then hired a best turnaround expert to get out this mess at a very nice profit. The investment made a lot of money for his investors but it also got ugly in the end when everyone in Beatrice hated him
I don’t think small investors can replicate what Buffett did at Dempster Mill. Today we may call situations like this value traps and unless an investor can unlock the value by taking a controlled position, he is very unlikely to get the return Buffett got for Dempster Mill. But if there is one lesson we can learn from the Dempster Mill case, I think it is this:

By buying assets at a bargain price, we don't need to pull any rabbits out of a hat to get extremely good percentage gains. This is the cornerstone of our investment 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.”

The last point I noted in the 1962 letter was a short position. It may not be material to Buffett’s outstanding relative performance against the Dow, but he had a short position about 4% to 5% of the beginning assets under management. Most of this occurred in conjunction with a work-out situation. In his words, “The short sales eliminated the general market risk related to that situation.”

To be continued…

Revisit The Buffett Partnership In 1957, 1960, 1962 And 1966 - Part II

In my previous article, I analyzed how Warren Buffett managed to outperform the Dow by 17.7% in 1957 when the Dow was down 8.4%. In this article, I will move on to the year of 1960. Here is the table of outperformance for reference purposes:

In 1960, the Dow declined 6.2% whereas the Buffett Partnership advanced 18.6%. The outperformance was a whopping 24.8%. Having been skeptical of the market’s advance in 1959, the Oracle wrote the following to his investors in the 1959 letter.

“The Dow-Jones Industrial Average, undoubtedly the most widely used index of stock market behavior, presented a somewhat faulty picture in 1959. This index recorded an advance from 583 to 679, or 16.4% for the year. When the dividends which would have been received through ownership of the average are added, an overall gain of 19.9% indicated for 1959.

Despite this indication of a robust market, more stocks declined than advanced on the New York Stock Exchange during the year by a margin of 710 to 628. Both the Dow-Jones Railroad Average and Utility Average registered declines.

Most investment trusts had a difficult time in comparison with the Industrial Average. Tri-Continental Corp. the nation's largest closed-end investment company (total asset $400 million) had an overall gain of about 5.7% for the year.
Massachusetts Investors Trust, the country's largest mutual fund with assets of $1.5 billion showed an overall gain of about 9% for the year.

Most of you know I have been very apprehensive about general stock market levels for several years. To date, this caution has been unnecessary. By previous standards, the present level of ‘blue chip’ security prices contains a substantial speculative component with a corresponding risk of loss. Perhaps other standards of valuation are evolving which will permanently replace the old standard. I don't think so. I may very well be wrong; however, I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a "New Era" philosophy where trees really do grow to the sky.
To the extent possible, I continue to attempt to invest in situations at least partially insulated from the behavior of the general market.”

In this letter, Buffett shrewdly pointed out the divergence he observed: The Dow advanced 16.4% while more stocks declined than advanced on the NYSE during 1959. This divergence suggested that the advance was probably led by a small group of stocks, or in this case, very likely the “blue chip” securities. This divergence suggests another way that Buffett looks at the general market. It is widely known that one of his favorite metrics to use to value the general market is total cap as a percentage of GNP. However, by looking at the components that make up the exchange, we can also get a good sense of the market condition. In the case of 1959, the divergence observed by Buffett should serve as a cautious sign for investors.

I don’t know whether the portfolio allocation decision Buffett made leading up to 1960 was due to anticipation of a decline in the general market or not but at the end of 1959, there was a particularly large position that made up 35% of the portfolio. This is a workout that should be uncorrelated to the market movement.

“Last year, I mentioned a new commitment which involved about 25% of assets of the various partnerships. Presently this investment is about 35% of assets. This is an unusually large percentage, but has been made for strong reasons. In effect, this company is partially an investment trust owing some thirty or forty other securities of high quality. Our investment was made and is carried at a substantial discount from asset value based on market value of their securities and a conservative appraisal of the operating business.”

As some of the readers know, this investment was Sanborn Map. The readers can get the details in the 1960 letter. Essentially, Sanborn Map is a stock that was trading around $45 per share and had an investment portfolio worth about $65 per share. Sanborn Map also had a declining, yet still profitable map business that was earning less than $100,000 or less than $1 per share (Sanborn had 105,000 shares outstanding).

To unlock the value of Sanborn Map, Buffett practiced what nowadays called activism, joined by his friends Walter Schloss, Fred Stanback and Henry Brandt. In the end, he purchased enough shares to effective take control of the company and Sanborn Map exchanged a portion of the investment portfolio for company shares. As part of the deal, the Buffett partnership tendered all their shares.
It is worth noting that the Sanborn Map investment is different from National American in that Sanborn Map’s business quality and earnings power were much worse than those of National American. However, Sanborn’s asset value provides better protection as the investment portfolio could be readily liquidated.

Although in both cases, Buffett made a lot of money for his investors, often overlooked was the amount of effort he put into both Sanborn Map and National American. In the case of National American, he and his partner Dan had to go to the countryside to first find out who may own the shares and then to ask every possible shareholder to sell them their shares. In the case of Sanborn Map, he almost went on a proxy fight in order to unlock the value.

Neither investment would turn out as good as they were if not for the tremendous amount of hard work Buffett put in. Many Buffett followers know that his early career involved buying cigar-butt type of companies, but I wonder how many of us think about the fact that he went extra miles by doing whatever he needed to do in order to take control of the companies he invested in so he could unlock the value. The classic Ben Graham approach, combined with his determination and persistence, contributed to his early successes.

To be continued.