Thursday, December 12, 2013

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:
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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.

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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!

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