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.

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