Warren E. Buffett
Every serious value investor is aware of the above famous rules from the Oracle of Omaha. These two seemingly simple rules require considerably more than mere memorization. In practice, never lose money is almost impractical, especially in a full-blown bear market. No one does a better job than the rule setter himself in achieving the above goals. So when reading through Warren Buffett's letters to partners from 1957 to 1969 again, I set up the goal to analyze how did Mr. Buffett generate gains during the down years in 1957,1960,1962 and 1966.
First of all, let's take a look at the performances of the Buffett Partnership during the down years against the Dow. Below is the performance of the Dow Jones and the Buffett Partnership during the aforementioned periods:
Dow BP Out-performance
1957: -8.4% 9.3% 17.7%
1960: -6.2% 18.6% 24.8%
1962:-7.6% 11.9% 19.5%
1966:-15.6% 16.8% 32.4%
In all 4 years, the Dow suffered from mild to severe declines while the Buffett Partnership generated gains. The out-performance is nothing short of spectacular. In order to analyze how Mr. Buffett achieved the above results, I read the annual letters of these 4 years, the preceding years if available(1956, 1959,1961 and 1965) as well as the succeeding years (1958, 1961, 1963 and 1967). I also read Snowball by Alice Schroeder for supplemental information if needed.
This article series will start with the year of 1957. Here is an excerpt from the 1956 letter that explains his view of the general market of 1957:
"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."
With this view that the market is priced above intrinsic value, Buffett's adjusted the ratio of general issues and work-outs to 70-30, meaning that 30% of his portfolio should not be impacted by market moves. Naturally one may ponder how did Buffett come to the view that the market is priced above intrinsic value. In order to answer that question, ideally one should find the market cap as a percentage of GNP for the year 1956 because that is Buffett's favorite metric to use when valuing the overall market. However, I was not able to find such data for 1956. As an alternative, I gathered the Shiller P/E information for the S&P index until 1956. Assuming the data I gathered is correct, the pre-1956 average Shiller P/E for the S&P is just over 14 times. Here is the monthly Shiller P/E ratio for 1956:
1-Dec-56
|
17.2
|
1-Nov-56
|
17.1
|
1-Oct-56
|
17.4
|
1-Sep-56
|
17.8
|
1-Aug-56
|
18.7
|
1-Jul-56
|
18.9
|
1-Jun-56
|
18.2
|
1-May-56
|
18.5
|
1-Apr-56
|
19.4
|
1-Mar-56
|
19.4
|
1-Feb-56
|
18.3
|
1-Jan-56
|
18.3
|
On average, S&P had a Shiller P/E of 18.3 during 1956. Although based on the ratio itself, the market was not terribly expensive, the ratio was still much higher than the pre-1956 historical average of a little over 14 times.
Now that we know the market was expensive, what stocks did Mr.Buffett buy during 1956 and 1957? I could not find the answer I wanted in the 1957 letter to partners. However, a careful read of Chapter 22 of the Snowball by Alice Schroeder reveals that at least one of the stocks he bought was National American.
According to Ms. Schroeder, this is the story between the Oracle and National American.
"Monen had
joined Warren on a personal side project that he had been pursuing for some time:
buying the stock of an Omaha-based insurer, National American Fire Insurance.
This company’s worthless stock had been sold to farmers all over Nebraska in
1919 by unscrupulous promoters in exchange for the Liberty Bonds issued during
World War I. Since then, its certificates had lain crumbling in drawers, while
their owners gradually lost hope of ever seeing their money again.
Warren had
discovered National American while working at Buffett-Falk, flipping through
the Moody’s Manual.
The
company was headquartered only a block away from his father’s office. William
Ahmanson, a prominent Omaha insurance agent, had originally been sucked into it
unawares, set up as a local front man for what had started out as a fraud. But
the Ahmanson family had gradually turned it into a legitimate company. Now,
Howard Ahmanson, William’s son, was feeding top-drawer insurance business into
National American
through Home Savings of America, a company he had founded in California, which
was becoming one of the largest and most successful savings-and-loan companies
in the United States?
The
defrauded farmers had no idea that their moldering paper was now worth
something. Howard had been quietly buying the stock back from them on the cheap
for years through his younger brother Hayden, who ran National American. By now
the Ahmansons owned seventy percent of the company.
Warren
admired Howard Ahmanson.'Nobody else was quite as audacious at
managing capital as Howard Ahmanson. He was very shrewd in a lot of ways.
Formerly, a lot of people came in to Home Savings and paid their mortgages in
person. Howard put the mortgage at the farthest branch away from where you
lived so that you paid by mail and didn’t spend half an hour of one of his guys’
time telling them about your kids. Everybody else had been to see It’s a
Wonderful Life and felt that you should do this Jimmy Stewart stuff, but Howard
didn’t want to see his customers. His operating costs were way under anybody
else’s.'
National
American was earning $29 per share, and Howard’s brother Hayden was buying its
stock for around $30 per share. Thus, as with the rarest and most attractive of
the cheap stocks that Warren stalked, the Ahmansons could pay virtually the
entire cost of buying a share of stock out of one year’s profits from that single
share. National American was the cheapest stock Warren had ever seen—except for
Western Insurance. And it was a nice little company, too, not a soggy cigar
butt.
'I tried
to buy the stock for a long time. But none of it was getting to me, because
there was a security dealer in town and Hayden had given this guy the
shareholders list. This stockbroker—he regarded me as a punk kid. But he had
the list. And I didn't have the list. So he was buying the stock at thirty for
Hayden’s account.'
Cash on
the barrel from Hayden Ahmanson sounded good to some of the farmers compared to
their worthless certificates. Though they had paid around $100 per share many
years before and were only receiving $30, many of them had gradually convinced
themselves that they were better off without the stock.
Warren was
determined. 'I looked it up in some insurance book or
something. If you went back to the twenties you could see who were the
directors. They made some of these bigger stockholders the directors from the
towns they worked the hardest for sales. There was a town called Ewing,
Nebraska, which has got no population at all. But somebody sold a lot of stock
out there. And that’s how they probably got the local banker on the board
thirty-five years earlier.'
So Dan
Monen, Warren’s partner and proxy, went off to the countryside carrying wads of
Warren’s money and some of his own. He cruised around the state in a
red-and-white Chevrolet, showing up in rural county courthouses and banks,
casually asking who might own shares of National American.26
He sat on front porches, drinking iced tea, eating pie with
farmers and their wives, and offering cash for their stock certificates.
'I didn’t
want Howard to know because I was topping his price. He had been picking it off
at thirty bucks, and I’d had to raise the price some. The shareholders had been
listening for probably ten years at thirty bucks, so it was the first time the
price moved.'
The first
year Warren paid $35 each for five shares of the stock. The farmers’ ears
pricked up. Now they realized that buyers were competing for the stock; they
began to think maybe they weren't better off without it. The price had to keep
moving up.
'Finally,
toward the end, I paid a hundred. That was the magic
number, because it was what they’d paid in the first place. A
hundred bucks, I knew, would bring out all the stock.
And sure enough, one guy came in when Dan Monen was doing this and he said, ‘We
bought this like sheep, and we’re
selling it like sheep.’
That they
were. Many had sold at less than three times the $29 a year the company was
earning. Monen eventually accumulated two thousand shares, ten percent of
National American’s stock. Warren kept it in the original shareholders’ names,
with a power of attorney attached that gave him control, rather than transferring
it into his name. 'That would have tipped Howard off to the
fact that I was out there competing with
him. He didn’t know. Or, if he did, he had insufficient information. I just
kept collecting shares. Then, the
day I walked into Hayden’s office, I plopped them all down and said I wanted to
transfer them to my name. And he
said, ‘My brother’s going to kill me.’ But in the end, he transferred the
stock.'
The
brainstorm behind Warren’s National American coup had been more than just the
price. He had learned the value of gathering as much as possible of something
scarce."
To be continued...
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