Thursday, December 12, 2013

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…

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