We start this series of review of Warren Buffett’s letters with his second letter to partners of Buffett Partnerships that he wrote in 1957 (the first letter isn’t available).
Buffett was just 27 years of age when he wrote this letter to his partners. So you can imagine his level of understanding at an age when most people are clueless about the future and are instead lost in the world of revelry and merriment.
But Buffett had his priorities well set. By this time, he had already:
- Started and closed several small businesses (like selling chewing gum, Coca-Cola, weekly magazines, golf balls and stamps) that could earn him enough money to save and invest.
- Bought a farm using his investments.
- Accumulated more than US$ 90,000 in savings (measured in 2009 dollars).
- Filed his first income tax return…at the age of 14!
- Graduated with a Bachelor of Science in Business Administration (1949).
- Earned a Master of Science in Economics from Columbia (1951).
- Studied “Security Analysis” under Benjamin Graham and David Dodd (and earned the only A-Grade that Graham ever gave to any of his students).
- Read Graham’s The Intelligent Investor several times
- Worked as a securities analyst under Graham at Graham-Newman Corp. (1954-56).
He started Buffett Partnership Ltd. in 1956 after Graham retired and closed his partnership.
At this time, Buffett’s personal savings were over US$ 174,000 (or US$ 1.2 million inflation adjusted to 2009 dollars).
Buffett Partnership Ltd. was an investment partnership – actually a set of investment partnerships – that Buffett started to manage money of his friend and relatives, using the principles he had learned from first studying under Graham, and then working with him.
In 1957, Buffett had three partnerships operating the entire year.
The letter he wrote to his partners during that year contains a lot of simple, yet profound ideas that are relevant till today.
Intrinsic value as the bedrock
Buffett started his letter talking about the general stock market level, which he thought was priced above the intrinsic value.
This – importance of intrinsic value and its comparison with market prices – is one of the many great concepts that Buffett had learned from Graham (the other being margin of safety and Mr. Market).
Anyways, since Buffett thought that the US markets were priced higher than intrinsic value then, he also thought that there was a possibility of stock prices declining substantially in the future.
Compare this with the view most investors, analysts, fund managers, and other experts share in times when stock markets are frothy (like they were as recently as 2008).
In such times, the concept of intrinsic value is thrown out of the window because everyone wants to enjoy the ride to the top – often forgetting that the higher the markets rise in relation to intrinsic value, the greater would be the reversion to the intrinsic value.
Like here is the chart showing Sensex over the past many years, as compared to the average earnings of companies that form part of the index. Notice that the Sensex has largely moved in line with the earnings (a variable used in calculation of intrinsic value).
Whenever there have been sharp gaps created between stock prices and intrinsic value, stock prices have risen or fallen to come back to the level of intrinsic value prevalent then.
Most of us rarely give any credibility to such a simple concept, but Buffett cared about it way back in 1957.
In fact, he was even ready to employ borrowed money (not advisable for you) to buy stocks if the markets were to fall below intrinsic value.
But then, he clearly stated…
All of the above is not intended to imply that market analysis is foremost in my mind. Primary attention is given at all times to the detection of substantially undervalued securities.
That is the number one rule for you as well, dear investor.
Cut the Sensex nonsense…don’t given the index any importance in your decision to buy individual stocks – except knowing whether the general markets are way too high or way to low as compared to the general intrinsic value of listed stocks.
Like what Prof. Sanjay Bakshi suggested in a recent interview with Safal Niveshak…
The simple rule that I can give is that the Indian stocks have hovered from 11x P/E multiple on the lower end for the NSE-Nifty to a 27x on the higher side.
So obviously if you are buying stocks when the P/E multiples are 23, 24 or beyond, you should be a bit careful. You shouldn’t put a lot of money in stocks.
But if the stock that you like a lot is available to you in an environment where the aggregate multiples are 12-14, or even right now, which is about 15, then it’s a good environment to buy into long term stocks.
In other words, worry about Sensex or Nifty only to check the “general environment” in which stocks are trading, but never to make a decision whether to buy or sell individual stocks (this decision must solely be guided by the study of intrinsic values).
Ignore the noise
The past year witnessed a moderate decline in stock prices. I stress the word “moderate” since casual reading of the press or conversing with those who have had only recent experience with stocks would tend to create an impression of a much greater decline.
I can recount several examples from my early life as an analyst and investor, when even a slight fall in stock prices, and especially prices of stocks I owned, sent me to a state of shock!
Business media also does a good job to add fuel to such sparks, thereby leading small investors to run for cover under a bunker when it’s just drizzling outside!
That is why you read terms like “Black Monday”, Black Tuesday”, “Black Everyday”…for days when the Sensex crashes by a few hundred points.
This is despite the fact that such “black” days do not mean much when you are looking to invest with a 10-20 year timeframe.
These are just heartburns that the experts want you to see as heart attacks!
The best thing you can do is ignore short term movements in stock prices, even if they are sharp.
You must only be concerned with comparing stock prices with intrinsic values, and that’s it!
Give “luck” its due credit
The US markets declined by 8.4% in 1957. Despite this, Buffett’s three partnerships gained by 6.2%, 7.8%, and 25% respectively.
If I can eke out such great outperformance over the broader markets, I would call myself “genius”.
Buffett called himself “lucky in the short term”! That’s humility for you, another important attribute a value investor must have.
What is more, over the long term, Buffett just expected to beat the markets by 10% per annum on an average. So he did not expect a big outperformance from his investments, unlike what most of us think these days.
I can recollect meeting a fund manager sometime in 2006, who boasted how his fund’s NAV had outperformed the competitor’s by 10 paise! Then there was this fund manager who earned a big bonus for “losing less” money as compared to his peers.
Such weirdness is widely prevalent in the markets, so you must watch out when a mutual fund asks you for money showing the “shiny” past out-performance. In most cases, that out-performance must have been due to sheer randomness and not due to the fund manager’s ability.
Patience is a virtue for value investors
The last part of Buffett’s 1957 letter carries a very important lesson in patience for value investor. Here is what he wrote…
To some extent our better than average performance in 1957 was due to the fact that it was a generally poor year for most stocks. Our performance, relatively, is likely to be better in a bear market than in a bull market so that deductions made from the above results should be tempered by the fact that it was the type of year when we should have done relatively well. In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.
Despite calling ourselves “value investors”, a lot of us lose patience when stock prices are falling and get elated when they are rising.
But as Buffett wrote, a true value investor is likely to perform better in a bear market than in a bull market.
This is simply because when you are value investor, you buy good quality stocks and that too only at reasonable margin of safety (around 30-50%).
So when stock prices fall in a bear market, your good quality stocks bought at reasonable margin of safety may earn you lesser losses than the broader markets.
On the other hand, in a bull market, when even garbage is considered a dessert, and people are lapping up everything that’s rising in price, Mr. Market usually ignores good quality “boring” businesses which you hold in your portfolio…
…and thus you must be happy to earn just as much as the broader markets. That’s when you must not try to ride the bull but instead tell those riding it – “I’ll see you in the next bear market!”
This wouldn’t be arrogance on your part. This would be sensibility, as Buffett has proved over the past six decades.
Welcome stagnant or falling markets
A stagnant or falling market – especially when the stagnation or fall is spread over a number of years – leads most investors to self-doubt their strategies.
I meet a lot of investors who sold out most of their stocks at huge losses post the 2008 crash and have not returned to the market again. When I ask them the reason, most would say, “Who says stocks do well in the long run? Look what they have done in the past 4-5 years!”
Then there are others who are elated after a stock they bought jumps up in price.
The young Buffett did not think anything like this in 1957. As he wrote…
During any acquisition period, our primary interest is to have the stock do nothing or decline rather than advance. Therefore, at any given time, a fair proportion of our portfolio may be in the sterile stage. This policy, while requiring patience, should maximize long term profits.
Importantly, Buffett made a mention of an “acquisition period” here and not an “acquisition date”. He seemed interested in buying a particular stock over a period of time instead of what most investors generally do – utilize all excess cash to buy the maximum shares of a stock they can using that cash.
I have done this in the past, thereby creating problems when some stocks I bought fell in price (after I bought). The better thing I would have done was to buy stocks in a systematic manner – bit by bit, and over a period of time.
If you are to practice this philosophy, you would require immense degree of patience. But, as Buffett wrote, that would lead to maximization of long term profits.
In later years, Buffett used a different story to talk about the importance of “acquisition period” and “falling stock prices” for long term investors.
Here is what he wrote in his 1997 letter to shareholders…
If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices?
These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?
Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.
In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying! This reaction makes no sense.
Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Now at 34, I expect to be a net buyer of stocks over the next 10 years. And this is the reason I would be happier seeing sinking (or just moderately rising) stock prices…not a bull market that takes stock prices beyond my comfort levels.
What about you?
“Special situations” as part of investment strategy
In Part 3 of my interview of Prof. Sanjay Bakshi, he said…
The business of investing is a highly competitive business, so you must find an edge.
You may decide to specialise only in “special situations”. You may say – “I only want to work in event-driven strategies. I don’t want to take bets on India’s long-term growth story because almost everyone else is doing that. I know there are often mis-priced bets in the field of tender offers, share buybacks, large dividend payouts, spinoffs, going-private transactions, mergers and acquisitions, capital structure changes, asset sales etc.
The 27 year old Buffett was beautifully practicing this – of specializing across investment situations – in 1957.
He termed his special situations as “work-outs”. Here is how he defined the same…
A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations.
Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally. At the end of 1956, we had a ratio of about 70-30 between general issues and work-outs. Now it is about 85-15.
Nothing can be simpler than the above paragraphs to define the complex subject of “special situation investing”.
In fact, Buffett also mentioned a couple of key checklist points for investors who are interested in working on special situations:
- A special situation is “dependent on a specific corporate action” for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. So the checklist point is to answer what is the probability of the corporate action to happen. Higher is better for an investor to deal in that special situation.
- The risk with special situations is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally. So when you deal with special situations, a view on the economic or stock market picture may be excluded from your checklist.
Another key aspect of investing that Buffett hinted here was that of “allocation”. So in a year when stock markets fell a bit and Buffett identified attractive businesses to invest in, he reduced his allocation to special situation investments, from 30% in 1956 to 15% in 1957.
Here is an important takeaway for investors dealing/not dealing in special situations – It’s important to set a proper asset allocation strategy before you start to invest…and then it’s equally important to follow that strategy in stock market ups and downs.
Key ideas from Buffett’s 1957 letter
Here is a summary of the key ideas we discussed in this review of Buffett’s 1957 letter to partners:
- Give due importance to intrinsic value while making your investment decisions.
- Over time, stock prices generally revert to intrinsic value.
- Ignore the Sensex (what it is doing, where it is going) except to check the pulse of the “general investing environment”.
- Ignore short term movements in stock prices, even if they are sharp. You must only be concerned with comparing stock prices with intrinsic values, and that’s it.
- Give luck its due credit (but luck, like love, is a verb…so practice hard to get lucky, like Buffett did).
- Humility is one of the most important attributes of a value investor.
- Over the long term, if you can do your work properly, expect to outperform the broader market at just a reasonable rate. Never expect a big outperformance, for such an expectation might lead you to commit grave errors of commission.
- Being a value investor, expect to perform better in a bear market than in a bull market.
- Patience is a virtue, and especially if you are a stock market investor.
- It’s important to set a proper asset allocation strategy before you start to invest…and then it’s equally important to follow that strategy in stock market ups and downs.
And, by the way, read “The Intelligent Investor” before making your first stock purchase.
Anyways, this was my review of Buffett’s 1957 letter to partners. Let me know if I missed something. Also, let me know your own lessons from this letter.
Finally, I would appreciate your view on my notes to the letter – have they really added value to your learning as an investor.
Next Friday, we will review Buffett’s 1958 letter to partners, which you can read here.