This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. Slightly off tangent random fact: in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”
“It should be pointed out that Dempster last year was 100% an asset conversion problem and therefore, completely unaffected by the stock market and tremendously affected by our success with the assets. In 1963, the manufacturing assets will still be important, but from a valuation standpoint it will behave considerably more like a general since we will have a large portion of its money invested in generals pretty much identical with those in Buffett Partnership, Ltd…Therefore, if the Dow should drop substantially, it would have a significant effect on the Dempster valuation. Likewise, Dempster would benefit this year from an advancing Dow which would not have been the case most of last year…”
In a previous article (1961 Part 2), we discussed the topics of expected return and expected volatility, where we made the assertion that Buffett was ever conscious of how each security would behave relative to overall markets and in the long-run, and on a forward looking basis.
His comments above on Dempster again demonstrate this, by focusing on the underlying drivers of price movement, not just categorical surfaces. Because the name of a security hasn’t changed, doesn’t mean that everything about it stays the same.
As background, in 1962, Buffett installed as the new CEO of Dempster (a control position where Buffett owned a majority stake) Harry Bottle who successfully transformed the assets of Dempster from Inventory, Receivables, and PPE into mostly Cash and Marketable Securities.
In 1962, the valuation of Dempster was mostly unaffected by the bear market that year since the assets consisted of inventory, receivables, etc. With the asset conversion, in 1963 and beyond, the valuation of Dempster would be far more sensitive to market swings since “a large portion of its money” was “invested in generals pretty much identical to those in” the Partnership.
“Our target is an approximately ½% decline for each 1% decline in the Dow, and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative.”
Here we see an explicit goal outlined for portfolio downside volatility. Notice, this is only a downside volatility goal, with no stipulations about upside volatility.
Everyone talks about volatility as a bad, bad thing. In truth, people really only hate portfolio downside volatility, and welcome extreme high upside volatility in their portfolios.
Liquidity, Mark to Market, Volatility
“The figures for our performance involve no change in the valuation of our controlling interest in Dempster Mill Manufacturing Company, although developments in recent months point toward a probable high realization.” (As of 6/30/1962)
“When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate). Last year, our Dempster holding was valued by applying what I felt were appropriate discounts to the various assets.”
Control of Dempster was achieved in 1961, therefore, the mark to market on Dempster (at year-end 1961) was based on balance sheet liquidation of assets (marked at discounts to face value) and liabilities (100% face value), not market quotations.
During the first six months of 1962, the Dow returned -21.7%, while the Partnership outperformed substantially returning -7.5%.
At the end of 1961, Dempster was ~22% of Partnership NAV, which no doubt helped bolster performance when the market took a nosedive. However, had the market taken off for the moon instead, Buffett’s position in Dempster would have negatively impacted performance.
Illiquid positions can decrease portfolio volatility on both the upside and the downside, thus be sure to utilize securities of this breed (the proverbial double-edged sword) with caution.