Buffett Partnership Letters: 1968 & 1969

During 1969, the Partnership transitioned into Berkshire Hathaway. Therefore this concludes our series on portfolio management and the Buffett Partnership Letters. Please see our previous articles in this series. Control, Hurdle Rate, Compounding, When To Sell

“…controlled companies (which represent slightly over one-third of net assets at the beginning of the year)…we cannot make the same sort of money out of permanent ownership of controlled businesses that can be made from buying and re-selling such businesses, or from skilled investment in marketable securities. Nevertheless, they offer a pleasant long term form of activity (when conducted in conjunction with high grade, able people) at satisfactory rates of return.”

“Particularly outstanding performances were turned in by Associated Cotton Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Company, a subsidiary of B-H run by jack Ringwalt. Both of these companies earned about 20% on capital employed in their businesses.”

We’ve previously written that portfolio capital compounding can be achieved in multiple ways:

• “Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.”

• Compounding can be achieved by operating entities owned in the portfolio by “reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.”

In the quotes above, Buffett was referring to the latter method.

Toward the end of the Partnership, Buffett struggled with the continuous churn & reinvestment process as prices in the marketplace rose and rendered good capital reinvestment opportunities difficult to find. Enter the attractiveness of leaving capital with operating entities (in which he had a controlling stake) that can generate profits (compound) & reinvestment capital, at “satisfactory rates of return,” without Buffett having to watch too closely (provided he found “high grade, able people” to oversee these control investments).

Buffett seemed agnostic between the two as long as the control situations produced “satisfactory rates of return.” As always, the devil lies in the details: what is a “satisfactory rate of return”? Was this figure Buffett’s mental hurdle rate?

Nevertheless, this serves as an useful reminder to investors today that the process of buying and selling assets is not the only way to compound and generate portfolio returns. In fact, sometimes it’s better to hold on to an asset, especially when good reinvestment opportunities are rare.

Process Over Outcome

“It is possible for an old, over-weight ball player, whose legs and batting eye are gone, to tag a fast ball on the nose for a pinch-hit home run, but you don’t change your line-up because of it.”

AUM, Sizing

“…our $100 million of assets further eliminates a large portion of this seemingly barren investment world, since commitments of less than about $3 million cannot have a real impact on our overall performance, and this virtually rules out companies with less than about $100 million of common stock at market value…”

Returning Capital

For those searching for language related to returning capital, the letter dated May 29^th, 1969 is a must read.

Buffett Partnership Letters: 1967 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. For any business, tapping the right client base and keeping those clients happy is crucial. To do so, Buffett believed in the establishment of mutually agreed upon objectives, and keeping his clients abreast of any changes in those objectives.

In 1967, change was indeed in the air. In the passages below, Buffett candidly discusses the rationale and impact of these changes (in both his personal life and the market) with his clients. Such behavior in the investment management industry is rather rare, simply because it risks torpedoing an existing (and very lucrative) business model.

Clients

“…some evolutionary changes in several ‘Ground Rules’ which I want you to have ample time to contemplate before making your plans for 1968. Whereas the Partnership Agreement represents the legal understanding among us, the ‘Ground Rules’ represent the personal understanding and in some way is the more important document.”

“Over the past eleven years, I have consistently set forth as the BPL investment goal an average advantage in our performance of ten percentage points per annum in comparison with the Dow…The following conditions now make a change in yardsticks appropriate:

1. The market environment has changed progressively over the past decade, resulting in a sharp diminution in the number of obvious quantitative based investment bargains available;
2. Mushrooming interest…has created a hyper-reactive pattern of market behavior against which my analytical techniques have limited value; 
3. The enlargement of our capital base to about $65 million when applied against a diminishing trickle of good investment ideas has continued to present…problems…;
4. My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner.

“In my opinion what is resulting is speculation on an increasing scale. This is hardly a new phenomenon; however, a dimension has been added by the growing ranks of professional…investors who feel they must ‘get aboard’…To date it has been highly profitable…Nevertheless, it is an activity at which I am sure I would not do particularly well…It represents an investment technique whose soundness I can neither affirm nor deny. It does not completely satisfy my intellect (or perhaps my prejudices), and most definitely does not fit my temperament. I will not invest my own money based upon such an approach – hence, I will most certainly not do so with your money.

Any form of hyper-activity with large amounts of money in securities markets can create problems for all participants. I make no attempt to guess the actions of the stock market…Even if there are serious consequences results from present and future speculative activity, experience suggests estimates of timing are meaningless…

The above may simply be ‘old fogeyism’ (after all, I am 37). When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially, I am out of step with present conditions. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.”

Psychology, Benchmark

“The final, and most important, consideration concerns personal motivation. When I started the partnership I set the motor that regulated the treadmill at ‘ten points better than the Dow.’ I was younger, poorer and probably more competitive. Even without the three previously discussed external factors making for poorer performance [see bullet points at top], I would still feel that changed personal conditions make it advisable to reduce the speed of the treadmill…

Elementary self-analysis tells me that I will not be capable of less than all-out effort to achieve a publicly proclaimed goal to people who have entrusted their capital to me. All-out effort makes progressively less sense…This may mean activity outside the field of investments or it simply may mean pursuing lines within the investment field that do not promise the greatest economic reward. An example of the latter might be the continued investment in a satisfactory (but far from spectacular) controlled business where I like the people and the nature of the business even though alternative investments offered an expectable higher rate of return. More money would be made buying businesses at attractive prices, then reselling them. However, it may be more enjoyable (particularly when the personal value of incremental capital is less) to continue to own them and hopefully improve their performance, usually in a minor way…

Specifically, our longer term goal will be to achieve the lesser of 9% per annum or a five percentage point advantage over the Dow. Thus, if the Dow averages -2% over the next five years, I would hope to average +3% but if the Dow averages +12%, I will hope to achieve an average of only 9%. These may be limited objectives, but I consider it no more likely that we will achieve even these more modest results under present conditions than I formerly did that we would achieve our previous goal of a ten percentage point average annual edge over the Dow.”

Shifting personal goals and life decisions can materially impact future returns.

Time Management

“When I am dealing with people I like, in businesses I find stimulating (what business isn’t), and achieving worthwhile overall returns on capital employed (say, 10-12%) it seems foolish to rush from situation to situation to earn a few more percentage points. It also does not seem sensible to me to trade known pleasant personal relationships with high grade people, at a decent rate of return, for possible irritation, aggravation or worse at potentially higher returns.”

We’ve heard of the concept of risk-adjusted return. But what about time or aggravation-adjusted return?

Buffett Partnership Letters: 1967 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Creativity, Trackrecord

“…although I consider myself to be primarily in the quantitative school…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…So the really big money tends to be made by investors who are right on the qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Such statistical bargains have tended to disappear over the years…Whatever the cause, the result has been the virtual disappearance of the bargain issue as determined quantitatively – and thereby of our bread and butter.”

Rome wasn’t built in one day. Neither was Warren Buffett’s investment philosophy. Here, he is debating the merits of quantitative vs. qualitative analysis. In the 1966 & 1967 letters, we see Buffett gradually shifting his investment philosophy, drawing closer to the qualitative analysis for which he’s now famous, under the influence of Charlie Munger.

The necessity of this debate grew as AUM increased and markets got more expensive (disappearance of the quantitative "bread and butter"), and as Buffett considered next steps in career progression. By the end of 1967, he had proven that he can compound capital in a treadmill, fund-style vehicle, but what next, especially as the market environment became difficult and opportunities rare? (More on this in Part 2)

Today, it’s difficult to imagine the Oracle’s investment philosophy ever requiring improvement or change, but here we see evidence that suggests it has indeed evolved over the years. The ability to adapt & improve is what separates the one-trick ponies from the great investors of today and tomorrow.

This brings us to a corollary that’s very much applicable to the asset allocation and investment management world. During the fund manager evaluation process, most clients and allocators focus intensely on historical performance trackrecords because they believe it’s an indicator of potential future performance.

But by focusing on historical figures, it’s possible to lose sight of a very important variable: change.

Our personalities and investment philosophies are products of circumstance, in life and in investing – sensitive to external influences, personal or otherwise. Examples include: emergence of new competition, availability of opportunity sets, increased personal wealth, marriage & family, purchase of baseball teams, drug habits, etc. Even great investors like Warren Buffett have evolved over the years to accommodate those influences.

It would be wise to pay attention to external influences and agents of change (the qualitative) during the fund manager evaluation process, and not rely solely on the historical trackrecord (the quantitative). 

Cash, Liquidity, Volatility

As of November 1^st 1967, “we have about $20 million invested in controlled companies, but we also have over $16 million in short-term governments. This makes a present total of over $36 million which clearly will not participate in any upward movement the stock market may have.”

Around this time, BPL had ~$70MM AUM. This means cash accounted for 23% of NAV, and control positions for 29% of NAV.

The control positions likely had very limited liquidity if Buffett needed to sell. This leads me to wonder if the high cash balance was kept for reasons other than dry powder for future opportunities, such as protection against possible investor redemptions. (Remember, at this juncture, Buffett did not yet have permanent capital).

Also, notice that Buffett’s is very much aware of the expected volatility of his portfolio vs. his benchmark – that over 50% ($36MM) of the portfolio will likely not participate in any upward market movement.

Expected Return, Volatility

“We normally enter each year with a few eggs relatively close to hatching; the nest is virtually empty at the moment. This situation could change very fast, or might persist for some time.”

Quoting Ben Graham: “‘Speculation is neither illegal, immoral nor fattening (financially).’ During the past year, it was possible to become fiscally flabby through a steady diet of speculative bon-bons. We continue to eat oatmeal but if indigestion should set in generally, it is unrealistic to expect that we won’t have some discomfort.”

Expected Return ≠ Expected Volatility

Making Mistakes

“Experience is what you find when you’re looking for something else.”

Probable Munger-ism.

Buffett Partnership Letters: 1966 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Duration

“An even more dramatic example of the conflict between short term performance and the maximization of long term results occurred in 1966. Another party, previously completely unknown to me, issued a tender offer which foreclosed opportunities for future advantageous buying…If good ideas were dime a dozen, such a premature ending would not be so unpleasant…However, you can see how hard it is to develop replacement ideas…we came up with nothing during the remainder of the year despite lower stock prices, which should have been conducive to finding such opportunities.”

We previously wrote about “duration risk” for the equity investor in relation to Buffett’s 1965 letter:

“…duration risk is a very real annoyance for the minority equity investor, especially in rising markets. Takeout mergers may increase short-term IRR, but they can decrease overall cash on cash returns. Mergers also result in cash distributions for which minority investors must find additional redeployment options in a more expensive market environment.”

Here is Buffett openly articulating this exact problem one year later in 1966. While increased short-term returns are good, duration creates other unwanted headaches such as finding appropriate reinvestment opportunities.

Liquidity, When To Buy, When To Sell

“Who would think of buying or selling a private business because of someone’s guess on the stock market? The availability of a quotation for your business interest (stock) should always be an asset to be utilized if desired. If it gets silly enough in either direction, you take advantage of it. Its availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgments.”

Market liquidity should be used as an advantage. It’s important to harness the power of liquidity in an effective & productive manner. Of course, leave it to us humans to turn something positive into a force of self-destruction!

Clients, When To Buy, When To Sell

Next time your clients ask you to time the market, be sure to read the following script prepared by Warren Buffett:

“I resurrect this ‘market-guessing’ section only because after the Dow declined from 995 at the peak in February to about 865 in May, I received a few calls from partners suggesting that they thought stocks were going a lot lower. This always raises two questions in my mind: (1) if they knew in February that the Dow was going to 865 in May why didn’t they let me in on it then; and (2) if they didn’t know what was going to happen during the ensuing three months back in February, how do they know in May? There is also a voice or two after any hundred point or so decline suggesting we sell and wait until the future is clearer. Let me again suggest two points: (1) the future has never been clear to me (give us a call when the next few months are obvious to you – or, for that matter, the next few hours); and, (2) no one ever seems to call after the market has gone up one hundred points to focus my attention on how unclear everything is, even though the view back in February doesn’t look so clear in retrospect.”

When To Buy, When To Sell

“We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do. The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.”

This is similar to Bruce Berkowitz’s comments about not predicting, but pricing.

In the last sentence, Buffett states that he only cares about “what should happen, not when it should happen.” Is this actually true? Buffett, of all people, understood very clearly the impact of time on annualized return figures. 

In fact, BPL’s return goal was 10% above the Dow annually. In order to achieve this, Buffett had to find investments that provided, on average, annual returns 10% greater than the Dow.

Control

“Market price, while used exclusively to value our investments in minority positions, is not a relevant factor when applied to our controlling interests. When our holdings go above 50%, or a smaller figure if representing effective control, we own a business not a stock, and our method of valuation must therefore change. Under scoring this concept is the fact that controlling interests frequently sell at from 60% to 500% of virtually contemporaneous prices for minority holdings.”

There is such a thing as a control premium – theoretically.

Buffett Partnership Letters: 1966 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Conservatism, Volatility

“Proponents of institutional investing frequently cite its conservative nature. If ‘conservatism’ is interpreted to mean ‘productive of results varying only slightly from average experience,’ I believe the characterization is proper…However, I believe that conservatism is more properly interpreted to mean ‘subject to substantially less temporary or permanent shrinkage in value than total experience.’” 

“The first might be better labeled ‘conventionalism’ what it really says is that ‘when others are making money in the general run of securities, so will we and to about the same degree; when they are losing money, we’ll do it at about the same rate.’ This is not to be equated with ‘when others are making it, we’ll make as much and when they are losing it, we will lose less.’ Very few investment programs accomplish the latter – we certainly don’t promise it but we do intend to keep trying.”

Notice Buffett’s definition of conservatism in investing involves both “temporary or permanent shrinkage in value” – this is in contrast to a later Buffett who advises shrugging off temporary shrinkages in value. Why this change occurred is subject to speculation.

The second quote is far more interesting. Buffett links the concept of conservatism with the idea of portfolio volatility upside and downside capture vs. an index (or whatever industry benchmark of your choosing).

Ted Lucas of Lattice Strategies wrote an article in 2010 attributing Warren Buffett’s investment success to Buffett’s ability, over a long period of time, to consistently capturing more upside than downside volatility vs. the S&P 500. Based on the quote above, Buffett was very much cognizant of the idea of portfolio volatility upside vs. downside capture, so Ted Lucas’ assertion may very well be correct.

Sizing, AUM

“In the last three years we have come up with only two or three new ideas a year that have had such an expectancy of superior performance. Fortunately, in some cases, we have made the most of them…It is difficult to be objective about the causes for such diminution of one’s own productivity. Three factors that seem apparent are: (1) a somewhat changed market environment; (2) our increased size; and (3) substantially more competition.

It is obvious that a business based upon only a trickle of fine ideas has poorer prospects than one based upon a steady flow of such ideas. To date the trickle has provided as much financial nourishment as the flow…a limited number of ideas causes one to utilize those available more intensely.”

Sizing is important because when good ideas are rare, you have to make the most of them. This is yet another example of how, when applied correctly, thoughtful portfolio construction & management could enhance portfolio returns.

As AUM increases or declines, and as availability of ideas ebb and flow – both of these factors impact a wide variety of portfolio management decisions.

When To Buy, Intrinsic Value, Expected Return , Opportunity Cost

“The quantitative and qualitative aspects of the business are evaluated and weighted against price, both on an absolute basis and relative to other investment opportunities.”

“…new ideas are continually measured against present ideas and we will not make shifts if the effect is to downgrade expectable performance. This policy has resulted in limited activity in recent years…”

Buffett’s buying decision were based not only on the relationship between purchase price and intrinsic value, but also contribution to total “expectable performance,” and an investment’s merits when compared against “other investment opportunities,” the last of which is essentially an opportunity cost calculation.

Sizing, Diversification

“We have something over $50 million invested, primarily in marketable securities, of which only about 10% is represented by our net investment in HK [Hochschild, Kohn, & Co]. We have an investment of over three times this much in a marketable security…”

Hochschild, Kohn = 10% NAV

Another investment = “three times” size of Hochschild, or ~30% NAV

So we know in 1966, 40% of Buffett’s portfolio NAV is attributable to 2 positions.

Buffett Partnership Letters: 1965 Part 4

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. AUM, Trackrecord, Sizing

“…I believe that we have done somewhat better during the past few years with the capital we have had in the Partnership than we would have done if we had been working with a substantially smaller amount. This was due to the partly fortuitous development of several investments that were just the right size for us – big enough to be significant and small enough to handle.

I now feel that we are much closer to the point where increase sized may prove disadvantageous…What may be the optimum size under some market and business circumstances can be substantially more or less than optimum under other circumstances…as circumstances presently appear, I feel substantially greater size is more likely to harm future results than to help them.”

Asset under management (“AUM”) should not be a stagnant or passive consideration. The AUM is essentially the denominator in the return on equity calculation. The adjustment of AUM relative to portfolio gain and loss will directly impact the trackrecord. The optimal AUM will fluctuate depending on market conditions and/or opportunities available.

However, how to “adjust” AUM is a whole other can of worms.

Historical Performance Analysis, Special Situations, AUM, Expected Return, Hurdle Rate, Sizing, Time Management

“The ‘Workout’ business has become very spasmodic. We were able to employ an average of only $6 million during the year…and this involved only a very limited number of situations. Although we earned about $1,410,000, or about 23 ½% on average capital employed (this is calculated on an all equity basis...), over half of this was earned from one situation. I think it unlikely that a really interesting rate of return can be earned consistently on large sums of money in this business under present conditions.”

Over the previous 10 years, a portion of Buffett’s portfolio was consistently invested in special situations. But we see from that quote above that with AUM increasing, Buffett began to reconsider the allocation to this basket after examining its historical return contribution.

• Does the expected return available meet my minimum return standards (hurdle rate)?
• If so, can I deploy enough capital into the basket such that it contributes meaningfully to portfolio performance and absolute profts? (For example, a 1% allocation that returns 100%, while a return high percentage-wise, adds only a little boost to overall portfolio performance)
• How much of my (or my team’s) time am I will to allocate given the expected return and profits?

Perhaps another interesting lesson is that as AUM shifts, strategies that made sense at one point, may not always be as effective.

Sourcing, Sizing

“I do not have a great flood of good ideas as I go into 1966, although again I believe I have at least several potentially good ideas of substantial size. Much depends on whether market conditions are favorable for obtaining a larger position.”

Good ideas, even just a few, when sized correctly will lead to profits.

Conversely, ideas – no matter how good – if sized too small or impossible to obtain in adequate size for the portfolio, won’t make much of a difference.

Selectivity, Sizing, Expected Return, Opportunity Cost, Hurdle Rate, Correlation, Capital Preservation

“We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily when we see such an opportunity. W probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%. Any such situations are going to have to promise very significantly superior performance relative to the Dow compared to other opportunities available at the time.

They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal (anything can happen on a short-term quotational basis which partially explains the greater risk of widened year-to-year variations in results). In selecting the limit to which I will go in any one investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow.”

Buffett’s sizing decisions were selective, and dependent upon a number of conditions, such as:

• The expected return of the potential investment
• The expected return of the potential investment compared with the expected return of the Dow, and other potential investments (this is the opportunity cost and hurdle rate consideration)
• Whether the potential investment is correlated with other current and potential investments
• The possibility of expected loss of the potential investment (capital preservation consideration)

When To Buy

“Our purchase of Berkshire started at a price of $7.60 per share in 1962…the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965…”

Buffett was comfortable buying as prices went up. This is in contrast to many value investors who are most comfortable buying on the way down.

Buffett Partnership Letters: 1965 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Control, Volatility

“When such a controlling interest is acquired, the assets and earnings power of the business become the immediate predominant factors in value. When a small minority interest in a company is held, earning power and assets are, of course, very important, but they represent an indirect influence on value which, in the short run, may or may not dominate the factors bearing on supply and demand which result in price.”

“Market price, which governs valuation of minority interest positions, is of little or no importance in valuing a controlling interest…When a controlling interest is held, we own a business rather than a stock and a business valuation is appropriate.”

Today, people often reference Buffett’s advice about owning a “business,” not just a “stock.” It’s interesting to note that a prerequisite, at the origin of this advice, involves having a “controlling interest.”

Only to investors with control, do earnings power and assets become the predominant determinants of value. Otherwise, for minority investors, outside factors (such as supply and demand) will impact price movement, which in turn will determine portfolio value fluctuations.

This is strangely similar to Stanley Druckenmiller’s advice: “Valuation only tells me how far the market can go once a catalyst enters the picture...The catalyst is liquidity.” Druckenmiller’s “catalyst” is Buffett’s “factors bearing on supply and demand which result in price.”

Control, Liquidity

“A private owner was quite willing (and in our opinion quite wise) to pay a price for control of the business which isolated stock buyers were not willing to pay for very small fractions of the business.

There’s a (theoretical) Control Premium. There’s also a (theoretical) Liquidity Premium. So (theoretically) the black sheep is the minority position that’s also illiquid.

Then again, all this theoretical talk doesn’t amount to much because investment success is price dependent. Even a minority illiquid position purchased at the right price could be vastly profitable.

Mark to Market, Subscriptions, Redemptions

“We will value our position in Berkshire Hathaway at yearend at a price halfway between net current asset value and book value. Because of the nature of our receivables and inventory this, in effect, amounts to valuation of our current assets at 100 cents on the dollar and our fixed assets at 50 cents on the dollar. Such a value, in my opinion, is fair to both adding and withdrawing partners. It may be either higher or lower than market value at the time.”

We discussed in the past the impact of mark to market decision, and why it’s relevant to those seeking to invest/redeem with/from fund vehicles that contain quasi-illiquid (or esoteric difficult to value) investments yet liquid subscriptions and redemption terms (e.g., hedge funds, certain ETFs and Closed End Funds). Click here, and scroll to section at bottom ,for more details.

Benchmark, Clients

“I certainly do not believe the standards I utilize (and wish my partners to utilize) in measuring my performance are the applicable ones for all money managers. But I certainly do believe anyone engaged in the management of money should have a standard of measurement, and that both he and the party whose money is managed should have a clear understanding why it is the appropriate standard, what time period should be utilized, etc.”

“Frankly I have several selfish reasons for insisting that we apply a yardstick and that we both utilize the same yardstick. Naturally, I get a kick out of beating part…More importantly, I ensure that I will not get blamed for the wrong reasons (having losing years) but only for the right reasons (doing poorer than the Dow). Knowing partners will grade me on the right basis helps me do a better job. Finally, setting up the relevant yardsticks ahead of time insures that we will all get out of this business if the results become mediocre (or worse). It means that past successes cannot cloud judgment of current results. It should reduce the chance of ingenious rationalizations of inept performance.”

Time Management, Team Management, Clients

“…our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business. This, of course, is the result of really outstanding personnel and cooperative partners.”

The skill set required for client servicing is completely different from the skills required for investment management. But unfortunately, most investors/funds have clients that require servicing.

Some are fortunate enough to have team resources that shoulder the majority of client obligations. Yet, the client component never disappears completely. Disappearance may be wishful thinking, though minimization is certainly a possibility.

Reflect upon your procedures and processes – what changes could you implement in order to make a claim similar to the one that Buffett makes above?

Buffett Partnership Letters: 1965 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Trackrecord, Compounding, Duration, Special Situations, Time Management

“A disadvantage of this business is that it does not possess momentum to any significant degree. If General Motors accounts for 54% of domestic new car registrations in 1965, it is a pretty safe bet that they are going to come fairly close to that figure in 1966 due to owner loyalties, deal capabilities, productivity capacity, consumer image, etc. Not so for BPL. We start from scratch each year with everything valued at market when the gun goes off…The success of past methods and ideas does not transfer forward to future ones.”

Investing, compounding, and trackrecord creation is a perpetual intellectual treadmill – “We start from scratch each year with everything valued at market when the gun goes off,” and the “success of past methods and ideas” contribute only slightly to future returns.

In 1965-1966, a large portion of Buffett’s portfolio still consisted of generally undervalued minority stakes and special situation workouts.

Though not often highlighted, duration risk is a very real annoyance for the minority equity investor, especially in rising markets. Takeout mergers may increase short-term IRR, but they can decrease overall cash on cash returns. Mergers also result in cash distributions for which minority investors must find additional redeployment options in a more expensive market environment.

Special situations investors have to run even harder on the intellectual treadmill since their portfolios contain a natural ladder of duration as the special situations resolve and “workout.”

All this activity is subject to the 24 hours per day time constraint. How does one maximize portfolio compounding given these obstacles?

I suspect it was mental debates like these that drove Buffett, in later years, to seek out the continuous compounding investments such as Coca Cola, Wells Fargo, etc., to which he could outsource the task of compounding portfolio equity.

Here’s the basic rationale behind the term “outsourced compounding” extracted from an article I wrote a few months ago:

"Compounding can be achieved by the portfolio manager / investor when making investments, which then (hopefully) appreciates in value, and the repetition of this cycle through the reinvestment of principal and gains. However, this process is limited by time, resources, availability of new ideas to reinvest capital, etc.

Operating business achieve compounding by reinvesting past earnings back into the same business (or perhaps new business lines). In this respect, the operating business has an advantage over the financial investor, who must constantly search for new opportunities.

Tom Russo of Gardner Russo & Gardner, quoted above in a November 2011 edition of Value Investor Insight (many thanks to Rafael Astruc of Garrison Securities for tipping PMJar on this), highlights an important and useful shortcut for portfolio managers – why not outsource part of the burden of compounding to the operating businesses in one’s portfolio? (Price dependent, of course.)"

Expected Return, Volatility, Historical Performance Analysis, Process Over Outcome

“…our results, relative to the Dow and other common-stock-form media usually will be better in declining markets and may well have a difficult time just matching such media in very strong markets. With the latter point in mind it might be imagined that we struggled during the first four months of the half to stay even with the Dow and then opened up our margin as it declined in May and June. Just the opposite occurred. We actually achieved a wide margin during the upswing and then fell at a rate fully equal to the Dow during the market decline.

I don’t mention this because I am proud of such performance – on the contrary. I would prefer it if we had achieved our gain in the hypothesized manner. Rather, I mention it for two reasons: (1) you are always entitled to know when I am wrong as well as right; and (2) it demonstrates that although we deal with probabilities and expectations, the actual results can deviate substantially from such expectations, particularly on a short-term basis.”

Buffett wanted to correctly anticipate not only the expected return, but also the expected volatility of his portfolio. He was not “proud” when the return pattern of the portfolio vs. his index (Dow) did not occur according to his prediction (even though he still beat the index by a wide 9.6% margin during the first 6 months of the year) – “I would prefer it if we had achieved our gain in the hypothesized manner.”

This demonstrates that Buffett was not singularly focused on outcome, but process as well. He wanted to understand why the unexpected (albeit good) outcome occurred despite a process that should have led to something different.

Also, notice that the good outcome did not provide any sense of comfort and lead Buffett to ignore the anomaly in expected volatility. Over the years, I’ve noticed that many investors only dissect downside return anomalies and completely ignore upside return anomalies. Buffett’s actions here show that it’s important to understand both directionally because a rouge variable that causes unexpected upside patterns could just as easily reverse course and lead to unexpected poor results.

Lastly, I want to point out that the key to understanding sources of portfolio return and volatility requires the dissection of historical performance returns. For more on this, check out our discussion on the 1964 letter Part 3.

Buffett Partnership Letters: 1965 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. The 1965 letter is a treasure trove of insightful portfolio management commentary from Warren Buffett. This is the Buffett for purists – the bright, candid young investor, encountering intellectual dilemmas, thinking aloud about creative solutions, and putting to paper the mental debates pulling him one direction and then another. Fascinating stuff!

Portfolio Management, Sizing, Diversification, Expected Return, Risk, Hurdle Rate, Correlation, Selectivity, Psychology

“We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change underlying value of the investment.

We are obviously following a policy regarding diversification which differs markedly from that of practically all public investment operations. Frankly there is nothing I would like better than to have 50 different investment opportunities, all of which have a mathematical expectation (this term reflects that range of all possible relative performances, including negative ones, adjusted for the probability of each…) of achieving performance surpassing the Dow by, say, fifteen percentage points per annum. If the fifty individual expectations were not intercorrelated (what happens to one is associated with what happens to the other) I could put 2% of our capital into each one and sit back with a very high degree of certainty that our overall results would be very close to such a fifteen percentage point advantage.

It doesn’t work that way.

We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, ‘How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?’ This depends to a great degree on the wideness of the spread between the mathematical expectations of number one versus number eight. It also depends upon the probability that number one could turn in a really poor relative performance. Two securities could have equal mathematical expectations, but one might have 0.05 chance of performing fifteen percentage points or more worse than the Dow, and the second might have only 0.01 chance of such performance. The wide range of expectation in the first case reduces the desirability of heavy concentration in it.

The above may make the whole operation sound very precise. It isn’t. Nevertheless, our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations. Imprecise and emotionally influenced as our attempts may be, that is what the business is all about. The results of many years of decision-making in securities will demonstrate how well you are doing on making such calculations – whether you consciously realize you are making the calculations or not. I believe the investor operates at a distinct advantage when he is aware of what path his thought process is following.”

"There is one thing of which I can assure you. If good performance of the fund is even a minor objective, any portfolio encompassing one hundred stocks (whether the manager is handling one thousand dollars or one billion dollars) is not being operated logically. The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has on the overall portfolio expectation."

Lots of fantastic insights here. The most important take away is that, even for Buffett, portfolio management involves more art than science – it’s imprecise, requiring constant reflection, adaptation, and awareness of ones decisions and actions.

Expected Return, Trackrecord, Diversification, Volatility

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable. The greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected results, assuming different choices have different expectations of performance.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of ‘results,’ I am talking of performance relative to the Dow) in order to achieve better overall long-term performance. Simply stated, this means I am willing to concentrate quite heavily in what I believe to be the best investment opportunity recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater…Looking back, and continuing to think this problem through, I fell that if anything, I should have concentrated slightly more than I have in the past…”

Here, Buffett outlines the impact of diversification on the expected return and expected volatility of a portfolio, as well as the resulting trackrecord.

Consciously constructing a more concentrated portfolio, Buffett was willing to accept a bumpier trackrecord (more volatile returns vs. the Dow) in return for overall higher long-term returns.

To fans of this approach, I offer two points of caution:

• Increased concentration does not automatically equate to higher returns in the long-term – this is also governed by accurate security selection, or as Buffett puts it, “the various expectations of choices available”
• Notice, at this juncture in 1965-1966, Buffett has a 10-year wildly superior trackrecord. This is perhaps why short-term volatility no longer concerned him (or his clients) as much. If your fund (and client base) is still relatively new, think carefully before emulating.

Buffett Partnership Letters: 1964 Part 3

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Historical Performance Analysis, Process Over Outcome, Psychology

“…the workouts (along with controls) saved the day in 1962, and if we had been light in this category that year, our final results would have been much poorer, although still quite respectable considering market conditions during the year…In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have looked much poorer compared to the Dow…Finally, in 1964 workouts were a big drag on performance.”

There is a chart in the January 18, 1965 partnership letter, in which Buffett breaks down the performance of Generals vs. Workouts for 1962-1964, and discusses the return attribution of each category in different market environments.

Most investors conduct some form of historical performance review, on a quarterly or annual basis. It’s an important exercise for a variety of reasons:

• To better understand your sources of historical return – performance analysis forces you to examine the relationship between your process vs. the outcome. Was the outcome as expected? If not, do changes need to be made to the process?
• To help you and your team become more self-aware – what you do well, badly, and perhaps reveal patterns of behavioral strength and weakness (here's an article about an interesting firm that offers this analysis)
• Team Compensation
• Highlight necessary adjustment to the portfolio and business
• Etc.

The investment management world spends a lot of time scrutinizing the operations of other businesses. Shouldn’t we apply the same magnifying glass to our own?

Sizing, Catalyst, Hedging, Activism, Control

“What we really like to see in situations like the three mentioned above is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it…Such activity should usually result in either appreciation of market prices from external factors or the acquisition by us of a controlling position in a business at a bargain price. Either alternative suits me.”

“Many times…we have the desirable ‘two strings to our box’ situation where we should either achieve appreciation of market prices from external factors or from the acquisition of control positions in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don’t have.”

Buffett discusses the phenomenon known as the “two strings” on his bow which allowed for heavy concentration in a few positions. The potential to (eventually) acquire a controlling stake in the underlying company served has an “insurance policy” via the creation of a catalyst after asserting control. (Some may argue that activism is applicable here as well. However, we tread cautiously on this train of thought because activism by no means entails a 100% success rate.)

It’s important to understand that control is not an option available to all investors. Therefore, when sizing positions, one should reconsider the exact emulation of Buffett’s enthusiastic buying as price continues to decline, and concentrated approach.

Interestingly, if a controlling stake in a company serves as an insurance policy (as Buffett describes it), is ‘control’ a type of portfolio hedge?

Activism, Control

“We have continued to enlarge the positions in the three companies described in our 1964 midyear report where we are the largest stockholders…It is unlikely that we will ever take a really active part in policy-making in any of these three companies…”

Control ≠ Activism

Conservatism

“To too many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional or an unconventional approach, per se, is conservative.”

“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.”

“We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner.”

Buffett Partnership Letters: 1964 Part 2

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Cash

“If a 20% or 30% drop in the market value of your equity holding (such as BPL) is going to produce emotional or financial distress, you should simply avoid common stock type investments. In the words of the poet – Harry Truman – ‘If you can’t stand the heat, stay out of the kitchen.’ It is preferable, of course, to consider the problem before you enter the ‘kitchen.’

I had a discussion a few months ago with a friend about the difference between “Cash” vs. “CASH.” In my asset allocation context:

• “Cash” is readily deployable into securities and assets when opportunities arise, whereas
• “CASH” should never be exposed to the vicissitudes of any capital market that has any chance of loss (bonds, equity, or otherwise)

People often discuss Buffett’s habit of keeping plenty of cash on the sidelines awaiting opportunities, but they rarely point to the difference between a stash of dry powder ready for redeployment anytime, versus a worst case scenario nest egg that supports basic living necessities.

Based on the quote above, Buffett advised his clients to consider something similar before giving him any capital to manage.

So ask yourself, have you ever considered the difference between “Cash” vs. “CASH,” and if so, do you have a figure in mind? After all, as Buffett suggests, it’s preferable to consider this before entering the heated kitchen of the financial markets.

Expected Return

“The gross profits in many workouts appear quite small. It’s a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss.”

As we have discussed in the past, and see again in the quote above, Buffett kept close tabs on the future expected return of his portfolio.

Interestingly, here, he takes this concept one step further by introducing something new. Buffett may have kept some sort of loss provision (either actual or mental) for his basket of “work-out” securities similar to bad debt expense or loan provisions in accrual accounting.

Buffett Partnership Letters: 1964 Part 1

Continuation of our series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Given the recent discussions/debates around taxes and potentially shifting tax rates, we thought it appropriate to share some historical Buffett wisdom on the topic.

Tax

“We do not play any games to either accelerated or defer taxes. We make investment decisions based on our evaluation of the most profitable combination of probabilities. If this means paying taxes – fine…”

“More investment sins are probably committed by otherwise quite intelligent people because of ‘tax considerations’ than from any other cause. One of my friends – a noted West Coast philosopher [Charlie Munger] – maintains that a majority of life’s errors are caused by forgetting what one is really trying to do…

What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound…

If gains are involved, changing portfolios involves paying taxes. Except in very unusual cases…the amount of the tax is of minor importance if the difference in expectable performance is significant…

There are only three ways to avoid ultimately paying the tax: (1) die with the asset – and that’s a little too ultimate for me – even the zealots would have to view this ‘cure’ with mixed emotions; (2) give the asset away – you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc., either; and (3) lose back the gain – if your mouth waters at this tax-saver, I have to admire you – you certainly have the courage of your convictions.

So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury – at the lowest rates the rules will allow.”

Patience, Sourcing, Liquidity

“…I consider the buying end to be about 90% of this business…These stocks have been bought and are continuing to be bought at prices considerably below their value to a private owner. We have been buying one of these situations for approximately 18 months and both of the others for about a year. It would not surprise me if we continued to do nothing but patiently buy these securities week after week for at least another year, and perhaps even two years or more.”

In Buffett's biography The Snowball, I believe there is an anecdote that Buffett and his associates would go knocking on doors in small towns to seek out shares of XYZ stock for purchase. Based on the quote above, it would take years for him to accumulate full positions. How’s that for patience, not to mention liquidity implications?!

Most public market investors, who invest in liquid securities, don't spent a lot of time focused on sourcing. Could there be a hidden advantage for those who focus on obscure or illiquid issuances, and manage to creatively source them at bargain prices?

Buffett Partnership Letters: 1963 Part 4

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Compounding, Capital Preservation

“Since the whole subject of compounding has such as crass ring to it, I will attempt to introduce a little class into this discussion by turning to the art world. Francis I of France paid 4,000 ecus in 1540 for Leonardo da Vinci’s Mona Lisa. On the off chance that a few of you have not kept track of the fluctuations of the ecu, 4,000 converted out to abut $20,000.

If Francis had kept his feet on the ground and he (and his trustees) had been able to find a 6% after-tax investment, the estate now would be worth something over $1,000,000,000,000,000.00. That’s $1 quadrillion…all from 6%.

…there are other morals to be drawn here. One is the wisdom of living a long time. The other impressive factor is the swing produced by relatively small changes in the rate of compound.”

“If, over a meaningful period of time, Buffett Partnership can achieve an edge of even a modest number of percentage points over the major investment media, its function will be fulfilled.”

Starting around the early 1960s, Buffett discusses the concept of compounding more frequently – perhaps because he’s become increasingly interested in its power. After all, an author’s words often reflect the subject most prevalent in his/her mind.

We likewise believe that compounding is an important, yet under-discussed, area of investment management. The entire investment management industry stems from the belief in (oneself or others) the ability to compound capital at a higher rate than “average” (however you define “average”).

Our industry often profiles the “flavors of the week,” putting those with spectacular short-term returns on display. Unfortunately, investor prone to spectacular upside returns, are sometimes also prone to disastrous drawdowns.

Which brings to my mind the trackrecord of a well-known oil and gas investor. His long-term trackrecord was spectacular (something in the range of 20-30%+ annually for 20+ years) until he became enamored with natural gas (in all fairness, he may yet be proven correct in the “long-run”). In either 2009 or 2010 (when the price of natural gas plummeted) he produced a -97% year. Yep, minus ninety-seven percent.

Unfortunately, the law of compounding hath no pity. If you invested $1,000 with him at the very beginning, compounded at 25% for 20 years, but stayed around to experience the -97% return, the investment that was worth $86,736 in year 20 was now only worth $2,602 in year 21 (which doesn’t include the fees you paid over the years, so chances are, you’ve actually experienced loss of principal).

Remember, it was the tortoise, not the hare, who won the race. A 1-2% outperformance relative to “average” may seem negligible in the short-term, but over the course of many years, the absolute dollar contribution of that excess margin of return becomes substantial. It never hurts to remind your investors, every once in awhile, as Buffett did.

Buffett Partnership Letters: 1963 Part 3

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: When To Buy, When To Sell, Activism, Catalyst, AUM When To Buy, Activism, Catalyst, Control

“…controls develop from the general category. They results from situations where a cheap security does nothing price-wise for such an extended period of time that we are able to buy a significant percentage of the company’s stock…Whether we become active or remain relatively passive at this point depends upon our assessment of the company’s future and the management’s capabilities.”

“We do not want to get active merely for the sake of being active. Everything else being equal I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.”

“Active or passive, in a control situation there should be a built-in profit…Our willingness and financial ability to assume a controlling position gives us two-way stretch on many purchases in our group of generals. If the market changes its opinion for the better, the security will advance in price. If it doesn’t, we will continue to acquire stock until we can look to the business itself rather than the market for vindication of our judgment.” 

Warren Buffett is renowned for his strong stomach, and willingness to continuously purchase and ingest increasing stakes as falling prices deter others. I believe the quote above holds the rationale behind this courageous behavior.

I think it's important to point out, that for each purchasing quest as the price falls, there exists a tipping point – the point at which Buffett obtains a controlling position – such that if the market continues to undervalue the asset, he will “look to the business itself rather than the market for vindication,” thus unlocking value by enacting his own catalyst as a control/majority investor.

Many investors attempt to emulate Buffett’s strong-stomach approach. However, I would advise caution to those investors with limited cash resources or asset under management, without which investors could end up with too much of his/her portfolio in a minority stake of an asset that remains perpetually undervalued.

AUM

“Our rapid increase in assets always raises the question of whether this will result in a dilution of future performance. To date, there is more of a positive than inverse correlation between size of the Partnership and its margin over the Dow…Larger sums may be an advantage at times and a disadvantage at others. My opinion is that our present portfolio could not be improved if our assets were $1 million or $5 million. Our idea inventory has always seemed to be 10% ahead of our bank account. If that should change, you can count on hearing from me.”

I have heard it remarked that capital is the enemy of return. This is true under many circumstances, however in some instances, as Buffett outlines above, a large capital base has its benefits. For example, see our discussion above on When To Buy, Activism, Catalyst, and Control.

When To Sell

“Our business is making excellent purchases – not making extraordinary sales.”

Buffett Partnership Letters: 1963 Part 2

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Topics covered include: Benchmark, Hurdle Rate, Expected Return, Volatility, & Team Management.  

Benchmark, Hurdle Rate

“At plus 14% versus plus 10% for the Dow, this six months has been a less satisfactory period than the first half of 1962 when we were minus 7.5% versus minus 21.7% for the Dow.”

“If we had been down 20% and the Dow had been down 30%, this letter would still have begun “1963 was a good year.”

“Our partnership’s fundamental reason for existence is to compound funds at a better-than-average rate with less exposure to long-term loss of capital than the above investment [benchmarks]. We certainly cannot represent that we will achieve this goal. We can and do say that if we don’t achieve this goal over any reasonable period, excluding an extensive speculative boom, we will cease operation.”

“A ten percentage point advantage would be a very satisfactory accomplishment and even a much more modest edge would produce impressive gains…This view (as it has to be guesswork – informed or otherwise) carries with it the corollary that we much expect prolonged periods of much narrower margins over the Dow as well as at least occasional years when our record will be inferior…to the Dow.”

Buffett’s performance goal was relative (10% annual above the Dow), not absolute return. He once again makes a statement about ceasing operation if he doesn’t achieve this goal – the man was determined to add value, not content leaching fees.

But a question continues to tickle my brain:

Why 10% above the Dow? Why not 5% or 15.7%? What is significant about this 10% figure (other than an incredibly ambitious goal)? Buffett plays coy claiming “guesswork – informed or otherwise,” but we know that Buffett was not the random-number-generating-type.

Expected Return, Volatility

“We consider all three of our categories to be good businesses on a long-term basis, although their short-term price behavior characteristics differ substantially in various types of markets.”

“Our three investment categories are not differentiated by their expected profitability over an extended period of time. We are hopeful that they will each, over a ten or fifteen year period, produce something like the ten percentage point margin over the Dow that is our goal. However, in a given year they will have violently differentiated behavior characteristics, depending primarily on the type of year it turns out t be for the stock market generally.”

As we have discussed in the past, Buffett was extremely conscious of the expected return and expected volatility (in a number of different scenarios) of his portfolio positions. For more commentary on this, please see our previous articles on expected return and volatility.

Buffett is “hopeful” that the investments he selects “will each, over a ten or fifteen year period, produce something like the percentage point margin over the Dow that is our goal.”

But how does he determine which investment fits this criteria during the initial diligence process prior to purchase – especially since the Dow itself is perpetually fluctuating?

Team Management

“…the Dempster story in the annual letter, perhaps climaxed by some lyrical burst such as ‘Ode to Harry Bottle.’ While we always had a build-in profit in Dempster because of our bargain purchase price, Harry accounted for several extra serves of dessert by his extraordinary job.”

“Beth and Donna have kept an increasing work load flowing in an excellent manner. During December and January, I am sure they wish they had found employment elsewhere, but they always manage to keep a mountain of work ship-shape…Peat, Marwick, Mitchell has done their usual excellent job of meeting a tough timetable.”

Praise – lay it on thick. The tool of appreciation can perhaps reach the uncharted corners of loyalty in your employees’ hearts where compensation had previously failed.

Buffett Partnership Letters: 1963 Part 1

Continuation in a series on portfolio management and the Buffett Partnership Letters, please see our previous articles for more details. Clients, Leverage, Subscriptions, Redemptions

“We accept advance payments from partners and prospective partners at 6% interest from date of receipt until the end of the year…Similarly, we allow partners to withdraw up to 20% of their partnership account prior to yearend and charge them 6% from date of withdrawal until yearend…Again, it is not intended that partners use us like a bank, but that they use the withdrawal right for unanticipated need for funds.                                     

“Why then the willingness to pay 6% for an advance payment money when we can borrow from commercial banks at substantially lower rates? For example, in the first half we obtained a substantial six-month bank loan at 4%. The answer is that we except on a long-term basis to earn better than 6%...although it is largely a matter of chance whether we achieve the 6% figure in any short period. Moreover, I can adopt a different attitude in the investment of money that can be expected to soon be part of our equity capital than I can on short-term borrowed money.” 

“The advance payments have the added advantage to us of spreading the investment of new money over the year, rather than having it hit us all at once in January.”

Buffett allowed his investors annual windows for subscription and redemption (to add or withdraw capital). However, clients could withdraw capital early at 6% penalty. Clients could also add capital early and receive 6% return.

Paying investors 6% for their advance payments technically constitutes a form of leverage. However, as Buffett points out, not all forms of leverage are created equal. Margin lines are usually short-term with the amount of capital available constantly shifting, tied to value of underlying portfolio holdings which are usually marketable securities. Bank loans have limited duration until the debt must be repaid or terms renegotiated. In contrast to the two previous common forms of leverage, paying investors 6% (or whatever percentage depending on the environment) is most similar to long-term leverage with permanent terms (until the annual subscription window), since the capital will stay, converting from “debt” to an equity investment.

A friend recently relayed a story on Buffett giving advice to an employee departing to start his own fund. Apparently, it was a single piece of information: allow subscriptions and redemptions only one day per year.

The paperwork, etc. aside, I believe the true rationale behind this advice lies in the last quote shown above. Similar to how advance payments allowed Buffett the advantage of “spreading the investment of new money over the year,” having one subscription/redemption date would allow a portfolio manager to offset capital inflows against capital outflows, thereby decreasing the necessity of having to selling positions to raise liquidity for redemptions and scraping around for new ideas to deploy recent subscriptions. In other words, it minimizes the impact of subscriptions and redemptions on the existing portfolio.

Risk Free Rate, Fee Structure, Hurdle Rate

“…6% is more than can be obtained in short-term dollar secure investments by our partners, so I consider it mutually profitable.”

Not only was 6% the rate applicable to early redemptions or subscriptions, 6% was also the incentive fee hurdle rate, such that if the Partnership returned less than 6%, Buffett would not receive his incentive fee.

Based on the quote above, it would seem in 1963, 6% was approximately the risk free rate. Today (Aug 2012), the rate that can be “obtained in short-term dollar secure investments” is 1% at best.

Some funds still have minimum hurdle rate requirements built into incentive structure (I see this most commonly with private equity / long-term-commitment style vehicles). But most liquid vehicles (e.g., hedge funds) don’t have minimum hurdle rates determining whether they collect incentive fees in any given year.

This makes me wonder: why don’t most liquid funds vehicle fee structures have hurdle rates? It doesn’t seem unreasonable to me that, at a minimum, these funds should have an incentive fee hurdle rate equivalent to the risk-free-rate in any given year.

Tax

“A tremendous number of fuzzy, confused investment decisions are rationalized through so-called ‘tax considerations.’ My net worth is the market value of holdings less the tax payable upon sale. The liability is just as real as the asset unless the value of the asset declines (ouch), the asset is given away (no comment), or I die with it. The latter course of action would appear to at least border on a Pyrrhic victory. Investment decisions should be made on the basis of the most probably compounding of after-tax net worth with minimum risk.”

Taxes made simple by Warren Buffett.

Sadly, many investment funds today fail to consider tax consequences because the clients who matter (the large pensions and foundations) don’t pay taxes. So their smaller taxable clients suffer the consequences of this disregard.

Buffett Partnership Letters: 1962 Part 3

This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. A slightly off tangent and random fact, in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”

Team Management

“On April 17, 1962, I met Harry [Bottle] in Los Angeles, presented a deal which provided for rewards to him based upon our objectives being met, and on April 23^rd he was sitting in the president’s chair in Beatrice. Harry is unquestionably the man of the year. Every goal we have set for Harry has been met, and all the surprises have been on the pleasant side. He has accomplished one thing after another that has been labeled as impossible, and has always taken the tough things first...He likes to get paid well for doing well, and I like dealing with someone who is not trying to figure how to get the fixtures in the executive washroom gold-plated. Harry and I like each other, and his relationship with Buffett Partnership, Ltd. should be profitable for all of us.”

The quote above is the start of Buffett’s tendency to mention and praise employees / operating partners. This habit would continue in his letters over the next 50 years. Here, we see two important items related to team management.

1. Alignment of Interest – “rewards to him based upon our objectives being met,” which included 2,000 options (out of 60,146 total shares outstanding) equating to ~3% ownership, therefore a mutually beneficial relationship that’s “profitable for all…”

2. Appreciation / Praise – an underutilized strategy with the potential to work wonders for talent retention. It’s in each of our natures to want to feel appreciated, and to hear praise. This is something that too often people in the finance industry fail to understand. Throwing money at the problem unfortunately doesn’t work in every instance and instead starts bidding wars for talent (compensation, unfortunately, is not a competitive advantage when it comes to employee retention). There are other subtler and perhaps more effective ways to attract and retain employees.

Sizing

“The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors…We were fortunate in that we had a good portion of our portfolio in work-outs in 1962. As I have said before, this was not due to any notion on my part as to what the market would do, but rather because I could get more of what I wanted in this category than in generals. This same concentration in work-outs hurt our performance during the market advance in the second half of the year.”

Due to “availability factors,” portfolio sizing involves a certain degree of we-get-lemons-and-therefore-we-make-lemonade.

Although Buffett had the optimal and “actual percentage division among categories” in “some degress[s] planned” in his head, he remained flexible and made do with what market offerings were available at the time.

Buffett Partnership Letters: 1962 Part 2

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.”

Volatility

“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.

Buffett Partnership Letters: 1962 Part 1

This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details. There are 3 separate letters detailing the occurrences of 1962:

• July 6, 1962 – interim (mid-year) letter
• December 24, 1962 – brief update with preliminary tax instructions
• January 18, 1963 – annual (year-end) letter

A 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.”

Benchmark

“In outlining the results of investment companies, I do so not because we operate in a manner comparable to them or because our investments are similar to theirs. It is done because such funds represent a public batting average of professional, highly-paid investment management handling a very significant $20 billion of securities. Such management, I believe, is typical of management handling even larger sums. As an alternative to an interest in the partnership, I believe it reasonable to assume that many partners would have investments managed similarly.”

We’ve discussed in the past the importance of choosing a benchmark. It seems Buffett chose to benchmark himself against the Dow and a group of investment companies not because of similarities in style, but because they represented worthy competition (a group of smart, well-paid, people with lots of resources) and realistic alternatives to where Buffett’s clients would otherwise invest capital.

“Our job is to pile up yearly advantage over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%.”

Interestingly, the quote above implies that Buffett focused on relative, not absolute performance.

Trackrecord

“Please keep in mind my continuing admonition that six-months’ or even one-year’s results are not to be taken too seriously. Short periods of measurement exaggerated chance fluctuations in performance… experience tends to confirm my hypothesis that investment performance must be judged over a period of time with such a period including both advancing and declining markets…While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance…If any three-year or longer period produces poor results, we all should start looking around for other places to have our money.”

In other words, short-term performance doesn’t mean anything so don’t let it fool you into a false sense of investment superiority. A three-year trackrecord is the absolute minimum upon which results should be judged, although five or more years is best in Buffett’s opinion. Additionally, the last sentence seems to imply that Buffett was willing to shut down the Partnership if return goals were not met.

“If you will…shuffle the years around, the compounded result will stay the same. If the next four years are going to involve, say, a +40%, -30%, +10%, and -6%, the order in which they fall is completely unimportant for our purposes as long as we all are around all the end of the four years.”

Food for thought: the order of annual return occurrence doesn’t impact the final compounding result (as long as you stick around for all the years). Not sure what the investment implications are, just a fun fact I guess – one that makes total sense once Buffett has pointed it out. Basic algebra dictates that the sequential order of figures in a product function doesn’t change the result.

Clients, Time Management

“Our attorneys have advised us to admit no more than a dozen new partners (several of whom have already expressed their desire) and accordingly, we have increased the minimum amount for new names to $100,000. This is a necessary step to avoid a more cumbersome method of operation.”

“…I have decided to emphasize certain axioms on the first pages. Everyone should be entirely clear on these points…this material will seem unduly repetitious, but I would rather have nine partners out of ten mildly bored than have one out of ten with any basic misconceptions.”

Each additional moment spent on client management, is a moment less on investing.

Keeping down the number of clients keeps things simple operationally – at least according to Buffett. I have heard contradicting advice from some fund managers who claim to prefer a larger number of clients (something about Porter’s Five Forces related to Customer Concentration).

For his existing clients, Buffett smartly set ground rules and consistently reminded his clients of these rules, thereby dispelling any myths or incorrect notions and (hopefully) preventing future misunderstandings.

Buffett Partnership Letters: 1961 Part 4

This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.

Conservatism

“Many people some years back thought they were behaving in the most conservative manner by purchasing medium or long-term municipal or government bonds. This policy has produced substantial market depreciation in many cases, and most certainly has failed to maintain or increase real purchasing power.”

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you…You will be right, over the course of many transactions, if your hypothesis is correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”

“I might add that in no way does the fact that our portfolio is not conventional provide that we are more conservative or less conservative than standard methods of investing. This can only be determined by examining the methods or examining the results. I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets.”

Conservatism ≠ Buying “Conservative” Securities

Food for thought: currently (today’s date is 6/23/12), millions of retirees and older individuals in America hold bonds and other fixed income securities believing that they are investing “conservatively.” In light of current bond market conditions, where the 10-Year Treasury and 30-Year Treasury yields 1.67% and 2.76% respectively, is it time for people to reconsider the traditional definition of conservatism and conservative allocation? The bond example recounted by Buffett sounds hauntingly familiar. According to history, it ended badly for bond holders the last time around.

Buffett also highlights the importance of focus on conservatism inherent in the investment process, that of objective fact gathering and interpretation “through knowledge and reason.”

Interestingly, the last quote above implies that Buffett believed “evaluation of performance in down markets” an adequate measure of conservatism. Another name for this measurement is called drawdown analysis, and drawdown analysis is very much a measure of volatility (i.e., temporary impairment of capital). How then, does this view reconcile with his later comments about temporary vs. permanent impairments of capital?

Clients, Benchmark

“The outstanding item of importance in my selection of partners, as well as in my subsequent relations with them, has been the determination that we use the same yardstick. If my performance is poor, I expect partners to withdraw…The rub, then, is in being sure that we all have the same ideas of what is good and what is poor. I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other.”

“While the Dow is not perfect (nor is anything else) as a measure of performance, it has the advantage of being widely known, has a long period of continuity, and reflects with reasonable accuracy the experience of investors generally with the market…most partners, as an alternative to their investment in the partnership would probably have their funds invested in a media producing results comparable to the Dow, therefore, I feel it is a fair test of performance.”

For any business, tapping the right client base and keeping those clients happy is crucial. Buffett advises the establishment of a mutually agreed upon objective (i.e., benchmark), so that the client and portfolio manager can mutually agree whether performance during any given period is “good” or “poor.” Coincidentally, this is similar to what Seth Klarman advises during an interview with Jason Zweig.

This is why the benchmark is so important – it is the mechanism through which clients can decide if a portfolio manager is doing a good or bad job. Picking the right benchmark is the tricky part…

Clients

“With over 90 partners…”

For those of you wondering how many clients Buffett had in his partnerships at the end of 1961, there you go!

Trackrecord, Mark To Market, Liquidity

“Presently, we own 70% of the stock of Dempster with another 10% held by a few associates. With only 150 or so other stockholders, a market on the stock is virtually non-existent…Therefore, it is necessary for me to estimate the value at yearend of our controlled interest. This is of particular importance since, in effect, new partners are buying in based upon this price, and old partners are selling a portion of their interest based upon the same price…and at yearend we valued our interest at $35 per share. While I claim no oracular vision in a matter such as this, I believe this is a fair valuation to both new and old partners.”

With such a large, illiquid controlling stake, Buffett had difficulty determining the “fair” mark to market for Dempster. Dilemmas such as this are still commonplace today, especially at funds that invest in illiquid or private companies.

As Buffett points out, the mark directly impacts new and old investors who wish to invest or redeem capital from the fund. Anyone who invests in a fund of this type should carefully diligence the mark to market methodology before investing (and redeeming) capital.

There’s another more murky dimension, the investment management industry’s dirty little secret: difficulty in determining an accurate mark makes it possible for funds to “jimmy” the mark and therefore influence the performance trackrecord / return stream reported to investors.