Archives for October 2012

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Last time, I reviewed lessons from Warren Buffett’s 1960 letter to partners of Buffett Partnership.

Today, I review the letter for 1961. Buffett wrote two letters during 1961 – once in July 1961 and then the annual letter in Jan. 1962. The first letter carried Buffett’s core rules for the partnerships. It was the annual letter where Buffett talked about his philosophy.

So I’m reviewing just the annual letter (written in Jan. 1962). From this time onwards, I’m also making a change in the way I analyse Buffett’s philosophy.

Given that I am reviewing the letters in a chronological order, I might write about a certain philosophy that Buffett followed in a particular year, which changed in subsequent years.

So, apart from analysing a particular year’s letter, I will try to cull out one specific theme from that letter and then see how that theme evolved for Buffett in the future.

Anyways, let’s start with the analysis of the 1961 letter.

[Read more…] about Wit, Wisdom, Warren (Issue #5): Conservative Investing

Last week, I reviewed lessons from Warren Buffett’s 1959 letter to partners of Buffett Partnership.

Today, I review the letter for 1960.

This is going to be a long-long review given the amazing number of ideas I could cull out from the letter, so make yourself comfortable before you start reading it.

Lessons in beating the street
The US stock market as represented by the Dow Jones Industrial Average (DJIA) declined in 1960, after strong gains in the previous two years. Including dividends, the DJIA fell by almost 6% during the year.

Buffett’s seven partnerships (up from six in 1959) gained around 23%, thereby again outperforming the broader market by a decent margin.

In the 1960 letter, Buffett reiterated his objective…

My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average. I believe this Average, over a period of years, will more or less parallel the results of leading investment companies. Unless we do achieve this superior performance there is no reason for existence of the partnerships.

However, I have pointed out that any superior record which we might accomplish should not be expected to be evidenced by a relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is achieved, it will be through better-than-average performance in stable or declining markets and average, or perhaps even poorer-than-average performance in rising markets.

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.

A few lessons can be gained from these notes:

1. Set performance standards in advance and then follow them: As we read in the review of Buffett’s 1957 letter, he had set a standard of outperforming the market by 10% per annum over the long term.

Setting your own long-term return target will also make your task simpler as against accepting whatever return you earn and then using that as a benchmark. This way, you will see a strong year (when your portfolio advances by say 25%) as just an aberration like you will see a weak year (when you are down -20%).

The important thing to do is to start with a reasonable standard (like I want to beat the Sensex by 8-10% annually over the long run) and then try to meet it over a period of time. This will keep you focused. Of course, the standard has to be reasonable and you can’t expect to be beating the market year after year, especially during periods of mania.

2. Direct investing versus mutual fund investing: A lot of investors enter directly into stocks expecting to “do well” in the long run. Doing well isn’t enough when you are working hard to identify great businesses and then taking the risk of putting your money where your faith is.

Of course, your foremost target must not be to earn supersized returns from your overall investments. You must only target a return that can help you meet your financial objectives (like Graham’s “adequate return” as per his definition of investment).

But when it comes to stock picking, you either target outperforming the market or else give your savings to a smart fund manager who can beat the market on your behalf (and consistently over the long run).

As Buffett writes in the letter, the important thing is to be beating par (index), and especially in down markets.

There is a simple criterion I suggest people just starting out in stock picking – check your direct equity returns over five years. If you can outperform the benchmark and most good mutual funds, continue to pick stocks. Otherwise just give your money to a fund manager (of course, a majority of fund managers are a joke, but then you can always find a smart guy with some hard work).

There’s no point running on a treadmill – investments that don’t go anywhere – where you will be worse off the longer you stay.

Buffett advises something similar to his partners…

Unless we do achieve this superior performance there is no reason for existence of the partnerships.

I’m not sure how many investors and mutual fund managers are so honest with themselves and their clients respectively.

3. Good years and bad years: Stock market does not move in a straight line. There are good years, there are bad years, and they follow each other. Of course for people who started investing in 2008, there are only bad years, but even they need to understand that law of averages work very well in the stock market.

Here’s a quote from Horace that Benjamin Graham used for the foreword of the first edition of Security Analysis, and which summarises what Buffett mentioned about good and bad years above – “Many shall be restored that now are fallen and many shall fall that now are in honor.”

Thus the target for you, the value investor, must not be to earn great returns year after year. Rather, your target must be to do better than the average market in a bad year (like 2008) and do at par with the market in a good year (like 2009).

To reiterate what Buffett wrote in the 1960 letter…

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur.

For the long term, however, you must set a standard return target (which should be better than what the market could earn), and then work towards meeting it.

Like Buffett was working towards beating the US market, especially in the bad years (like 1957 and 1960)…

Data Source: Buffett’s 1960 Letter
This is where the real importance of value investing lies for you – buying sustainable businesses at margin of safety so that you reduce your chances of permanent loss of capital, even in bad markets.

4. Conventional investing vs. conservative investing: Buffett wrote…

Although four years is entirely too short a period from which to make deductions, what evidence there is points toward confirming the proposition that our results should be relatively better in moderately declining or static markets.

To the extent that this is true, it indicates that our portfolio may be more conservatively, although decidedly less conventionally, invested than if we owned “blue-chip” securities. During a strongly rising market for the latter, we might have real difficulty in matching their performance.

Buffett described “conventional investing” as buying blue-chip stocks – ones that are generally traded at rich valuations as compared to non-blue-chip, and despite this fact, are considered as safe havens.

Data Source: Ace Equity
For Buffett, safety of an investment always negatively correlates with the valuation an investor pays for stocks. So a higher valuation as compared to intrinsic value means lower safety (what if things go wrong?) and a lower valuation equates with greater safety.

Thus, Buffett was happy investing in a “conservative” manner, i.e., focusing his sights on non-blue-chip stocks that traded at reasonable to cheap valuations – ones that had large margin of safety attached to them (we’ll study a case below).

This was classic Benjamin Graham, as Buffett was then 100% Graham (only later did he call himself 85% Graham and 15% Philip Fisher).

The art of “value unlocking”: Sanborn Map
In the 1960 letter, Buffett talked extensively about his investment in Sanborn Map, a map-publishing company. Sanborn Map formed a huge 35% of Buffett’s assets, and he presented it as a case study in value unlocking.

Sanborn was a Graham-style investment for Buffett. On the nature of this business, this is what he recognized…

For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort.

Buffett also gave an historical perspective on Sanborn, wherein he mentioned that the company’s once-lucrative core business of map publishing declined starting 1950s (driven by a new and competitive method that made inroads into the company’s territory).

The impact on Sanborn was so much that it, as Buffett wrote, “…amounted to an almost complete elimination of what had been sizable, stable earning power”. Its net profit of US$ 500,000 in the late 1930s declined to less than US$ 100,000 by late 1950s.

Source
Then, Buffett added…

However, during the early 1930’s Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.

In other words, while Sanborn’s core business was declining, the company was gradually adding to its investment portfolio, which at the end of 1959 was about a size of US$ 2.5 million (at cost).

On a market value basis, the investment portfolio was valued at US$ 65 per share (up from US$ 20 per share in 1938) as compared to Sanborn’s stock price of US$ 45 per share (down from US$ 110 per share in 1938).

Effectively, in 1938, Sanborn’s core mapping business was selling at US$ 90 per share (US$ 110 of stock price minus US$ 20 per share of investment portfolio). Against this, by 1958, the core business was valued at US$ -20 (US$ 45 of stock price minus US$ 65 per share of investment portfolio)!

Source: Buffett’s 1960 Letter
This raised Buffett’s interest in the company, as he saw a great margin of safety in it.

His basic assumption was that, despite the decline in business profits (Sanborn was still profitable then, and the business still exists in 2012 to provide mapping services to the US insurance industry)…

…Sanborn in 1958 still possessed a wealth of information of substantial value to the insurance industry. To reproduce the detailed information they had gathered over the years would have cost tens of millions of dollars.”

In effect, for a business that was selling at around US$ 4.7 million of market cap (US$ 45 x 105,000 shares), Buffett’s replacement value was around “tens of millions of dollars”!

Seeing this anomaly, he bought Sanborn’s stock throughout 1958 and 1959. As Roger Lowerstein mentions in his biography of Buffett – Buffett: The Making of an American Capitalist – the master investor was trusting in Graham’s testimony – sooner or later a stock would rise to value.

But it didn’t!

As Buffett wrote…

The very fact that the investment portfolio had done so well served to minimize in the eyes of most directors the need for rejuvenation of the map business.

This was a clear case of idiots running a good (cash generating) business.

Buffett was appalled at seeing that the company’s 14 directors combined held just 46 shares of stock out of 105,000 shares outstanding. In effect, these top men had no interest in seeing the value of Sanborn’s stock rise and thus were not interested in improving the company’s core earning power.

What is more, while the company was cutting back on its dividends due to declining profits, the salaries and other payments made to the directors were not cut.

Anyways, in a true Graham style, Buffett accumulated Sanborn’s shares by buying the stake of a deceased director, who was holding 15,000 shares in the company. Then, aided by his open market purchases, Buffett came to own a large stake in the company, became a director, and then lobbied the management to unlock the value in the investment portfolio.

His idea was to…

…separate the two businesses, realize the fair value of the investment portfolio and work to re-establish the earning power of the map business. There appeared to be a real opportunity to multiply map profits through utilization of Sanborn’s wealth of raw material in conjunction with electronic means of converting this data to the most usable form for the customer.

A control position added massively to Buffett’s margin of safety, which was already there in terms of the company’s stock valuation being low as compared to its investment portfolio.

After the initial opposition to Buffett’s plan of unlocking value of the investment portfolio, Sanborn’s management capitulated in 1960.

Buffett unlocked Sanborn’s value by separating the investment portfolio into a separate unit, sold the investments at fair value, and then distributed the investments among the company’s shareholders (including himself).

Effectively, he bought a wallet with US$ 100 in it for US$ 70, and not only got to keep the money, but also sell the wallet!

Buffett did all this quickly after coming on board because a large portion of Sanborn’s money was tied up in blue-chip stocks, which Buffett didn’t care for at then prices (as we discussed above).

In all, as per Lowenstein’s book, Buffett made a quick 50% profit on his investment in Sanborn.

This sharp profit in a short time and on a large proportion of his portfolio was the reason Buffett earned a market-beating return for his partnerships in 1960.

But he was quick to point out that Sanborn’s case showed…

…the futility of measuring our results over a short span of time such as a year. Such control situations may occur very infrequently. Our bread-and-butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action.

To the extent that partnership funds continue to grow, it is possible that more opportunities will be available in “control situations.”

In other words, while Buffett was always willing to take advantage of special situations (like Sanborn’s value unlocking) when they arose, he was at heart an investor who preferred to buy undervalued securities and sell when the undervaluation was corrected.

By the way, an interesting insight that initially missed my eye was Buffett’s understanding of “technology”, which he has otherwise claimed that he does not understand. 🙂

This is what Buffett wrote of the future prospects of Sanborn’s mapping business…

There appeared to be a real opportunity to multiply map profits through utilization of Sanborn’s wealth of raw material in conjunction with electronic means of converting this data to the most usable form for the customer.

If that’s not a sharp understanding of the future of technology, than what is it?

Investing heavily in your best ideas
While this may be a scary choice to make – concentrating your investments in a few stocks – that is what the young Buffett was doing in 1960s.

Sanborn, for instance, formed about 35% of Buffett’s portfolio in 1960. Plus it was a small company with an illiquid stock (just 105,000 shares outstanding).

Despite these attributes that can scare any investor, Buffett saw a great opportunity and invested heavily in Sanborn. He later did the same thing with See’s Candy in the 1970s.

Let’s me be clear here. I am not suggesting that you put 30-40% of your money in any one stock or investment. However, if you really believe in an idea, you may be willing to take it to around 10-15% of your portfolio.

Too many people over-diversify – allocating the same amount of money to their best ideas as to their worst ones. But then, as they say, “Concentrate to grow your wealth and diversify to preserve it.”

In fact, one of Buffett’s most ardent followers, Mohnish Pabrai discusses the importance of making big bets infrequently in his book The Dhandho Investor.

So while you may buy a number of stocks for your portfolio, it pays in the long run to put most of your money in your best ideas.

“But I am no Buffett!”
You might wonder – “Buffett was able to unlock value in Sanborn simply because he earned a seat on the board and then spun off the investment portfolio. I can’t buy enough shares to get on the board of a company that I think holds a value unlocking potential! So how could I profit like Buffett did?”

Well, what if I say that you are more empowered than Buffett of 1960?

Yes it’s true! The Information Age empowers you, dear investor.

If you can find a value unlocking potential like Sanborn (though it’s difficult to find such a bargain in a period when information spreads so fast…but just in case), all you need to do is own the stock and then spread the word around.

Sure, nobody may notice your analysis or even care about it at first, but then have faith in what Graham said, “Sooner or later a stock would rise to value.”

As long as your intention is not to find a greater fool to unload your junk upon (which means you are not trying to create a fake market in a junk stock), go out and tell the world about your analysis (like you may share it on the Safal Niveshak Forum :-)).

Your (genuine) story will spread, sooner than later. That will lead to value unlocking.

There have been several cases of value unlocking in India that have earned investors a good amount of money – Bajaj Auto, Cadila Healthcare, Eicher Motors, Zee Telefilms, and Piramal Healthcare are some prominent names that come to mind.

So there’s a potential to earn good returns in this space of value unlocking through special situations. I am no expert in this space, but am really looking forward to learn more (to add to my limited circle of competence).

Next Friday, I will review Buffett’s 1961 letter to partners, which you can read here.

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