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Last week, we studied lessons from Warren Buffett’s 1957 letter to partners of Buffett Partnerships.
Lest you forget, here is a summary of the key lessons we discussed in the previous review:
- Give due importance to intrinsic value while making your investment decisions.
- Over time, stock prices generally revert to intrinsic value.
- Ignore the Sensex (what it is doing, where it is going) except to check the pulse of the “general investing environment”.
- Ignore short term movements in stock prices, even if they are sharp. You must only be concerned with comparing stock prices with intrinsic values, and that’s it.
- Give luck its due credit (but luck, like love, is a verb…so practice hard to get lucky, like Buffett did).
- Humility is one of the most important attributes of a value investor.
- Over the long term, if you can do your work properly, expect to outperform the broader market at just a reasonable rate. Never expect a big outperformance, for such an expectation might lead you to commit grave errors of commission.
- Being a value investor, expect to perform better in a bear market than in a bull market.
- Patience is a virtue, and especially if you are a stock market investor.
- It’s important to set a proper asset allocation strategy before you start to invest…and then it’s equally important to follow that strategy in stock market ups and downs.
Today, I review the letter for 1958.
Exuberant market = Run for cover
As we read last time, 1957 was a bad year for the US stock market, which declined by 8.4% over the previous year. However, despite this, Buffett’s three partnerships gained by 6.2%, 7.8%, and 25% respectively. Buffett attributed this outperformance to “luck in the short term”.
Anyways, after a weak 1957, 1958 turned out to be great for the US market, which gained by 38.5% (including dividends).
Against this, Buffett’s five partnerships (from three in 1957) gained between 36.7% and 46.2%, thereby outperforming the boarder market once again.
Buffett thought the sharp gains in stock price in 1958 was largely a display of “exuberance” after a dull previous year. As he wrote…
A friend who runs a medium-sized investment trust recently wrote: “The mercurial temperament, characteristic of the American people, produced a major transformation in 1958 and ‘exuberant’ would be the proper word for the stock market, at least”.
I think this summarizes the change in psychology dominating the stock market in 1958 at both the amateur and professional levels. During the past year almost any reason has been seized upon to justify “Investing” in the market.
There are undoubtedly more mercurially-tempered people in the stock market now than for a good many years and the duration of their stay will be limited to how long they think profits can be made quickly and effortlessly.
While it is impossible to determine how long they will continue to add numbers to their ranks and thereby stimulate rising prices, I believe it is valid to say that the longer their visit, the greater the reaction from it.
Especially note this part – “I think this summarizes the change in psychology dominating the stock market in 1958 at both the amateur and professional levels. During the past year almost any reason has been seized upon to justify “Investing” in the market.”
See how closely it resembles the pre-2008 era when everyone and his mother had a valid reason to invest in stocks even as prices were going through the roof…
- I have to fund my child’s foreign education in 2 years, and that’s why…
- I have promised my wife a foreign tour next year, and that’s why…
- I have made so much money in the past six months, that’s why…
- I want to recover my money lost in the dotcom bust, that’s why…
- I have so much money and not sure what to do, that’s why…
- My colleagues are minting money from stocks, that’s why…
- I can retire easily in 10 years given my IPO listing gains, that’s why…
- This is India’s biggest-ever IPO, that’s why…
- I have to repay a loan in two years, that’s why…
- I just want more money, that’s why…
Of course, there were investors with genuine reasons for investing as well – like meeting life goals in the next 15-20 years – but their voices were suppressed by the noise all around.
The moment I stepped out of my house – in buses, local trains, taxis, streets – either people were talking how much they made in stocks, or they were buying IPO forms.
This is one reason, with my “I-hate-crowds” mentality, I then started hating to travel to my workplace at Nariman Point in Mumbai – the hotbed of India’s stock market noise and hubris.
Anyways, what Buffett has mentioned above is true of all rising markets…
- There’s a rise in the ratio of mercurially tempered people – those with rapid and unpredictable changes of mood.
- The overall mood is of exuberance.
- People give any and every reason to invest.
- These combine together to further stimulate rising stock prices.
So the lesson for you is – whenever you find such a deadly combination next time – simply run for cover!
Why? Because this is what Buffett wrote…
I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, prices, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected.
Remember early 2000, or late 2008? Periods of manic price rises and people minting money from stocks were followed by eventual trouble – stock market crashes, speculators and traders getting wiped out – all this while intrinsic values just took a marginal hit.
Illiquid stocks as double-edged swords
Buffett wrote about his investment in a bank called Commonwealth Trust Co., which he believed was:
- A very well managed business with substantial earnings power and friendly management, and
- Available at large discount from intrinsic value (US$ 50 stock price versus Buffett’s calculated intrinsic value of US$ 125). Even the P/E at 5x (based on EPS of US$ 10 per share) was pretty low, thus confirming the stock’s attractiveness.
This was the stock which, as Buffett had written in the 1957 letter, reached to around 20% of his total investment portfolio and had allowed him to take part in management decisions.
Over a period of a year or so, Buffett bought 12% of this bank at a price averaging about US$ 51 per share…and wanted the price to remain low as he was planning to buy more of the stock.
Commonwealth’s was highly illiquid stock – just 300 stockholders and average of 2 trades or so per month. The fallout of this was that when another investor started buying the stock, its price quickly shot up to US$ 65 where Buffett was neither buyer nor seller.
This is clearly reflective of Buffett’s discipline in not selling a rising stock because it was still materially undervalued (around 50%) as compared to his estimate of its intrinsic value (US$ 135 then). Plus he was also not interested in purchasing more at that price.
The reason was because it was an illiquid stock, and even a small buying order could have created a price rise of large magnitude, which would have hurt Buffett’s interest in acquiring more of the stock (and later selling a larger quantity without causing the price to fall substantially).
This holds a big lesson for investors in most small-cap and penny stocks, which see occasional sharp surges. Seeing the rise, investors get onto the gravy train expecting the price to rise even further.
What they fail to notice is that a large factor for the rise in prices of such stocks is their low liquidity, which leads to even one large buying order stimulating the stock to even higher levels.
I recently noticed this in case of Cera Sanitaryware, which is an illiquid stock with an average daily liquidity of just 5,000 shares. Just one large buy or sell order can send the stock’s price rolling.
Recently, a buy order of just 1 lac shares from a big investor – and this is a small order from the standards of big investors – sent the stock price up by 15% in a single day.
In other words, a buy order worth Rs 30 million sent the market cap of Cera surging by almost Rs 600 million!
While this may seem enticing when the stock is rising, the reverse happens when there is a large “Sell” order.
So you must always be careful while investing in illiquid stocks, as the impact cost of a large sell order can be huge in case the stock surges and a large investor wants to cash out.
The positive side of a stock being illiquid is that you, as a small investor, can buy it over a period of time (like Buffett’s “acquisition period” that we discussed in the previous review) without impacting the price materially.
Then, if the business is really good and the story spreads, and big investors take a bite of it, you would’ve already made your money.
Beware of permanent loss of capital
Here is how Buffett introduced Commonwealth Trust Co…
At the time we started to purchase the stock, it had an intrinsic value $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend at all despite earnings of about $10 per share which was largely responsible for a depressed price of about $50 per share. So here we had a very well managed bank with substantia1 earnings power selling at a large discount from intrinsic value. Management was friendly to us as new stockholders and risk of any ultimate loss seemed minimal.
While we discussed the initial part of Buffett’s take on Commonwealth above (that it was a great company and available at a good price etc.), another key idea Buffett left here was his concern for “permanent loss of capital”.
The core reason he looked for a solid business available at a great discount from intrinsic value was to ensure that he minimized the “risk of any ultimate loss”.
With Commonwealth, he was so sure of the business’s quality that he was willing to wait even for 10 years to get to his long term intrinsic value estimate of US$ 250 for the stock.
This must be the core philosophy of an investor – to avoid permanent loss of capital, and then be ready and willing to wait (and wait) for high values to be achieved from businesses that won’t destroy capital permanently.
Avoid extrapolating short term into long term
Buffett talked about his partnerships’ strong performance in 1958, but warned…
Our performance for any single year has serious limitations as a basis for estimating long term results.
This is so much unlike what most of us are happy doing – believing that one great year will lead to another, and then another…and we will live happily ever after with our rising stocks and wealth.
This is what financial companies and their agents use as a plank to lure gullible investors into buying dud products that are sold under the garb of “perennial outperformers”.
But as we learn from history, there have been no perennial outperformers. The stock markets work on the principle of “law of averages” – over time, stock prices revert to the mean (which is the intrinsic value).
Nothing can rise and rise and not fall – including your stocks and bloated ego during a bull market!
Intrinsic value as a reference point to sell stocks
We discussed during the review of 1957 letter Buffett’s focus on intrinsic value while buying stocks.
In the 1958 letter, he talked about the importance of selling stocks using intrinsic value as a reference point.
As I mentioned above, Buffett initially bought Commonwealth Trust Co. at an average price of US$ 51 per share. This was when the stock’s intrinsic value (as calculated by Buffett) was around US$ 125 per share, or a margin of safety of around 60%.
Buffett later sold this stock at an average price of US$ 80 per share when his intrinsic value estimate was US$ 135 per share. In effect, the margin of safety had shrunk to 40%.
Most of us would lap up stocks available at 40% discount to the intrinsic value – I personally use a margin of safety of 25-30%. But Buffett was operating at a time when it was easier to find deeply undervalued stocks (after all, security analysis was not widely popular, plus there was a great information asymmetry among people who studied companies deeply like Buffett, and those who didn’t). So he was selling a stock that was still priced 40% below the intrinsic value.
Herein lies an important lesson – the reason for selling a stock is not always the rise in its price. You must also sell a stock when the intrinsic value falls to meet the stock price, or the intrinsic value does not rises as much as the rise in stock price (and thus there is a reduction in margin of safety).
This is an important lesson for investors who are always doubtful about selling stocks. In fact, Buffett’s action with Commonwealth suggests that this is a great metric (when the margin of safety reduces) to sell your stocks and look for better bargains.
By the way, here’s another reason to sell a stock – if you can find a better opportunity, but don’t have any investible cash left.
If you noticed above, I mentioned that Buffett was willing to wait for 10 years to get to his long term intrinsic value estimate of US$ 250 for Commonwealth. But he sold the stock at US$ 80 a share because he identified an even better opportunity.
As he mentioned…
We were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share…
Key ideas from Buffett’s 1958 letter
Here is a summary of the key ideas we discussed in this review of Buffett’s 1958 letter to partners:
- In rising markets, there’s a rise in the ratio of mercurially tempered people – those with rapid and unpredictable changeableness of mood. The overall mood is of exuberance. People invest in stocks for any and every reason. These combine together to further stimulate rising stock prices. Whenever you find such a deadly combination next time, simply run for cover…because such exuberance will always leads to eventual trouble – stock market crashes.
- Be very careful while buying illiquid stocks – The impact cost of a large sell order can be huge in case the stock surges and a large investor wants to cash out.
- Illiquidity of a great stock can work to your advantage as a small investor. You can buy it over a period of time without impacting the price materially. Then, when big investors come to know the story and take a bite of it, you would’ve already made your money.
- Avoid extrapolating short term performance into long term performance. A 30-40% return from your stocks in one year doesn’t mean you will retire a rich investor in 10 years. It never happens!
- Use intrinsic value as a reference point to sell stocks – Sell when a stock reaches close to intrinsic value, and also when intrinsic value reaches close to stock price.
- Sell a stock (but only when you don’t have any investible cash left) if you can find a better opportunity – one with a greater margin of safety.
- Beware of permanent loss of capital…and then when you identify businesses that won’t impair your capital permanently, buy them and be willing to wait for even 10-15 years to create tremendous wealth from them.
This was my review of Buffett’s 1958 letter to partners. Let me know if I missed any lesson that you found out through your personal reading of the letter.
Next Friday, I will review Buffett’s 1959 letter to partners, which you can read here.
That was a great analysis, Vishal..:)
I have a question with respect to selling the stock near to its intrinsic value..Consider, I bought a stock with 60% MOS and sell it near to its intrinsic value, I may gain around 30-40%.. But I have seen many stocks, Dr. Reddy’s for eg, it has risen from 200 to 1600 increased by 700%. How would I enjoy such returns if my intrinsic value was around 400, I would have sold it long ago… That means we have to recalculate our intrinsic value every year, is that right??
Shankar,
I think the prices are ultimately slaves to earnings. You will need to recalculate IV every six months or yearly in order to take a Sell decision. And sell, when the MoS decreases. Now MoS will decrease only due to two possibilities, either Price rises to near IV or IV DROPS TO PRICE LEVEL.
Refer Prof. Bakshi’s interview: (Part 4)
//// ” You are really looking for businesses that are going to keep on doing well even during adverse economic conditions, and stick with them.
So when it comes to the idea of selling, I wouldn’t want to sell them just because they didn’t do anything for the next 2, 3, or 4 years. I won’t apply the Graham rule to such stocks.
It’s very rare to find such situations. Think about Nestle. The guy who found it 20 years ago or 10 years ago, doesn’t need to do anything else in his life. For him, to switch out of that stock simply because it’s moved up a lot, or not gone anywhere for 3 years – either of those two decisions – would have been foolish.
Thus doing anything in that stock would have been a mistake, other than just buying and sitting on it. Some stocks are of that nature and true wealth is created by being in those stocks and remaining there – not by jumping in and out.” /////
AND ALSO:(Part 4)
//// “The second reason to sell is when it’s gone to fair value. So there is no margin of safety left.
The value was 100, you bought it at 30, it’s gone to 90-95, nobody is sure what the value is but the price is absolutely sure, and there is very little margin of safety. So you sell it.
Notice, I said “it’s gone to fair value” and not that “its price has increased to fair value”.
For a stock to no longer be a bargain, it’s not necessary for price to rise to value. It can happen the other way as well – Value can fall to a point where there is no margin of safety left.” /////
Coming back to your example, Dr Reddy. Interestingly, the stock has moved from Rs.550/ to 1650/- in last 9 years, a CAGR of 12.99%, and during this same period the EPS has grown from 23 to 88, a CAGR of 16.05%.
I think that itself answers the question, doesn’t it? 😛
Thanks for the explanation Bhatiaji..:)
Lagta hain main apna homework theek se nahin kar raha hoon !!!
You have no doubt covered all the points and your explaining the same in the last ten year context is good.
What I wonder though, is how much effort and research is needed and also how much money to be able to spot some really interesting stuff of the kind described in his letter. Obviously it is not easy and that is why he is what he is. I think the point of sitting (and avoiding trading) on good stories bought at reasonable prices is a important lesson.
Sudhir, this is what Buffett wrote in his 1976 letter…
“You will notice that our major equity holdings are relatively few. We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:
(1) favorable long-term economic characteristics;
(2) competent and honest management;
(3) purchase price attractive when measured against the yardstick of value to a private owner; and
(4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge.
It is difficult to find investments meeting such a test, and that is one reason for our concentration of holdings. We simply can’t find one hundred different securities that conform to our investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number that we do identify as
attractive.”
I think this says it all. We just need to identify those few great investments over a period of time…then sit, sit, and sit. Regards.
True understood the analyses part and the on the sit sit sit part.
The point I am trying to make is if you are doing it (investing) whole time this makes imminent sense.
For the others (who are employed or doing other stuff and also invest) it is that much tougher, not not doable, but quite tough. Or am I incorrect ?
Yes, it does require hard work to identify those opportunities. There’s no denying that part. But again, as Buffett has suggested time and again, we just to find those “few” opportunities…and thus one doesn’t need to really stress out to earn money as an investor.
What investors (who are also working on their jobs/businesses) generally do is chase a lot of stories, then get bogged down by the work (especially when markets are not doing well), and then think investing is rocket science…which it isn’t.
So yes, as you said, it’s not not doable, but tough (for mind and stomach :-)).
Noted. Yes it is staying away from the frenzy ….. and keeping a control on mind and having the stomach for it.
Hi Vishal
Thanks for another great post. Off late I realised that though Warrant Buffet letters are so straight and clear, even then it takes lot of reading to really take away ‘All’ the key lessons which he is trying to give. For instance going through Sanjay Bakshi’s post on float I learnt new ideas, which though in hindsight are clear, I could not catch those ideas when I read Warren Buffet letters. So thanks a ton for this initiative. In my view these are some additional ideas worth learning:
Special situations: One idea which I think we missed is Warren Buffet prefers to buy into special situations like announced mergers, rights issue etc when markets are trading high and it is difficult to buy stocks at reasonable valuation. (Buffet used the term workouts for this). Here is what he said in his letter “The higher the level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.” I think this is really a very important lesson. During current uncertain times, one view might be to invest only in special situations, where the risk of loss is very low, irrespective of the direction of the market. But we fail to realise that even if you make 10% in special situation in two months, it will be wrong to annualise it to 50%, because it will not be possible to get such ideas continuously. So a better approach during current uncertain times will be to spend time in finding undervalued stocks (plenty of which are available now), which over a 3-5 years can atleast double from current levels.
Control investor: Another thing we should remember that Warren Buffet is a control investor. Yes agreed, he ran a concentrated portfolio, buying a single stock which constitutes upto 20-25% of his portfolio, but he did that mostly when he had a say in the key decisions of the company “Our block of stock increased in value as its size grew, particularly after we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal”. So when one is running a concentrated portfolio, one should also find out whether he will have any say in key decisions of the company. Again to get the level of confidence required to run concentrated portfolio, one requires a deep knowledge about that particular company and most importantly confidence on the integrity of the management. I think, it will be difficult, if not impossible for most of the investors (including myself) to get that level of confidence. I know this can be quite controversial and many may disagree, but I believe more in a wide diversification where no single stock is more than 3-4% of one’s portfolio, where each stock has odds in its favour.
Thanks for your invaluable inputs, Anil! I had talked about the point on “special situations” in the review of Buffett’s 1957 letter. I agree to your second point about diversification. Thanks for sharing the same! Regards.
In the last paragraph, what did Buffett mean when he wrote “…I am attempting to create my own work-outs by acquiring large positions in several undervalued securities”?
Fabian, he meant taking such large stakes in companies that would enable him to take part in management decisions to ultimately create some special situations for himself.
Thanks for the clarification!
Hi Vishal
Like Buffet letters, do you have copies of old letters of other investors like Seth Klarman, Martin Whitman or shareholders letters of Tweedy Browne co. I downloaded what is available on their website, but could not get the old copies. Thanks
Anil, you can find some resources on this page.
My doubt is Vishal ..whether we Need to sell some stocks when it goes beyond a level..
…
That’s if you think that the stock has moved way above the long term IV, or when you can find a better stock – one that is selling at an even greater MoS.
Hi Vishal,
I think you should put a disclaimer at the “Sell when the stock reaches intrinsic value” para because in 1950’s and 1960’s Buffett was using Graham style investing i.e. finding cheap stocks and selling them when price would rise while after meeting Munger he changed his investing style to finding wonderful companies at fair price and not selling them even if there is huge price appreciation.
I think a novice investor reading your para will feel that he has to sell the stock once it reaches its intrinsic value.
But that’s perfectly fine, Krish. What I understand from Buffett’s letter is that he’s advising to sell a stock that the stock has moved way above the long term IV, or when you can find a better stock – one that is selling at an even greater MoS.
Talking of exuberance, the time to sell is when every one – the barber to the shoe shine boy starts recommending stocks to buy. Here is the real life story that happened before the famous stock market crash of 1929.
Bologna(Shoe shine boy) was known for dispensing tips and inside information he had been told by his customers. “Legend has it one of those tips sparked Joe Kennedy(John Kennedy’s father) into selling out his position months — some say days — before the market crashed,” Fisher writes. “One morning, while walking up Wall Street, Kennedy noticed Bologna was momentarily without customers and reading ‘The Wall Street Journal.’ So, he climbed aboard the wooden chair and dug his heels into the footrests while Bologna put the paper down and picked up his brushes.
“The usual hellos had been exchanged when Bologna asked, ‘You wanna tip?’ ” Kennedy said he did, and listened as Bologna told him to “Buy oils and rails. They’re gonna hit the sky. Had a guy here today with inside knowledge.” Fisher writes that Kennedy figured the market must really be out of control if a shoeshine boy was telling him what to buy. Kennedy swiftly sold everything and went so far as to bet prices would fall by selling short. Kennedy not only survived the crash, but made a fortune in the process.
Bologna was known for dispensing tips and inside information he had been told by his customers. “Legend has it one of those tips sparked Joe Kennedy into selling out his position months — some say days — before the market crashed,” Fisher writes. “One morning, while walking up Wall Street, Kennedy noticed Bologna was momentarily without customers and reading ‘The Wall Street Journal.’ So, he climbed aboard the wooden chair and dug his heels into the footrests while Bologna put the paper down and picked up his brushes.
“The usual hellos had been exchanged when Bologna asked, ‘You wanna tip?’ ” Kennedy said he did, and listened as Bologna told him to “Buy oils and rails. They’re gonna hit the sky. Had a guy here today with inside knowledge.” Fisher writes that Kennedy figured the market must really be out of control if a shoeshine boy was telling him what to buy. Kennedy swiftly sold everything and went so far as to bet prices would fall by selling short. Kennedy not only survived the crash, but made a fortune in the process
According to Woodside money manager Ken Fisher’s book, “100 Minds that Made the Market,” (Classic Books) Bologna was known for dispensing tips and inside information he had been told by his customers. “Legend has it one of those tips sparked Joe Kennedy into selling out his position months — some say days — before the market crashed,” Fisher writes. “One morning, while walking up Wall Street, Kennedy noticed Bologna was momentarily without customers and reading ‘The Wall Street Journal.’ So, he climbed aboard the wooden chair and dug his heels into the footrests while Bologna put the paper down and picked up his brushes.
“The usual hellos had been exchanged when Bologna asked, ‘You wanna tip?’ ” Kennedy said he did, and listened as Bologna told him to “Buy oils and rails. They’re gonna hit the sky. Had a guy here today with inside knowledge.” Fisher writes that Kennedy figured the market must really be out of control if a shoeshine boy was telling him what to buy. Kennedy swiftly sold everything and went so far as to bet prices would fall by selling short. Kennedy not only survived the crash, but made a fortune in the process. So did Baruch.
Thank you Mr. Chandrashekar for sharing this wonderful story (and the lesson therein)! Regards.