Wit, Wisdom, Warren (Issue #8): Margin of Safety

Last time, I reviewed lessons from Warren Buffett’s 1962 letter to partners of Buffett Partnership, with a focus on his view on the power of compounding.

Today, I review his 1963 letter, focusing this time on his investment in Dempster Mill Manufacturing Company (DMMC), and the one big lesson that comes out of it.

Buffett’s investment in DMMC
In the sixth part of this series, we discussed on the categories that Buffett created to segregate his investments based on their varying characteristics. The four broad categories were generals, control situations, relatively undervalued generals, and workouts (special situations).

DMMC, like Sanborn Map that we discussed in the fourth part, was a control situation for Buffett.

Here is what he wrote about DMMC in his 1962 letter…

We are presently involved in the control of Dempster Mill Manufacturing Company of Beatrice, Nebraska. Our first stock was purchased as a generally undervalued security five years ago. A block later became available, and I went on the Board about four years ago. In August 1961, we obtained majority control.

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, and in any case, would have no meaning for a controlling block.

Our own actions in such a market could drastically affect the quoted price. Therefore, it is necessary for me to estimate the value at yearend of our controlling 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.

The estimated value should not be what we hope it would be worth, or what it might be worth to an eager buyer, etc., but what I would estimate our interest would bring if sold under current conditions in a reasonably short period of time.

Our efforts will be devoted toward increasing this value, and we feel there are decent prospects of doing this.

DMMC was a manufacturer of farm implements and water systems with sales in 1961 of about US$ 9 million. The company was thinly profitable and the return on invested capital (ROIC) was poor.

Buffett considered the reasons for the poor financials as a poor management situation, along with a fairly tough industry situation.

Now you may wonder, “How could Buffett buy a poor quality business when he always stresses on buying high quality ones?”

Note that this was early 1960s, and Buffett was still 100% Graham. He was sold on Graham’s big idea of net-nets (stocks, even of bad businesses, that could be bought at a price below their net current asset value or NCAV).

Look at DMMC. In 1962, the company’s book value was US$ 75 per share, NCAV was US$ 50 per share, and Buffett had bought his controlling stake at an average price of US$ 28 per share (he valued the business at US$ 35 per share at the end of 1962), or around 45% discount to NCAV.

He wrote…

While I claim no oracular vision in a matter such as this, I feel this is a fair valuation to both new and old partners. Certainly, if even moderate earning power can be restored, a higher valuation will be justified, and even if it cannot, Dempster should work out at a higher figure.

Buffett was in fact so convinced about his ability to turn around DMMC’s fortunes that his holding in the stock represented 21% of his partnership’s total net assets (based on DMMC’s stock price of US$ 35).

But then, as he had always written, since DMMC was a control situation, his investments would generate returns only by improving the business, and not merely because other stocks in the US markets were rising.

As he wrote…

In a raging bull market, operations in control situations will seem like a very difficult way to make money, compared to just buying the general market. However, I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs,
provide a means of insulating a portion of our portfolio from these dangers.

Anyways, by 1963, Buffett’s investment in DMMC rose to 73%. Buffett had also realized that his efforts to use the existing management to change the company’s fortunes were going fruitless.

So, on the recommendation of a “good friend”, whom we now know as Charlie Munger, Buffett brought in Harry Bottle to lead DMMC’s operations in 1963.

Here is what Bottle did…

• Reduced inventory by 75%, thus reducing carrying costs of inventory and risk of obsolescence
• This freed up capital for investments in marketable securities
• Cut selling and general expenses by 50%, and manufacturing expenses by 25%
• Closed 5 unprofitable branches leaving DMMC with 3 profitable onces
• Closed production units that were tying up capital but were operating at losses

This is what Buffett had to say about Harry’s accomplishments…

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.

Our breakeven point has been cut virtually in half, slowmoving or dead merchandise has been sold or written off, marketing procedures have been revamped, and unprofitable facilities have been sold.

Led by Bottle, a large part of DMMC’s manufacturing assets (which were generating poor returns) were sold and converted to cash, which was converted to marketable securities. Here, Buffett had a stronghold.

While Buffett was not able to turn around DMMC’s business, the fact that he bought the business so cheap (44% discount to NCAV) helped him earn good returns from this investment.

In 1963, DMMC’s security portfolio alone was worth US$ 35 per share, plus its manufacturing business was worth US$ 16 per share, thus totalling to US$ 51 per share (as compared to Buffett’s average purchase price of US$ 28 per share).

Here is what he wrote, and something that is so very important for all investors, whether buying a general or a control situation…

By buying assets at a bargain price, we don’t need to pull any rabbits out of a hat to get extremely good percentage gains. This is the cornerstone of our investment philosophy: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”

Welcome “margin of safety”
What Buffett wrote above was like his ode to Ben Graham and his “margin of safety” principle. If you haven’t done it already, read Chapter 20 of Graham’s The Intelligent Investor, where he writes about margin of safety as the central concept of investment.

Buffett calls margin of safety as “the three most important words in all of investing”.

Here is what he wrote in his 1992 letter…

We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

Here is something from his 1962 letter that must be the cornerstone of every value investor’s philosophy…

A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.

Here are the three promises Buffett made to his partners in the 1963 letter…

I cannot promise results to partners. What I can and do promise is that:

1. Our investments will be chosen on the basis of value, not popularity;
2. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and
3. My wife, children and I will have virtually our entire net worth invested in the partnership.

Margin of safety has always been central to how Buffett has conducted himself as an investor.

Anyways, here is an interesting point that Graham made in The Intelligent Investor…

…the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

In effect, Graham was saying that investors buying low-quality businesses were at a greater risk than those buying expensive good quality businesses (or ones with zero margin of safety).

I’m not sure if Philip Fisher, Charlie Munger, or even Buffett would fully agree to this. But there’s no doubt that buying a “moderately valued but good business” (one with low margin of safety) is a safer proposition than buying a “cheap but bad business” (of course, when we have to choose between just these two options).

With the former, you may achieve just satisfactory results. With the latter, you may be dead!

As Graham concludes in his chapter on margin of safety…

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

What a lesson!

What do you say?

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