Sage advice

It’s a close call, though no prizes for guessing that we’re focusing on the work of the gawky guy from Nebraska, and one aspect of it in particular. Later this month, Berkshire Hathaway (US:BRK.B), the vast conglomerate that was the successor vehicle to Buffett’s partnership, will release its annual report for 2017. The most eagerly awaited part of that will be Buffett’s annual letter to Berkshire’s shareholders; eagerly awaited because, in part, it’s like getting an investment course from the most successful investor on the planet free of charge; Buffett’s letter will contain at least one penetrating insight delivered in an easy-to-understand, folksy tone and sprinkled with his familiar self-deprecatory humour.

But the great man – so great that, you notice, we’ve dropped the usual ‘Mr’ appellation that we would use for the living – got his taste for writing from the annual letters that he sent to the limited partners of the Buffett Partnership, who, in the very early days, comprised extended family and a few close family friends.

The letters begin tentatively. They are an obligation that Buffett must fulfil to the people who supplied him with capital. However, it is soon clear he enjoys writing them, and he is a good writer with a laid-back avuncular sort of style, a tendency towards shaggy-dog stories and that self-deprecating humour that is a sign of his confidence in his ability. He has a natural inclination to educate and he is not short of opinions – especially about the investment industry. Small wonder that the letters get longer and, in 1961, he doubles his output to two letters a year.

One thing about which he is strident, repetitive and consistent is the returns that partners should expect. For a man who has said that “the first rule of investing is not to lose money and the second rule is not to forget the first”, Buffett’s target returns are surprising.

In his first letter to his partners, commenting on 1957, he says: “Over the years I will be quite satisfied with a performance that is 15 per cent a year better than the [Dow Jones Industrial] Average”. By 1960, this attitude had hardened: “My continued objective... is to achieve a long-term performance record superior [to the Dow],” adding that “unless we do achieve superior performance, there is no reason for the existence of the partnership”. But acceptable performance, he triple underlined, would only be relative, not absolute. Thus, “I would consider a year in which we declined 15 per cent and the Average 30 per cent to be much superior to a year when both we and the Average advanced 20 per cent”.

Later he developed this idea: “Our best years relative to the Dow are likely to be in declining or static markets. Therefore, the advantage we seek will probably come in sharply varying amounts. There are bound to be years when we are surpassed by the Dow, but if over a long period we can average 10 percentage points per year better than it, I will feel the results have been satisfactory.”

Of course, as the table shows, there were no years when the Dow surpassed the partnership. The closest it ever came was in 1958 when the Dow advanced 38.5 per cent to the partnership’s 40.9 per cent; that meant, after Buffett’s cut, that the limited partners failed to beat the Dow. Yet over the years Buffett’s amazing performance meant the limited partners became wealthy and Buffett became rich. Most of his family’s capital was tied up in the partnership; in addition, as general partner, Buffett took a quarter of each year’s profits above 6 per cent.

As to how he did it, early on he told partners that “our investments will be chosen on the basis of value, not popularity; (and) 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”.

Note that phrase, “wide margin of safety”, which came straight from the investment manual of Buffett’s teacher, Benjamin Graham. In practical terms, that meant the partnership’s investments fell under one of three headings:

■ Generally undervalued securities where the partnership was a passive investor riding on the coat tails of active shareholders who had plans afoot to put under-utilised assets to better use.

■ Work-outs where the returns depended on corporate action such as a merger, a spin-off or a reorganisation. At any time the partnership might hold five to 10 of these and would lever up likely returns with some borrowing to fund the holding “since there is a high degree of safety in this category”.

■ Control situations where the partnership was the active investor. 

By definition, such positions were few and the timing of returns was largely guesswork. Nevertheless, they become more important for the partnership. Even by 1960 Buffett was into these situations when, as a 29-year-old, he got himself on the board of Sanborn Map Company, a venerable operation that had accumulated an investment portfolio that was worth more than the company’s stock market value. In 1962 he started buying shares in Berkshire Hathaway, a New England textiles company. By 1965 the partnership controlled Berkshire, which – much to Buffett’s surprise – was “a delight to own”. He added: “While a Berkshire is hardly going to be as profitable as a Xerox... it is a very comfortable sort of thing to own. As my West-Coast philosopher says, it is well to have a diet consisting of oatmeal as well as cream puffs.”

The ‘West-Coast philosopher’ was Charlie Munger, a lawyer who, increasingly, was influencing Buffett and would eventually become the vice-chairman of Berkshire. For the partnership, the end game was approaching. In early 1966 Buffett closed the partnership to new investors. 

A year later he warned that “we now find very few securities that are understandable to me, available in decent size, and which offer the expectation of investment performance meeting our yardstick of 10 percentage points per annum superior to the Dow”. In October 1967 he complained that “I am out of step with present conditions” in equity markets, although he would not “abandon a previous (investment) approach whose logic I understand even though it may mean foregoing large and apparently easy, profits”. He did, however, cut the partnership’s long-term target returns to 9 per cent a year or five percentage points better than the Dow, whichever was lower.

Not that there was to be a long term. In May 1969 Buffett announced his intention to close the partnership, in the process causing much distress to wealthy partners who had come to rely on the golden returns he generated. He hardly left them in the lurch, providing fulsome advice and an alternative investment manager – Bill Ruane – for their capital. But by the end of 1970, the Buffett Partnership was no more. In physical form, all that remained was the paper chain of those partnership letters, some of the best quotes from which are printed below. To retrieve all the letters, type ‘buffett partnership letters’ into your search engine, there are several sources.

On the importance of measuring investment performance

“People who watch their weight, their golf scores and fuel bills seem to shun quantitative evaluation of their investment management skills although it involves the most important client in the world – themselves. It is of enormous dollars-and-cents importance to evaluate objectively the accomplishments of the fellow who is actually handling your money, even if it’s you.”

On thinking rationally

“Our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations.”

“It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now. It is obvious that an inability to "get even" in a security that has declined is of no importance. It is obvious that the inner warm glow that results from having held a winner last year is of no importance in making a decision as to whether it belongs in an optimum portfolio this year.”

“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.”

On conservative investing

“To many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning.”

“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.”

“There is nothing at all conservative about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.”

“The most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets.”

On professional investment managers

“Their merits do not lie in superior results or greater resistance to decline in value. Rather, I feel they earn their keep by the ease of handling, the freedom from decision making and the automatic diversification they provide, plus – perhaps most important – the insulation afforded from temptation to practice patently inferior techniques which seem to entice so many would-be investors.”

“Proponents of institutional investing frequently cite its conservative nature. If ‘conservative’ is interpreted to mean ‘productive of results varying only slightly from average experience’, I believe the characterization is proper. Such results are almost bound to flow from wide diversification among high grade securities. Since, over a long period, ‘average experience’ is likely to be good experience, there is nothing wrong with the typical investor utilizing this form of investment medium.”

“In the great majority of cases the lack of performance exceeding or even matching an unmanaged index in no way reflects lack of either intellectual capacity or integrity. I think it is much more the product of: (1) group decisions – my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is "safe" and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

On the ideal characteristics of an investment

The following tick list applied to one of the partnership’s earliest major investments, but it is really a generic description of factors that have appealed to Buffett throughout his 60-year career.

“1. Very strong defensive characteristics;

2. Good solid value building up at a satisfactory pace and

3. Evidence to the effect that eventually this value would be unlocked, although it might be one year or 10 years.”

“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.”

“We will not go into businesses where technology which is away over my head is crucial to the investment decision. I know about as much about semi-conductors or integrated circuits as I do of the mating habits of the chrzaszcz. (That's a Polish May bug, students – if you have trouble pronouncing it, rhyme it with thrzaszcz.)”

On building an investment portfolios

“If good performance of the fund is even a minor objective, any portfolio encompassing 100 stocks is not being operated logically. Anyone owning such numbers of securities after presumably studying their investment merit (and I don't care how prestigious their labels) is following what I call the Noah School of Investing – two of everything.”

On forecasting

“My own investment philosophy has developed around the theory that prophecy reveals far more of the frailties of the prophet than it reveals of the future.”

“I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities. However, 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, of even undervalued securities can be expected to be substantially affected.”

On paying taxes and having a social conscience

“More investment sins are probably committed by otherwise quite intelligent people because of ‘tax considerations’ than from any other cause.”

“I have never been able to understand why taxes come as such a body blow to many people since the rate on long-term capital gains is lower than on most lines of endeavour – tax policy indicates that digging ditches is regarded as socially less desirable than shuffling stock certificates.”

“I don't want to liquidate a business employing 1,100 people when the management has worked hard to improve their relative industry position, with reasonable results. I have no desire to trade severe human dislocations for a few percentage points of additional return per annum.”