Writing on 1961 performance, Buffett write
“We will do relatively well compared to the general market in down or static markets, but that we may not look so good in advancing markets. In strongly advancing markets I expect to have real difficulty keeping up with the general market.”
Buffet performance is good till date, and in down or static market, it outperform the Dow, but in strong advancing market, Buffett face difficulty.
While Dow gain was 22.2% including dividend and Buffett gain was average 45.9%
Buffett completed full five years and performance is as follows
Buffett further write about the performance,
If my performance is poor, I expect partners to withdraw, and indeed, I should look for a new source of investment for my own funds. If performance is good, I am assured of doing splendidly, a state of affairs to which I am sure I can adjust.
Buffet was good example of rationality, he always work on the side of partners, he was more interested on partners side, rather having only self-interest, and blaming on external factors for performance.
Up till 1960 Buffett use Dow for performance measurement, but Buffett write
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. I have no objection to any other method of measurement of general market performance being used, such as other stock market averages, leading diversified mutual stock funds, bank common trust funds, etc.
Dow is not perfect nor anything else, as a measure of performance, it has only advantage of widely known, and In now a days, mutual find always measure their performance against major indices, nothing is wrong in that, but Indices is not correct method to measure the performance, it might be measure against the peer group mutual fund, having same category, that might be fair measure, beating the indices is like a war, and it’s a continuous yardstick in every market.
Method of Operations
Buffett describe the method of Operations, and in my opinion, these are very important methods, few operations as a retail investor, we are unable to do, but it’s important to know how it works?
Buffett explains three categories of investment, and these categories have different behaviour characteristics, and money allotted to each category, will have an important effect on performance, and these allocation of fund to the three categories are planned, but accidental based upon availability.
| Sr. No | Generals | |
| 1 | These are Undervalued Securities | |
| 2 | You can’t say anything about corporate policies and no timetable as to when the undervaluation may correct itself. | |
| 3 | BPL, largest category of investment | |
| 4 | More money has been made in this category | |
| 5 | 5% to 10% of assets | |
| 6 | of 5 or 6 generals, with small position in another 10 or 15 | |
| 7 | Sometimes these work out very fast; many times they take years. | |
| 8 | It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. | |
| 9 | 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. | |
| 10 | We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner. | |
| 11 | Just because something is cheap does not mean it is not going to go down | |
| 12 | During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as Dow | |
| 13 | The generals will outperform the Dow, and during sharply advancing years like 1961, |
Generals are the undervalued securities, there are no corporate events, cannot predict when the undervaluation is over, BPL has largest asset allocated to this category, at the time of buying we don’t know the specific reason for appreciation of the stock. The undervaluation of stocks, provides very large margin of safety, don’t buy at the last minute, when undervaluation is coming to over. Don’t expect that undervalued stock can’t go down.
| Sr. No | Work Outs | |
| 1 | These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities | |
| 2 | In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. | |
| 3 | Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs | |
| 4 | This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. | |
| 5 | if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. | |
| 6 | work-outs have provided our second largest category. | |
| 7 | At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development. | |
| 8 | I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. | |
| 9 | Excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. | |
| 10 | My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs. | |
Works outs are those stock having definite time frame, corporate events, such as mergers, spinoffs, liquidations etc.. Work-outs produces stable earnings as compare to Dow, It’s a second largest positions after “Generals” ten to fifteen positions at a time, Buffett used borrowed money to buy work-outs as they offer a high degree of safety, the borrowing limit is 25% of partnership assets.
| Sr. No | Control | |
| 1 | “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. | |
| 2 | Such operations should definitely be measured on the basis of several years | |
| 3 | Control situation may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it. | |
| 4 | These situations, too, have relatively little in common with the behaviour of the Dow | |
| 5 | Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. | |
| 6 | If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. | |
Controls are situations, where Buffett control the company by acquiring major stack, and influence the policy, these situations take time to yield results, if the stock is stagnant over a long period of time, and Buffett had an advantage of acquiring it more. These situations are insulated from the behaviour of the general market sentiments, if stock moves before acquiring the substantial stack in the company, Buffett sold it and complete the “General” operation.
As a retail investor, we can only perform the “General” operations, as we can buy undervalued stocks, and few of workouts but these carry little risk, if corporate actions not done in specific period you will stuck with the stock, and in case of Control situation, It is difficult to acquire major stack in the company, you need to have that much of money.
So, do your home work, before blindly following Buffett Strategies…..
Dempster Mill:
Dempster is a undervalued stock when he bought five years back, and now Buffett would like to convert it in to Control situation, He was on board four years back, it shows that any operation Buffett does is not overnight, it’s a fruit of many years hard work.
Buffett own around 80% of the company, Buffett like to calculate the controlling stack value at year end, because old partners are selling and new partners are buying on that same price. The estimated value should not be, what Buffett hope what it would be worth rather Buffett estimate, the business sold under current conditions, that should be the estimated price for old and new partners to buy or sell.
Dempster is a manufacturer of farm implements and water systems, Sales in 1961 of about $9 million. Operations have produced only nominal profits in relation to invested capital during recent years. This reflects the poor management situation.
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Dempster Mill (Data Source: Buffett 1961 Letter |
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| Year | 1961 | ||
| Sales | $ 9 | million | |
| Profit | Nominal | ||
| Net Worth | $ 4.5 | Million | |
| Book Value | $ 75 | Per Share | |
| Working capital | $ 50 | Per Share | |
| Buffett Valued at Year end | $ 35 | Per Share | This is the fair value for Old & New Partners |
| Buffett Acquired at | $ 28 | Per Share | |
Buffett bought at $28 per share while it has Book value of $75 and working capital at $50 per share, it’s a complete undervalued company, Buffett bought it in less than 50% to its book value per share. (The complete story of Dempster Mill is not over, I will Separately review the BPL operations in new blog post)
The operations in Control situations are very difficult to make money n ranging bull market, compared to buying the blue chips or general market, Buffett is more conscious of the 1961 market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.
Conservatism:
The Dempster description shows, how Buffett was conservative in buying business, while many people think they are conservative, by buying bonds, but these are not inflation proofs, and does not maintain real buying power.
Overly conscious people of inflation buy blue chip stocks, regardless of PE, dividend yield etc.. this is completely dangerous, and nothing is conservative in this.
“In my opinion, about speculating as to just how high a multiplier a greedy and capricious public will put on earnings.”
Buffett on speculation, which is all together against the conservatism
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. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.
You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.
Don’t buy herd, don’t buy on NEWS, tips, expert opinion, and on company guidelines, Buffett is right in saying, you are not right simply, large number of people agree with you, or important people agree with you, you will be right if your hypothesis, facts and reason is correct, lastly but important one True conservatism only possible with Knowledge and reason
Buffett further write, on evaluation of conservative investing, evaluate the performance in down market, Buffett never suffered a loss of more than 0.5% to 1% of total assets.
The Question of Size:
As the BPL results are great and people are knowing Buffett well and his ability as an Investor, growing day by day, so as the fund are also growing, but larger the fund hurts the results as a passive investment is concern, where Buffett does not want to influence the corporate policies, In some securities in which Buffett deals, are illiquid stocks, where buying 100 stock possible where as 10000 stock buying is impossible, therefore, larger sums are disadvantage. However in Control situation larger sums has a great advantage example like sanborn map
So, as a retail investor, having small sums, has a huge advantage, if you find a small cap company having all great parameters, like Business, Financial, management and available at undervalued conditions, with very small number of stocks trades every day, it has a great opportunity to buy, because big fish like mutual find, insurance, and FPI can’t buy those small cap, due to larger sums, when the interest is increasing in that company, you will get two benefits, first you will get benefit from earning in the business, as it’s a great business, and second from the expansion of the PE, and when expansion happens the PE undervaluation might over, so you have a great advantage if you have small sums to invest.
Buffett On Prediction:
You might feel that Buffett is on wrong track, as he is going to have prediction, but Buffett always avoid predictions.
“I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few when it is minus on the same order, and a majority when it is in between. I haven’t any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor.”
Over the next ten years market might plus 20 – 25% or negative 20 – 25 % , over the long period of years, Dow will perform 5 -7% per year compounded including dividend and market gain, and anybody expects more than that face disappointments,
Our job is to pile up yearly advantages 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 think Buffett philosophy is clear, over the ten year period market may have major positive and negative cycles, and in between market will result in 5-7% gain, don’t worry more about the absolute result of the market, Buffett measure is If Buffett down by 15% and Dow decline by 25%, is much superior to a year, when Dow and partnership down by 20%. Buffett want this to fully understand by the partner, this is more important to Buffett
And retail investor like us, we must measure our performance like this only, and in my opinion, this is more correct and good yardstick towards performance measurement, and don’t think market will never correct, market will always perform in cycles, be prepared for correction,
As Howard Marks says “You can’t predict, you can prepare”
Cycles are self- correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going On forever) because trends create the reasons for their own reversal. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.
—- Howard Marks “You Can’t Predict. You Can Prepare,” November 20, 2001
Buffett writes,
“Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring one year in the next ten–no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more,
we would struggle to be up as much. The consequence of performance such as this over a period of years would mean that if the Dow produces a 5% to 7% per year overall gain compounded, I would hope our results might be 15% to 17% per year.”
Market down by 35 – 40% in a year, over the next ten years, has high probabilities, and BPL should down by 15-20% and In static market BPL will beat the market by 10% points, but it not possible if market gain 20% in a year to beat by 10% point, Buffett will struggle, not Buffett every investor struggle,
In my opinion, Buffett always protect downside, and outperform the market, because Buffett never suffered a loss of more than 0.5% to 1% of total assets.
The above prediction may sound like a rash, but it might appear, or Buffett may be wrong in this prediction, However Buffett feel that partners must understand, what he thinks.
The overall section of prediction is very much true and important in every market, read and reread it again.
In 1961 (I) letter Buffett explains great points.
- Three methods, General, Work-outs & Control
- Dempster Mill bought as a General and convert it into Control Situation
- On Conservatism : True conservatism only possible with Knowledge and reason
- Don’t bother about the public or expert opinion, focus on Hypothesis, facts & reasoning
- On Size: Smaller size funds have advantage over big sums
- On Prediction: Over the ten year period market may correct 20% to 25%
- Don’t expect extraordinary returns, you will face disappointments
I recommend personally to re-read it again and again, its complete rational
(Disclaimer: All figures and data used from Buffett Partnership Letter 1961 (Dated, 24 January 1962), All are my opinions, and this is for educational purpose only. I am not genius or clever to understand all things, I may be wrong in interpreting the data and letter, take your decision on your own)
To Your Success with Lot of Love!
Harish S Kawalkar
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