A dozen lessons from reading Buffett’s early partnership letters (1/2)

I recently read Buffett’s early partnership letters from 1957-1970. It’s an amazing collection of letters that dispense wisdom in his typical folksy charm. His investment record was leaps and bounds better than the Dow Jones Index by the time he liquidated the partnership. When he started in 1957, his partnership began with capital of $105,100 (adjusted for inflation, it would amount to ~$900k). In 1969, the partnership had a net asset of ~$100m (~$700m in today’s dollar).

To show you how special he was even at this young phase:

  • Compounded results of 25.3% after management fees for 12 years
  • Operated predominantly by himself with no other investment team
  • He has said that in the early years, he had investment ideas “anywhere from 110% to 1000%” of the partnership’s capital.

I don’t think there will be another one like him.

However, we can all still learn something from him.

I decided to break it up into 2 blog posts to keep the posts somewhat short…I don’t even claim to have summarised the letters with these posts. The actual letters contain a lot more nuggets of wisdom and should be read in its entirety!

  1. “At all times, I attempt to have a portion of our portfolio in securities as least partially insulated from the behavior of the market, and this portion should increase as the market rises.” (1960)Warren had the goal of beating the Dow-Jones Industrial Average by 10% on a 3-5 year basis. He knew how difficult that is by relying solely on market sentiment. That is why he sought to augment his portfolio’s performance by having work-outs and control type investment.Work-outs provided steady stream of income. They are special situation type investment that relies on corporate actions for results, i.e takeover, spin-offs, liquidations. Work-outs was designed so “in years of market decline, it piles up a big edge for us; during bull markets, it is a drag on performance.”

    Control situation was in effect acting as private equity. “Investment results in the control category have to be measured on the basis of at least several years. Proper buying takes time. If needed, strengthening management, re-directing the utilization of capital, perhaps effecting a satisfactory sale or merger, etc., are also all factors that make this a business to be measured in years rather than months”

    Contrary to most people’s perception, Warren is not just a buy-and-hold investor. Jeff Gramm in Dear Chairman sums up how special Warren is:

    “It’s hard to believe there was ever a time when Warren Buffett’s aptitude for business was anything but superhuman. We think of him as a fully formed portfolio manager from the moment he launched his first investment partnership in 1956, when he was only twenty-five years old. He compounded wealth for himself and his investors at an astounding rate over the next twelve years and never suffered a losing year. Despite this stellar track record, the Buffett Partnerships were very much a work in progress. Buffett was constantly refining his investment style, even toying with short selling and pair trades at one point. As he told the New York Times in 1990, “I evolved. I didn’t go from ape to human or human to ape in a nice, even manner.””

    One of the key lessons here is to have the intellectual humility to try things that has the high probability of working. Don’t close your mind too early. Analyse it carefully, and if you think it can work, then try it. Over time, you will settle on a style that is most suitable to your characteristics and temperament.

     

  2. “I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow.” (1960)Warren operated a boutique investment partnership in an era where there wasn’t many boutiques. He wrote, “to many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative.” Buffett wanted to emphasise that first and foremost, his emphasis is on the limitation of downside risk. Re: Buffett’s “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” His view of risk is a permanent loss of capital, which leads to the next lesson…
  3. “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.”” (1962)Warren believed that the philosophy to sustained outperformance in investing is “margin of safety.” While his view of what constitutes margin of safety has changed over time from preference of paying bargain prices for mediocre businesses to paying fair prices for great businesses; he has never jumped into fashionable stocks or hyped-up market trends. He has had the discipline to avoid paying extravagant price. He never took part in an auction or a bidding war.
  4. “Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy” (1964)Here Warren spells out the importance of doing your own work and looking for disconfirming evidence to prove yourself wrong (a la Darwin and Charlie Munger). If you cannot disprove yourself, then it is likely to be a good investment. In saying that, some people understood the statement encourages them to be a contrarian. However, being a contrarian is not enough, you also need to be correct to get an above average result.
  5. “My wife, children and I will have virtually our entire net worth invested in the partnership.” (1963)Warren understands the power of incentives. To have his and his family’s fortunes aligned with the partnership ensured that he would not take risky decisions to jeopardise their wealth. It also sent out a signal that however the fund performs, the Buffetts will be on the same boat. It adds to Warren’s credibility when he is singing out the virtues of long-term investing and portfolio concentration to know that he really puts his money where his mouth is.
  6. “This year marked the transition from the office off the bedroom to one a bit (quite a bit) more conventional. Surprising as it may seem, the return to a time clock life has not been unpleasant. As a matter of fact, I enjoy not keeping track of everything on the backs of envelopes.” (1962)Please note that this was when Warren was managing $9.4m ($76m in 2017 terms). Not a piddly sum. His frugality is legendary, and in his case the frugality creates hunger to constantly innovate. There are other notable fund managers who are quite frugal: Guy Spier of Aquamarine Fund operated out of his apartment in his funds’ early days, Mohnish Pabrai operates out of a non-descript office in an Irvine business park and Tony Hansen of EGP Capital uses discount brokerage to keep his trading expense down. Amazon’s leadership principles also has a point on frugality: “Accomplish more with less. Constraints breed resourcefulness, self-sufficiency and invention. There are no extra points for growing headcount, budget size or fixed expense.”

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