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

….Continued

  1. “A division of profits between the limited partners and general partner, with the first 6% per year to partners based upon beginning capital at market, and any excess divided one-fourth to the general partner and three-fourths to all partners proportional to their capital. Any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.” (1961)
    The Buffett Partnership fee structure is a thing of wonder (albeit only for superior investors). The structure was: zero management fees with a 25% performance fee above a 6% hurdle. This allowed a real partnership to form with a sticky capital base as Warren wouldn’t get paid if he didn’t produce above 6% return. He structured the fees so that he would be under less pressure during the down years- the riskiest time for the limited partners to liquidate their partnership, allowing him to stay invested during lean times and even deploying more capital at the more attractive market prices. Note that this fee structure is gaining more popularity with boutique funds (Mohnish Pabrai, Li Lu) as it truly aligned all parties’ interest. Personally, I use this structure when managing my family’s capital with a high watermark structure.
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  2. “The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors. At the one extreme, the analyst exclusively oriented to qualitative factors would say. “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.” On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.” As is so often the pleasant result in the securities world, money can be made with either approach. And, of course, any analyst combines the two to some extent…
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    Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess – I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side – the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions. Such statistical bargains have tended to disappear over the years” (1967)
    The market is an adaptive beast. It is a biological system where the overarching objective is to profit. Most of the time, profit seeking agents scour the market to find underpriced securities. This can be seen through the vanishing opportunities. Net-nets (where a company is priced below on its net current assets) have disappeared over time. Merger arbitrage spread has shrunk. The market has gotten wiser about cash generating power and scalability of SAAS-based businesses to the point where enterprise software are more and more being sold through the cloud. Capitalism is a force that is constant and Schumpeter’s creative destruction is alive and well in the markets.
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  3. “We have to work extremely hard to find just a very few attractive investment situations. Such a situation by definition is one where my expectation (defined as above) of performance is at least ten percentage points per annum superior to the Dow. Among the few we do find, the expectations vary substantially. The question always is, “How much do I put in number one (ranked by expectation of relative performance) and how much do I put in number eight?” This depends to a great degree on the wideness of the spread between the mathematical expectation of number one versus number eight.” It also depends upon the probability that number one could turn in a really poor relative performance…
    .
    I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year – one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater” (1966)
    Above is a lesson in portfolio management and the importance of not falling into the trap of too much diversification. You have to find the sweet spot that is right for you, because when you over-diversify, you eventually are getting the market return-and you just need to purchase an index fund for that. Peter Lynch says that “There’s no use diversifying into unknown companies just for the sake of diversity.” This relates to the next lesson…
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  4. “More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. One of my friends – a noted West Coast philosopher maintains that a majority of life’s errors are caused by forgetting what one is really trying to do… our objective is to produce the maximum after-tax compound rate” (1965)
    This is something that I have observed in a lot of people. The tax structure in Australia doesn’t help with negative gearing and the different tax breaks available for investments. Nevertheless, there has been numerous instances where people want to get tax breaks by investing in asset classes that have far more significant downside risk than what the tax advantage can give. In investing, all you want to do is produce the best after-tax return.
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  5. “Consistently I have told partners that unless our performance was better than average, the money should go elsewhere. In recent years this idea has gained momentum throughout the investment (or more importantly, the investing) community. In the last year or two it has started to look a bit like a tidal wave. I think we are witnessing the distortion of a sound idea…
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    The payoff for superior short term performance has become enormous, not only in compensation for results actually achieved, but in the attraction of new money for the next round. Thus a self-generating type of activity has set in which leads to larger and larger amounts of money participating on a shorter and shorter time span” (1967)
    In every generation, there seems to be a sound idea that is taken to extreme. In 1960s and 70s, there were the nifty fifty stock that you supposedly could hold forever. All well and good, until the valuation of the fifty stocks went through the roof! In 1990s, there was the tech bubble- internet stocks that were supposed to eat the world. In 2000s, there was the proliferation of hedge funds with the notion that they can hedge their risks so they can generate steady returns. In 2010s, there’s the ICOs that are supposed to change money.Note that behind all those trends, there are valid reasons for it. The nifty fifty were solid companies, tech is the future and software is eating the world, some hedge funds are really good (original Buffett partnership was a hedge fund) and there are real reasons to be excited about bitcoins and blockhain. The problem is just it is always taken to the extreme. Take it to capitalism and everyone’s profit motive.
  6. I have no desire to trade severe human dislocations for a few percentage points additional return per annum.” (1969)
    The lesson here is, in the long run, ”how you want to profit” can be more important than “how much is the profit”. It is a personal question for all of us to answer, and it differs individually. The most important thing is for the “how” to be congruent to your personality and temperament.
    .
    By 1961 Warren had obtained majority control of Dempster Mill, a manufacturer of farm implements and water system. His investment thesis was a relatively simple one: Dempster had a book value of $75 per share and consolidated working capital of about $50 per share which was acquired at an average price of about $28. The company had a poor management situation, along with fairly tough environment. Warren figured that if the company can be turned around to restore some of its former glory, the book value will prove to be real and the investment be worth multiples of his purchase price.  However, Warren quickly realised that the management team had no interest in realising a turnaround. Thus, Harry Bottle was brought in through the recommendation of Charlie Munger. Mr Bottle implemented the turnaround, cutting significant costs (including significant layoffs) and revamping pricing. Within 2 years, they resold the business for significant profit.
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    In Dempster Mill, Warren obtained profit through a typical private equity type move. Interestingly, he would go on and consciously move away from this type of operation. This self-imposed limitation is perhaps what is most remarkable about Warren, and certainly one of his greatest lesson. In the prologue of The Snowball (emphasis added):_

    He deliberately limited his money,” says Munger. “Warren would have made a lot more money if he hadn’t been carrying all those shareholders and had maintained the partnership longer, taking an override.” Compounded over thirty-three years, the extra money would have been worth many billions—tens of billions—to him. He could have bought and sold the businesses inside Berkshire Hathaway with a cold calculation of their financial return without considering how he felt about the people involved. He could have become a buy-out king. He could have promoted and lent his name to all sorts of ventures. “In the end,” says Munger, “he didn’t want to do it. He was competitive, but he was never just rawly competitive with no ethics. He wanted to live life a certain way, and it gave him a public record and a public platform. And I would argue Warren’s life has worked out better this way.”

 

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