Sunday, October 24, 2010

Buffett Partnership Letters: 1962

Berkshire Hathaway's letters to shareholders are oft-quoted and Berkshire's annual shareholder meeting is well-followed, as value investors try to glean the wisdom of the world's greatest investor. But before he ran Berkshire, Warren Buffett was far less followed and ran his partnership with a sum of money much smaller than he employs today. The issues he faced then are probably far more relevant to the individual investor today than are Berkshire's current challenges. The following series attempts to summarize the key takeaways from Buffett's partnership letters.

Establishing the benchmark in advance

After the fact, a fund's performance can always be made to look good by comparing it to something that was worse. For this reason, Buffett prefers to set the benchmark ahead of time. Though noting that it has its flaws, Buffett has chosen the Dow Jones Industrial Average as a benchmark because it is widely known, has a long and continuous history, and reflects the experience of investors with the market. He notes that while it is an unmanaged index of 30 leading stocks, it still manages to beat most mutual funds.

Use a margin of safety

Most of the fund's assets are invested in securities representing companies in which Buffett has no control or influence. This has been the largest category of the fund's investments, and "more money has been made here than in either of the other categories". At the time of purchase, it is difficult to determine when or why these will appreciate in price. Yet, because of the lack of glamour and because there is nothing pending which would create favourable price action, these securities are available at very cheap prices.

Borrowing for investing is unnecessary

Buffett's preference is not to owe any money for his fund. However, he does note that situations he calls "work-outs" are particularly safe, and at times he does borrow against the portion of his portfolio invested in "work-outs". These are situations where Buffett invests in mergers, liquidiations or spin-offs, where the financial result can be calculated on a specific timetable, albeit with some risks. At any given time, he is invested in ten to fifteen such situations, and the results yield between ten and twenty percent (before borrowing).

Conservative investing is not what they say it is

A few years ago, Buffett writes in 1962, the purchase of municipal bonds was considered conservative. Today (1962), the purchase of blue chip stocks is considered conservative. Buffett disagrees: "There is nothing at all conservative, in my opinion, about speculating to just how high a multiplier a greedy and capricious public will put on earnings." Even though Buffett's portfolio is unconventional, he believes it to be conservative. He argues that the best test of conservatism in a portfolio is its performance when general market prices decline.

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