1965
BUFFETT PARTNERSHIP, LTD.
810 KIEWIT PLAZA
OMAHA 31, NEBRASKA
January 18, 1965
Our Performance in 1964
Although we had an overall gain of $4,846,312.37 in 1964, it was not one of our better years as judged by our
fundamental yardstick, the Dow-Jones Industrial Average (hereinafter called the "Dow"). The overall result for
BPL was plus 27.8% compared to an overall plus 18.7% for the Dow. The overall result for limited partners was
plus 22.3%. Both the advantage of 9.1 percentage points on a partnership basis and 3.6 points by the limited
partners were the poorest since 1959, which was a year of roughly comparable gains for the Dow.
Nevertheless, I am not depressed. It was a strong year for the general market, and it is always tougher for us to
outshine the Dow in such a year. We are certain to have years when the Dow gives us a drubbing and, in some
respects, I feel rather fortunate that 1964 wasn't the year.
Because of the problems that galloping markets pose
for us, a Dow repeat in 1965 of 1964 results would make it most difficult for us to match its performance, let
alone surpass it by a decent margin.
To bring the record up to date, the following summarizes the year-by-year performance of the Dow, the
performance of the Partnership before allocation to the general partner, and the limited partner's results:
Year
Overall Results From
Dow (1)
Partnership Results (2)
Limited Partners’
Results (3)
1957
-8.4%
10.4%
9.3%
1958
38.5%
40.9%
32.2%
1959
20.0%
25.9%
20.9%
1960
-6.2%
22.8%
18.6%
1961
22.4%
45.9%
35.9%
1962
-7.6%
13.9%
11.9%
1963
20.6%
38.7%
30.5%
1964
18.7%
27.8%
22.3%
(1)
Based on yearly changes in the value of the Dow plus dividends that would have been received through
ownership of the Dow during that year.
The table includes all complete years of partnership activity.
(2)
For 1957-61 consists of combined results of all predecessor limited partnerships operating throughout
the entire year after all expenses, but before distributions to partners or allocations to the general
partner.
(3)
For 1957-61 computed on the basis of the preceding column of partnership results allowing for
allocation to the general partner based upon the present partnership agreement, but before monthly
withdrawals by limited partners.
On a cumulative or compounded basis, the results are:
Year
Overall Results From
Dow
Partnership Results
Limited Partners’
Results
1957
-8.4%
10.4%
9.3%
1957 – 58
26.9%
55.6%
44.5%
67 1957 – 59
52.3%
95.9%
74.7%
1957 – 60
42.9%
140.9%
107.2%
1957 – 61
74.9%
251.0%
181.6%
1957 – 62
61.6%
299.8%
215.1%
1957 – 63
94.9%
454.5%
311.2%
1957 – 64
131.3%
608.7%
402.9%
Annual Compounded
Rate
11.1%
27.7%
22.3%
Investment Companies
We
regularly compare our results with the two largest open-end investment companies (mutual funds) that
follow a policy of being typically 95-100% invested in common stock, and the two largest diversified closed-
end investment companies.
These four companies, Massachusetts Investors Trust, Investors Stock Fund, Tri-
Continental Corporation, and Lehman Corporation, manage about $4.5 billion, are owned by about 550,000
shareholders, and are probably typical of most of the $30 billion investment company industry. My opinion is
that their results roughly parallel those of the overwhelming majority of other investment advisory organizations
which handle, in aggregate, vastly greater sums.
The purpose of this tabulation, which is shown below, is to illustrate that the Dow is no pushover as an index of
investment achievement. The advisory talent managing just the four companies shown commands annual fees of
over $8 million and this represents a very small fraction of the professional investment management industry.
The public batting average of this highly-paid and widely respected talent indicates performance a shade below
that of the Dow, an unmanaged index.
YEARLY RESULTS
Year
Mass.
Inv.
Trust (1)
Investors
Stock (1)
Lehman (2)
Tri-Cont
(2)
Dow
Limited
Partners
1957
-11.4%
-12.4%
-11.4%
-2.4%
-8.4%
9.3%
1958
42.7%
47.5%
40.8%
33.2%
38.5%
32.2%
1959
9.0%
10.3%
8.1%
8.4%
20.0%
20.9%
1960
-1.0%
-0.6%
2.5%
2.8%
-6.2%
18.6%
1961
25.6%
24.9%
23.6%
22.5%
22.4%
35.9%
1962
-9.8%
-13.4%
-14.4%
-10.0%
-7.6%
11.9%
1963
20.0%
16.5%
23.7%
18.3%
20.6%
30.5%
1964
15.9%
14.3%
13.6%
12.6%
18.7%
22.3%
(1)
Computed from changes in asset value plus any distributions to holders of record during year.
(2)
From 1964 Moody's Bank & Finance Manual for 1957-63. Estimated for 1964.
COMPOUNDED
Year
Mass.
Inv.
Trust (1)
Investors
Stock (1)
Lehman (2)
Tri-Cont
(2)
Dow
Limited
Partners
1957
-11.4%
-12.4%
-11.4%
-2.4%
-8.4%
9.3%
1957 – 58
26.4%
29.2%
24.7%
30.0%
26.9%
44.5%
1957 – 59
37.8%
42.5%
34.8%
40.9%
52.3%
74.7%
1957 – 60
36.4%
41.6%
38.2%
44.8%
42.9%
107.2%
68 1957 – 61
71.3%
76.9%
70.8%
77.4%
74.9%
181.6%
1957 – 62
54.5%
53.2%
46.2%
59.7%
61.6%
215.1%
1957 – 63
85.4%
78.5%
80.8%
88.9%
94.9%
311.2%
1957 – 64
114.9%
104.0%
105.4%
112.7%
131.3%
402.9%
Annual
Compounded
Rate
10.0%
9.3%
9.4%
9.9%
11.1%
22.3%
The repetition of these tables has caused partners to ask: "Why in the world does this happen to very intelligent
managements working with (1) bright, energetic staff people, (2) virtually unlimited resources, (3) the most
extensive business contacts, and (4) literally centuries of aggregate investment experience?" (The latter
qualification brings to mind the fellow who
applied for a job and stated he had twenty years of experience -
which was corrected by the former employer to read “one year's experience -twenty times.”)
This question is of enormous importance, and you would expect it to be the subject of considerable study by
investment managers and substantial investors.
After all, each percentage point on $30 billion is $300 million
per year. Curiously enough, there is practically nothing in the literature of Wall Street attracting this problem,
and discussion of it is virtually absent at security analyst society meetings, conventions, seminars, etc. My
opinion is that the first job of any investment management organization is to analyze its own techniques and
results before pronouncing judgment on the managerial abilities and performance of the major corporate entities
of the United States.
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.
Perhaps the above comments are unjust. Perhaps even our statistical comparisons are unjust. Both our portfolio
and method of operation differ substantially from the investment companies in the table.
However, I believe
both our partners and their stockholders feel their managements are seeking the same goal - the maximum long-
term average return on capital obtainable with the minimum risk of permanent loss consistent with a program of
continuous investment in equities. Since we should have common goals, and most partners, as an alternative to
their interest in BPL, would probably have their funds invested in media producing results comparable with
these investment companies, I feel their performance record is meaningful in judging our own results.
There is no question that an important service is provided to investors by investment companies, investment
advisors, trust departments, etc.
This service revolves around the attainment of adequate diversification, the
preservation of a long-term outlook, the ease of handling investment decisions and mechanics, and most
importantly, the avoidance of the patently inferior investment techniques which seem to entice some individuals.
All but a few of the organizations do not specifically promise to deliver superior investment performance
although it is perhaps not unreasonable for the public to draw such an inference from their advertised emphasis
on professional management.
One thing I pledge to you as partners - just as I consider the previously stated performance comparison to be
meaningful now, so will I in future years, no, matter what tale unfolds.
Correspondingly, I ask that you, if you
do not feel such a standard to be relevant, register such disagreement now and suggest other standards which can
be applied prospectively rather than retrospectively.
69 One additional thought - I have not included a column in my table for the most widely-used investment advisor
in the world - Bell management. People who watch their weight, 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.
While it may be of academic interest to evaluate the management accomplishments of
Massachusetts Investors Trust or Lehman Corporation, 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.
The Question of Conservatism
In looking at the table of investment company performance, the question might be asked: “Yes, but aren't those
companies run more conservatively than the Partnership?" If you asked that question of the investment company
managements, they, in absolute honesty, would say they were more conservative. If you asked the first hundred
security analysts you met, I am sure that a very large majority of them also would answer for the investment
companies. I would disagree.
I have over 90% of my net worth in BPL, and most of my family have percentages
in that area, but of course, that only demonstrates the sincerity of my view - not the validity of it.
It is unquestionably true that the investment companies have their money more conventionally invested than we
do. 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.
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. In some
corner of the world they are probably still holding regular meetings of the Flat Earth Society.
We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do
we derive comfort if they don't. 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 other conventional or unconventional - whether
others agree or disagree - we feel - we are progressing in a conservative manner.
The above may seem highly subjective. It is. You should prefer an objective approach to the question. I do. My
suggestion as to one rational way to evaluate the conservativeness of past policies is to study performance in
declining markets. We have only three years of declining markets in our table and unfortunately (for purposes of
this test only) they were all moderate declines. In all three of these years we achieved appreciably better
investment results than any of the more conventional portfolios.
Specifically, if those three years had occurred in sequence, the cumulative results would have been:
Tri-Continental Corp.
-9.7%
Dow
-20.6%
Mass.
Investors Trust
-20.9%
Lehman Corp.
-22.3%
Investors Stock Fund
-24.6%
Limited Partners
+45.0%
We don’t think this comparison is all important, but we do think it has some relevance. We certainly think it
makes more sense than saying “We own (regardless of price) A.T. &T., General Electric, IBM and General
Motors and are therefore conservative.” In any event, evaluation of the conservatism of any investment program
or management (including self-management) should be based upon rational objective standards, and I suggest
performance in declining markets to be at least one meaningful test.
70 The Joys of Compounding
Readers of our early annual letters registered discontent at a mere recital of contemporary investment
experience, but instead hungered for the intellectual stimulation that only could be provided by a depth study of
investment strategy spanning the centuries.
Hence, this section.
Our last two excursions into the mythology of financial expertise have revealed that purportedly shrewd
investments by Isabella (backing the voyage of Columbus) and Francis I (original purchase of Mona Lisa)
bordered on fiscal lunacy. Apologists for these parties have presented an array of sentimental trivia. Through it
all, our compounding tables have not been dented by attack.
Nevertheless, one criticism has stung a bit. The charge has been made that this column has acquired a negative
tone with only the financial incompetents of history receiving comment. We have been challenged to record on
these pages a story of financial perspicacity which will be a bench mark of brilliance down through the ages.
One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians
when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that
they received $24 net.
For this, Minuit received 22.3 square miles which works out to about 621,688,320 square
feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot
estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12 1/2 billion). To the
novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6 1/2% return
(The tribal mutual fund representative would have promised them this.) to obtain the last laugh on Minuit. At 6
1/2%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra
half point to get to 7%, the present value becomes $205 billion.
So much for that.
Some of you may view your investment policies on a shorter term basis.
For your convenience, we include our
usual table indicating the gains from compounding $100,000 at various rates:
4%
8%
12%
16%
10 Years
$48,024
$115,892
$210,584
$341,143
20 Years
$119,111
$366,094
$864,627
$1,846,060
30 Years
$224,337
$906,260
$2,895,970
$8,484,940
This table indicates the financial advantages of:
(1)
A long life (in the erudite vocabulary of the financial sophisticate this is referred to as the Methusalah
Technique)
(2)
A high compound rate
(3)
A combination of both (especially recommended by this author)
To be observed are the enormous benefits produced by relatively small gains in the annual earnings rate.
This
explains our attitude which while hopeful of achieving a striking margin of superiority over average investment
results, nevertheless, regards every percentage point of investment return above average as having real meaning.
Our Goal
71 You will note that there are no columns in the preceding table for the 27.7% average of the Partnership during
its eight-year lifespan or the 22.3% average of the limited partners. Such figures are nonsensical for the long
term for several reasons: (Don't worry about me "holding back" to substantiate this prophecy.)
(1)
Any significant sums compounded at such rates take on national debt proportions at alarming speed.
(2)
During our eight-year history a general revaluation of securities has produced average annual rates of
overall gain from the whole common stock field which I believe unattainable in future decades.
Over a
span of 20 or 30 years, I would expect something more like 6% - 7% overall annual gain from the Dow
instead of the 11.1% during our brief history. This factor alone would tend to knock 4 points or so off of
our annual compounding rate. It would only take a minus 20.5% year in 1965 for the Dow to bring it
down to a 7% average figure for the nine years. Such years (or worse) should definitely be expected
from time to time by those holding equity investments. If a 20% or 30% drop in the market value of
your equity holdings (such as BPL) is going to produce emotional or financial distress, you should
simply avoid common stock type investments. In the words of the poet - Harry Truman – “If you can’t
stand the heat, stay out of the kitchen.
It is preferable, of course, to consider the problem before you
enter the “kitchen.”
(3)
We do not consider it possible on an extended basis to maintain the 16.6 percentage point advantage
over the Dow of the Partnership or the 11.2 percentage point edge enjoyed by the limited partners. We
have had eight consecutive years in which our pool of money has out-performed the Dow, although the
profit allocation arrangement left the limited partners short of Dow results in one of those years. We are
certain to have years (note the plural) when the Partnership results fall short of the Dow despite
considerable gnashing of teeth by the general partner (I hope not too much by the limited partners).
When that happens our average margin of superiority will drop sharply. I might say that I also think we
will continue to have some years of very decent margins in our favor.
However, to date we have
benefited by the fact that we have not had a really mediocre (or worse) year included in our average, and
this obviously cannot be expected to be a permanent experience.
So what can we expect to achieve? Of course, anything I might say is largely guesswork, and 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.
Nevertheless, you, as partners, are entitled to know my expectations, tenuous as they may be.
I am hopeful that
our longer term experience will unfold along the following basis:
(1)
An overall gain from the Dow (including dividends, of course) averaging in the area of 7% per annum,
exhibiting customarily wide amplitudes in achieving this average -- say, on the order or minus 40% to
plus 50% at the extremes with the majority o f years in the minus 10% to plus 20% range;
(2)
An average advantage of ten percentage points per annum for BPL before allocation to the general
partner - again with large amplitudes in the margin from perhaps 10 percentage points worse than the
Dow in a bad year to 25 percentage points better when everything clicks; and
(3)
The product of these two assumptions gives an average of 17% to BPL or about 14% to limited partners.
This figure would vary enormously from year to year; the final amplitudes, of course, depending, on the
interplay of the extremes hypothesized in (1) and (2).
I would like to emphasize that the above is conjecture, perhaps heavily
influenced by self-interest, ego, etc.
Anyone with a sense of financial history knows this sort of guesswork is subject to enormous error.
It might
better be left out of this letter, but it is a question frequently and legitimately asked by partners. Long-range
72 expectable return is the primary consideration of all of us belonging to BPL, and it is reasonable that I should be
put on record, foolish as that may later make me appear. My rather puritanical view is that any investment
manager, whether operating as broker, investment counselor, trust department, Investment Company, etc.,
should be willing to state unequivocally what he is going to attempt to accomplish and how he proposes to
measure the extent to which he gets the job done.
Our Method of Operation
In past annual letters I have always utilized three categories to describe investment operations we conduct. I now
feel that a four-category division is more appropriate. Partially, the addition of a new section - "Generals
Relatively Undervalued" - reflects my further consideration of essential differences that have always existed to a
small extent with our "Generals" group.
Partially, it reflects the growing importance of what once was a very
small sub-category but is now a much more significant part of our total portfolio. This increasing importance
has been accompanied by excellent results to date justifying significant time and effort devoted to finding
additional opportunities in this area. Finally, it partially reflects the development and implementation of a new
and somewhat unique investment technique designed to improve the expectancy and consistency of operations
in this category. Therefore, our four present categories are:
“Generals -Private Owner Basis”
- a category of generally undervalued stocks, determined by quantitative
standards, but with considerable attention also paid to the qualitative factor. There is often little or nothing to
indicate immediate market improvement. The issues lack glamour or market sponsorship.
Their main
qualification is a bargain price; that is, an overall valuation of the enterprise substantially below what careful
analysis indicates its value to a private owner to be. Again, let me emphasize that while the quantitative comes
first and is essential, the qualitative is important. We like good management - we like a decent industry - we like
a certain amount of “ferment” in a previously dormant management or stockholder group. But, we demand
value.
Many times in this category we have the desirable "two strings to our bow" situation where we should either
achieve appreciation of market prices from external factors or from the acquisition of a controlling position in a
business at a bargain price. While the former happens in the overwhelming majority of cases, the latter
represents an insurance policy most investment operations don't have. We have continued to enlarge the
positions in the three companies described in our 1964 midyear report where we are the largest stockholder.
All
three companies are increasing their fundamental value at a very satisfactory rate, and we are completely passive
in two situations and active only on a very minor scale in the third. It is unlikely that we will ever take a really
active part in policy-making in any of these three companies, but we stand ready if needed.
"Generals -Relatively Undervalued"
- this category consists of securi ties selling at prices relatively cheap
compared to securities of the same general quality. We demand substantial discrepancies from current valuation
standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept. It
is important in this category, of course, that apples be compared to apples - and not to oranges, and we work
hard at achieving that end.
In the great majority of cases we simply do not know enough about the industry or
company to come to sensible judgments -in that situation we pass.
As mentioned earlier, this new category has been growing and has produced very satisfactory results. We have
recently begun to implement a technique, which gives promise of very substantially reducing the risk from an
overall change in valuation standards; e.g. I we buy something at 12 times earnings when comparable or poorer
quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sell at 10
times.
This risk has always bothered us enormously because of the helpless position in which we could be left
compared to the "Generals -Private Owner" or "Workouts" types. With this risk diminished, we think this
category has a promising future.
73 3.
"Workouts"
- these are the securities with a timetable. They arise from corporate activity - sell-outs, mergers,
reorganizations, spin-offs, etc.
In this category we are not talking about rumors or "inside information"
pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in
the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a
degree), but instead to something upsetting the applecart so that the expected development does not materialize.
Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding
of tax rulings, etc. The gross profits in many workouts appear quite small. It's a little like looking for parking
meters with some time left on them. However, the predictability coupled with a short holding period produces
quite decent average annual rates of return after allowance for the occasional substantial loss. This category
produces more steady absolute profits from year to year than generals do.
In years of market decline it should
usually pile up a big edge for us; during bull markets it will probably be a drag on performance. On a long-term
basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.
"Controls"
- these are rarities, but when they occur they are likely to be of significant size. Unless we start off
with the purchase of a sizable block of stock, controls develop from the general - private owner category. They
result from situations where a cheap security does nothing pricewise for such an extended period of time that we
are able to buy a significant percentage of the company's stock. At that point we are probably in a position to
assume a degree of or perhaps complete control of the company's activities. Whether we become active or
remain relatively passive at this point depends upon our assessment of the company's future and the
managements capabilities.
We do not want to get active merely for the sake of being active.
Everything else being equal, I would much
rather let others do the work. However, when an active role is necessary to optimize the employment of capital,
you can be sure we will not be standing in the wings.
Active or passive, in a control situation there should be a built-in profit. The sine qua non of this operation is an
attractive purchase price. Once control is achieved, the value of our investment is determined by the value of the
enterprise, not the oftentimes irrationalities of the market place.
Any of the three situations where we are now the largest stockholders mentioned under Generals - Private
Owner could, by virtue of the two-way stretch they possess, turn into controls. That would suit us fine, but it
also suits us if they advance in the market to a price more in line with intrinsic value enabling us to sell them,
thereby completing a successful generals - private owner operation.
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, redirecting 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. For this reason, in controls, we are looking for wide margins of profit -if it appears at all close, we
quitclaim.
Controls in the buying stage move largely in sympathy with the Dow. In the later stages their behavior is geared
more to that of workouts.
You might be interested to know that the buyers of our former control situation, Dempster Mill Manufacturing,
seem to be doing very well with it. This fulfills our expectation and is a source of satisfaction. An investment
operation that depends on the ultimate buyer making a bum deal (in Wall Street they call this the "Bigger Fool
Theory") is tenuous indeed.
How much more satisfactory it is to buy at really bargain prices so that only an
average disposition brings pleasant results.
As I have mentioned in the past, the division of our portfolio among categories is largely determined by the
74 accident of availability. Therefore, in any given year the mix between generals, workouts, or controls is largely a
matter of chance, and this fickle factor will have a great deal to do with our performance relative to the Dow.
This is one of many reasons why single year's performance is of minor importance and good or bad, should
never be taken too seriously.
To give an example of just how important the accident of division between these categories is, let me cite the
example of the past three years.
Using an entirely different method of calculation than that used to measure the
performance of BPL in entirety, whereby the average monthly investment at market value by category is
utilized, borrowed money and office operating expenses excluded, etc., (this gives the most accurate basis for
intergroup comparisons but does not reflect overall BPL results) the generals (both present categories
combined), workouts, and the Dow, shape up as follows:
Year
Generals
Workouts
Dow
1962
-1.0%
14.6%
-8.6%
1963
20.5%
30.6%
18.4%
1964
27.8%
10.3%
16.7%
Obviously the workouts (along with controls) saved the day in 1962, and if we had been light in this category
that year, our final result would have been much poorer, although still quite respectable considering market
conditions during the year.
We could just as well have had a much smaller percentage of our portfolio in
workouts that year; availability decided it, not any notion on my part as to what the market was going to do.
Therefore, it is important to realize that in 1962 we were just plain lucky regarding mix of categories.
In 1963 we had one sensational workout which greatly influenced results, and generals gave a good account of
themselves, resulting in a banner year. If workouts had been normal, (say, more like 1962) we would have
looked much poorer compared to the Dow. Here it wasn't our mix that did much for us, but rather excellent
situations.
Finally, in 1964 workouts were a big drag on performance.
This would be normal in any event during a big plus
year for the Dow such as 1964, but they were even a greater drag than expected because of mediocre experience.
In retrospect it would have been pleasant to have been entirely in generals, but we don’t play the game in
retrospect.
I hope the preceding table drives home the point that results in a given year are subject to many variables - some
regarding which we have little control or insight. We consider all categories to be good businesses and we are
very happy we have several to rely on rather than just one. It makes for more discrimination within each
category and reduces the chance we will be put completely out of operation by the elimination of opportunities
in a single category.
Taxes
We have had a chorus of groans this year regarding partners' tax liabilities.
Of course, we also might have had a
few if the tax sheet had gone out blank.
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. This is certainly the case when
an emotionally supercharged element like taxes enters the picture (I have another friend -a noted East Coast
philosopher who says it isn't the lack of representation he minds -it's the taxation).
Let's get back to the West Coast. What is one really trying to do in the investment world? Not pay the least
75 taxes, although that may be a factor to be considered in achieving the end. Means and end should not be
confused, however, and the end is to come away with the largest after-tax rate of compound.
Quite obviously if
two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other
doesn't the latter course is superior. However, we find this is rarely the case.
It is extremely improbable that 20 stocks selected from, say, 3000 choices are going to prove to be the optimum
portfolio both now and a year from now at the entirely different prices (both for the selections and the
alternatives) prevailing at that later date. If our objective is to produce the maximum after-tax compound rate,
we simply have to own the most attractive securities obtainable at current prices, And, with 3,000 rather rapidly
shifting variables, this must mean change (hopefully “tax-generating” change).
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.
If gains are involved, changing portfolios involves paying taxes. Except in very unusual cases (I will readily
admit there are some cases), the amount of the tax is of minor importance if the difference in expectable
performance is significant. I have never been able to understand why the tax comes as such a body blow to
many people since the rate on long-term capital gain is lower than on most lines of endeavor (tax policy
indicates digging ditches is regarded as socially less desirable than shuffling stock certificates).
I have a large percentage of pragmatists in the audience so I had better get off that idealistic kick.
There are only
three ways to avoid ultimately paying the tax: (1) die with the asset - and that's a little too ultimate for me even
the zealots would have to view this "cure" with mixed emotions; (2) give the asset away - you certainly don't
pay any taxes this way, but of course you don't pay for any groceries, rent, etc., either; and (3) lose back the gain
if your mouth waters at this tax-saver, I have to admire you -you certainly have the courage of your convictions.
So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We
will do our level best to create the maximum revenue for the Treasury -at the lowest rates the rules will allow.
An interesting sidelight on this whole business of taxes, vis-à-vis investment management, has appeared in the
last few years.
This has arisen through the creation of so-called "swap funds" which are investment companies
created by the exchange of the investment company's shares for general market securities held by potential
investors. The dominant sales argument has been the deferment (deferment, when pronounced by an enthusiastic
salesman, sometimes comes very close phonetically to elimination) of capital gains taxes while trading a single
security for a diversified portfolio. The tax will only finally be paid when the swap fund's shares are redeemed.
For the lucky ones, it will be avoided entirely when any of those delightful alternatives mentioned two
paragraphs earlier eventuates.
The reasoning implicit in the swapee's action is rather interesting. He obviously doesn't really want to hold what
he is holding or he wouldn't jump at the chance to swap it (and pay a fairly healthy commission - usually up to
$100,000) for a grab-bag of similar hot potatoes held by other tax-numbed investors.
In all fairness, I should
point out that after all offerees have submitted their securities for exchange and had a chance to review the
proposed portfolio they have a chance to back out but I understand a relatively small proportion do so.
There have been twelve such funds (that I know of) established since origination of the idea in 1960, and several
more are currently in the works. The idea is not without appeal since sales totaled well over $600 million. All of
the funds retain an investment manager to whom they usually pay 1/2 of 1% of asset value. This investment
manager faces an interesting problem; he is paid to manage the fund intelligently (in each of the five largest
funds this fee currently ranges from $250,000 to $700,000 per year), but because of the low tax basis inherited
76 from the contributors of securities, virtually
his every move creates capital gains tax liabilities.
And, of course,
he knows that if he incurs such liabilities, he is doing so for people who are probably quite sensitive to taxes or
they wouldn't own shares in the swap fund in the first place.
I am putting all of this a bit strongly, and I am sure there are some cases where a swap fund may be the best
answer to an individual's combined tax and investment problems. Nevertheless, I feel they offer a very
interesting test-tube to measure the ability of some of the most respected investment advisors when they are
trying to manage money without paying (significant) taxes.
The three largest swap funds were all organized in 1961, and combined have assets now of about $300 million.
One of these, Diversification Fund, reports on a fiscal year basis which makes extraction of relevant data quite
difficult for calendar year comparisons.
The other two, Federal Street Fund and Westminster Fund (respectively
first and third largest in the group) are managed by investment advisors who oversee at least $2 billion of
institutional money.
Here's how they shape up for all full years of existence:
Year
Federal Street
Westminster
Dow
1962
-19.0%
-22.5%
-7.6%
1963
17.0%
18.7%
20.6%
1964
13.8%
12.3%
18.7%
Annual Compounded
Rate
2.6%
1.1%
9.8%
This is strictly the management record. No allowance has been made for the commission in entering and any
taxes paid by the fund on behalf of the shareholders have been added back to performance.
Anyone for taxes?
Miscellaneous
In the December 21st issue of AUTOMOTIVE NEWS it was reported that Ford Motor Co. plans to spend $700
million in 1965 to add 6,742,000 square feet to its facilities throughout the world.
Buffett Partnership, Ltd.,
never far behind, plans to add 227 1/4 square feet to its facilities in the spring of 1965.
Our growth in net assets from $105,100 (there's no prize for guessing who put in the $100) on May 5, 1956
when the first predecessor limited partnership.(Buffett Associates, Ltd. ) was organized, to $26,074,000 on
1/1/65 creates the need for an occasional reorganization in internal routine. Therefore, roughly
contemporaneously with the bold move from 682 to 909 ¼ square feet, a highly capable is going to join our
organization with responsibility for the administrative (and certain other) functions. This move will particularly
serve to free up more of Bill Scott's time for security analysis which is his forte. I’ll have more to report on this
in the midyear letter.
Bill (who continues to do a terrific job) and his wife have an investment in the Partnership of $298,749, a very
large majority of their net worth.
Our new associate (his name is being withheld until his present employer has
replaced him), along with his wife and children, has made an important investment in the Partnership. Susie and
I presently have an interest of $3,406,700 in BPL which represents virtually our entire net worth, with the
exception of our continued holding of Mid-Continent Tab Card Co., a local company into which I bought in
1960 when it had less than 10 stockholders. Additionally, my relatives, consisting of three children, mother ,
two sisters, two brothers-in-law, father-in-Law, four aunts, four cousins and six nieces and nephews, have
interests in BPL, directly or indirectly, totaling $1,942,592. So we all continue to eat home cooking.
77 We continue to represent the ultimate in seasonal businesses --open one day a year.
This creates real problems in
keeping the paper flowing smoothly, but Beth and Donna continue to do an outstanding job of coping with this
and other problems.
Peat, Marwick, Mitchell has distinguished itself in its usual vital role of finding out what belongs to whom. We
continue to throw impossible deadlines at them --and they continue to perform magnificently. You will note in
their certificate this year that they have implemented the new procedure whereby they now pounce on us
unannounced twice a year in addition to the regular yearend effort.
Finally -and most sincerely -let me thank you partners who cooperate magnificently in getting things to us
promptly and properly and thereby maximize the time we can spend working where we should be -by the cash
register. I am extremely fortunate in being able to spend the great majority of my time thinking about where our
money should be invested, rather than getting bogged down in the minutiae that seems to overwhelm so many
business entities.
We have an organizational structure which makes this efficiency a possibility, and more
importantly, we have a group of partners that make it a reality. For this, I am most appreciative and we are all
wealthier.
Our past policy has been to admit close relatives of present partners without a minimum capital limitation. This
year a flood of children, grandchildren, etc., appeared which called this policy into question; therefore, I have
decided to institute a $25,000 minimum on interests of immediate relatives of present partners.
Within the coming two weeks you will receive:
(1)
A tax letter giving you all BPL information needed for your 1964 federal income tax return. This letter
is the only item that counts for tax purposes.
(2)
An audit from Peat, Marwick, Mitchell & Co. for 1964, setting forth the operations and financial
position of BPL as well as your own capital account.
(3)
A letter signed by me setting forth the status of your BPL interest on 111165.
This is identical with the
figure developed in the audit.
(4)
Schedule “A” to the partnership agreement listing all partners.
Let Bill or me know if anything needs clarifying. Even with our splendid staff our growth means there is more
chance of missing letters, overlooked instructions, a name skipped over, a figure transposition, etc., so speak up
if you have any question at all that we might have erred. My next letter will be about July 15th" summarizing
the first half of this year.
Cordially,
Warren E. Buffett
78 BUFFETT PARTNERSHIP, LTD.
810 KIEWIT PLAZA
OMAHA 31, NEBRASKA
July 9, 1965
Warren E. Buffett, General Partner
William Scott
John M. Harding
First Half Performance:
During the first half of 1965, the Dow Jones Industrial Average (hereinafter call the “Dow”) declined from
874.13 to 868.03. This minor change was accomplished in a decidedly non-Euclidian manner. The Dow instead
took the scenic route, reaching a high of 939.62 on May 14 th .
Adding back dividends on the Dow of 13.49 gives
an overall gain through ownership of the Dow for the first half of 7.39 or 0.8%.
We had one of our better periods with an overall gain, before allocation to the general partner, of 10.4% or a 9.6
percentage point advantage over the Dow.
To bring the record up to date, the following summarizes the year-by-
year performance of the Dow, the performance of the Partnership before allocation to the general partner, and
the limited partners’ results:
Year
Overall Results From
Dow (1)
Partnership Results (2)
Limited Partners’
Results (3)
1957
-8.4%
10.4%
9.3%
1958
38.5%
40.9%
32.2%
1959
20.0%
25.9%
20.9%
1960
-6.2%
22.8%
18.6%
1961
22.4%
45.9%
35.9%
1962
-7.6%
13.9%
11.9%
1963
20.6%
38.7%
30.5%
1964
18.7%
27.8%
22.3%
1 st
half 1965
0.8%
10.4%
9.3%
Cumulative results
133.2%
682.4%
449.7%
Annual compounded
rate
10.5%
27.4%
22.2%
(1)
Based on yearly changes in the value of the Dow plus dividends that would have been received
through ownership of the Dow during that year.
The table includes all complete years of partnership
activity.
(2)
For 1957-61 consists of combined results of all predecessor limited partnerships operating
throughout the entire year after all expenses but before distributions to partners or allocations to the
general partner.
(3)
For 1957-61 computed on the basis of the preceding column of partnership results allowing for
allocation to the general partner based upon the present partnership agreement, but before monthly
withdrawals by limited partners.
Our constant admonitions have been: (1) that short-term results (less than three years) have little meaning,
particularly in reference to an investment operation such as ours that may devote a portion of resources to
control situations; and, (2) that our results, relative to the Dow and other common-stock-form media usually will
be better in declining markets and may well have a difficult time just matching such media in very strong
79 markets.
With the latter point in mind, it might be
imagined that we struggled during the first four months of the half to
stay even with the Dow and then opened up our margin as it declined in May and June.
Just the opposite
occurred. We actually achieved a wide margin during the upswing and then fell at a rate fully equal to the Dow
during the market decline.
I don’t mention this because I am proud of such performance – on the contrary, I would prefer it if we had
achieved our gain in the hypothesized manner. Rather, I mention it for two reasons: (1) you are always entitled
to know when I am wrong as well as right; and, (2) it demonstrates that although we deal with probabilities and
expectations, the actual results can deviate substantially from such expectations, particularly on a short-term
basis. As mentioned in the most recent annual letter, our long-term goal is to achieve a ten percentage point per
annum advantage over the Dow. Our advantage of 9.6 points achieved during the first six months must be
regarded as substantially above average. The fortitude demonstrated by our partners in tolerating such favorable
variations is commendable.
We shall most certainly encounter periods when the variations are in the other
direction.
During the first half, a series of purchases resulted in the acquisition of a controlling interest in one of the
situations described in the “General Private Owner” section of the last annual letter. When such a controlling
interest is acquired, the assets and earning power of the business become the immediate predominant factors in
value. When a small minority interest in a company is held, earning power and assets are, of course, very
important, but they represent an indirect influence on value which, in the short run, may or may not dominate
the factors bearing on supply and demand which result in price.
When a controlling interest is held, we own a business rather then a stock, and a business valuation is
appropriate. We have carried our controlling position at a conservative valuation at midyear and will reevaluate
it in terms of assets and earning power at yearend.
The annual letter, issued in January, 1966, will carry a full
story on this current control situation. At this time it is enough to say that we are delighted with both the
acquisition cost and the business operation, and even happier about the people we have managing the business.
Investment Companies:
We regularly compare our results with the two largest open-end investment companies (mutual funds) that
follow a policy of being, typically, 95-100% invested in common stocks, and the two largest diversified closed-
end investment companies. These four companies, Massachusetts Investors Trust, Investors Stock Fund, Tri-
Continental Corp., and Lehman Corp., manage over $4 billion and are probably typical of most of the $30
billion investment company industry. Their results are shown in the following table. My opinion is that this
performance roughly parallels that of the overwhelming majority of other investment advisory organizations
which handle, in aggregate, vastly greater sums.
Year
Mass.
Inv.
Trust (1)
Investors
Stock (1)
Lehman (2)
Tri-Cont (2)
Dow
Limited
Partners
1957
-11.4%
-12.4%
-11.4%
-2.4%
-8.4%
9.3%
1958
42.7
47.5
40.8
33.2
38.5
32.2
1959
9.0
10.3
8.1
8.4
20.0
20.9
1960
-1.0
-0.6
2.5
2.8
-6.2
18.6
1961
25.6
24.9
23.6
22.5
22.4
35.9
1962
-9.8
-13.4
-14.4
-10.0
-7.6
11.9
1963
20.0
16.5
23.7
18.7
20.6
30.5
1964
15.9
14.3
14.0
13.6
18.7
22.3
1 st
half 1965
0.0
-0.6
2.7
0.0
0.8
9.3
80 Cumulative
Results
114.9
102.8
111.7
115.4
133.2
449.7
Annual
Compounded
Rate
9.4
8.7
9.2
9.5
10.5
22.2
(1)
Computed from changes in asset value plus any distributions to holders of record during year.
(2)
From 1965 Moody’s Bank & Finance Manual for 1957-64. Estimated for first half 1965.
Last year I mentioned that the performance of these companies in some ways resembles the activity of a duck
sitting on a pond.
When the water (the market) rises, the duck rises; when if falls, back goes the duck. The water
level was virtually unchanged during the first half of 1965. The ducks, as you can see from the table, are still
sitting on the pond.
As I mentioned earlier in the letter, the ebb of the tide in May and June also substantially affected us.
Nevertheless, the fact we had flapped our wings a few times in the preceding four months enabled us to gain a
little altitude on the rest of the flock. Utilizing a somewhat more restrained lexicon, James H. Lorie, director of
the University of Chicago’s Center for Research in Security Prices was quoted in the May 25, 1965, WALL
STREET JOURNAL as saying: “There is no evidence that mutual funds select stocks better than by the random
method.”
Of course, the beauty of the American economic scene has been that random results have been pretty darned
good results. The water level has been rising.
In our opinion, the probabilities are that over a long period of
time, it will continue to rise, though, certainly not without important interruptions. It will be our policy,
however, to endeavor to swim strongly, with or against the tide. If our performance declines to a level you can
achieve by floating on your back, we will turn in our suits.
Advance Payments and Advance Withdrawals:
We accept advance payments from partners and prospective partners at 6% interest from date of receipt until the
end of the year. While there is no obligation to convert such advance payments to a partnership interest at the
end of the year, this should be the intent at the time it is paid to us.
Similarly, we allow partners to withdraw up to 20% of their partnership account prior to yearend and charge
them 6% from date of withdrawal until yearend when it is charged against their capital account.
Again, it is not
intended that partners use us like a bank, but that they use the withdrawal right for a truly unexpected need for
funds. Predictable needs for funds such as quarterly federal tax payments should be handled by a beginning-of-
the-year reduction in capital rather than through advance withdrawals from B.P.L. during the year. The
withdrawal privilege is to provide for the unanticipated.
The willingness to borrow (through advance payments) and lend (through advance withdrawals) at the same 6%
rate may sound downright “un-Buffettlike”. (You can be sure it doesn’t start my adrenaline flowing.) Certainly
such a no-spread arbitrage is devoid of the commercial overtones an observer might impute to the
preponderance of our transactions. Nevertheless, we think it makes sense and is in the best interest of all
partners.
The partner who has a large investment in indirect ownership of a group of liquid assets should have some
liquidity present in his partnership interest other than at yearend.
As a practical matter, we are reasonably certain
81 that advance withdrawals will be far more than covered by advance payments. For example, on June 30, 1965,
we had $98,851 of advance withdrawals and $652,931 of advance payments.
Why then the willingness to pay 6% for the net of advance payments over advance withdrawals when we can
borrow from commercial banks at substantially lower rates? The answer is that we expect on a long-term basis
to earn better than 6% (the general partner’s allocation is zero unless we do) although it is largely a matter of
chance whether we achieve the 6% figure in any short period. Moreover, I can adopt a different attitude
regarding the investment of money that can be expected to soon be a part of our equity capital than I can on
short-term borrowed money. The advance payments have the added advantage to us of spreading the investment
of new money over the year, rather than having it hit us all at once in January.
On the other hand, 6% is more
than can be obtained in short-term dollar secure investments by our partners, so I consider it mutually profitable.
Miscellaneous:
The bold expansion program to 909 ¼ square feet described in the annual letter was carried off without a hitch
(the Pepsi’s never even got warm).
John Harding joined us in April and is continuing the record whereby all the actions in the personnel field have
been winning ones.
As in past years, we will have a letter out about November 1 st
(to partners and those who have indicated an
interest to me by that time in becoming partners) with the commitment letter for 1966, estimate of the 1965 tax
situation, etc.
Cordially,
Warren E. Buffett
82 BUFFETT PARTNERSHIP, LTD.
810 KIEWIT PLAZA
OMAHA 31, NEBRASKA
November 1, 1965
To My Partners for 1966:
Enclosed are:
(1)
Two copies or the commitment letter for 1966, one to be kept by you and one returned to us. You may
amend the commitment letter right up to midnight, December 31st.
So get it back to us early, and if it
needs to be changed, just let us know by letter or phone. Commitment letters become final on December
31st. Every year I get a number or calls in the first week in January expressing a desire to add to the
January 1 st
capital. THIS CAN'T BE DONE.
(2)
A copy of our ever-popular "The Ground Rules." It is essential that we see eye-to-eye on the matters
covered therein. If you have different views - fine, yours may be better - but you shouldn't be in the
partnership. Please particularly note Ground Rule 7. This has been added this year reflecting a moderate
shift in my attitude over a period of time. It represents a decidedly unconventional (but logical in my
opinion when applied to our operation) approach and is therefore specifically called to your attention.
Any withdrawals will be paid January 5th. You may withdraw any amount you desire from $100 up to your
entire equity. Similarly, additions can be for any amount and should reach us by January 10 th .
In the event you
are disposing of anything, this will give you a chance to have the transaction in 1966 if that appears to be
advantageous for tax reasons. If additions reach us in November, they take on the status of advance payments
and draw 6% interest until yearend. This is not true of additions reaching us in December.
The partnership owns a controlling interest in Berkshire Hathaway Inc., a publicly-traded security. As
mentioned in my midyear letter, asset values and earning power are the dominant factors affecting the
valuation of a controlling interest in a business. Market price, which governs valuation of minority interest
positions, is of little or no importance in valuing a controlling interest. We will value our position in Berkshire
Hathaway at yearend at a price halfway between net current asset value and book value.
Because of the nature
of our receivables and inventory this, in effect, amounts to valuation of our current assets at 100 cents on the
dollar and our fixed assets at 50 cents on the dollar. Such a value in my opinion is fair to both adding and
withdrawing partners. It may be either of lower than market value at the time.
As I write this, we are orbiting in quite satisfactory fashion. Our margin over the Dow is well above average,
and even those Neanderthal partners who utilize such crude yardsticks as net profit would find performance
satisfactory. This is all, of course, subject to substantial change by yearend.
If anything needs clarification, call or write John Harding who is in charge of "de-confusing" partners. The tax
situation is about as reported in the August letter, but if you would like John to make the calculation for you,
he will be glad to do it.
Cordially,
Warren E. Buffett
83 P/S: We are continuing our "no prize" policy for the last ones to get their commitment letters back to us.
It will
make things easier for us if you get it back pronto. If you want to make changes later (before January lst), just
give us a call, and we'll amend it for you.