Tuesday, 8 May 2012

Warren Buffett's Letters to Partners - A Summary

Warren Buffett's annual letter to shareholders is the most widely read and admired letter of its kind in the corporate world.  Written in clear, accessible prose, using well-known sayings and metaphors - he's quoted from the Bible, Ben Franklin and country music - the letters serve not only to keep Berkshire Hathaway shareholders informed, but as a source of wisdom for all investors.  His intellectual framework offers something to a broader audience as well, including government officials, corporate leaders, financial professionals, businesspeople and entrepreneurs. 
Most investors are not as familiar, however, with his earlier letters to partners, written from the late 1950s to the late 1960s.  Never purposely published, they can nonetheless be found on the internet, although reading them one wonders whether they were written with at least one eye cocked to posterity.  The letters, though shorter and written for a more limited audience, share many of the same qualities that his later ones do.  The tone, style, and familiar references are the same, and the ultra-steady, original logic and clarity of thought already existed.  Indeed, his basic outlook was already firmly established.  
His depth of knowledge and understanding are especially impressive, given that he was in his late twenties when he wrote the earliest letters.  His firm grasp of business and investing prompted him to set an ambitious goal: to outperform the Dow by 10 percentage points per year over time.  And his results were even more striking than his aspirations: he returned over 30% annually for twelve years, without a single down year, compared to under 10% for the Dow. 
While Buffett believed then much of what he believes now, careful readers will detect a subtle evolution in his thinking, though no earth-shattering "Eureka" moments.  As he matured, he moved from Ben Graham's "Cigar Butt" investments, to buying excellent businesses with durable competitive advantages that produced predictable, and usually growing, earnings.  Ironically, it was Berkshire Hathaway itself, a failing textile mill when Buffett assumed control, that inspired this philosophical change.  Just a few years after he first happily mentions the company, he expresses dismay at how difficult the business is, and how unfavorable its prospects.  Once he realizes that a superior business is, well, superior, his thinking shifts quickly and seamlessly.  After all, he already had insights into the psychology of managers, the market position of companies, the history of commerce, and much else besides.
Below are some of the topics he emphasizes, organized according to theme.  The comments consider the entire set of letters as a whole.
On Market Volatility and the Short-Term Mindset
Early on, Buffett studies market psychology and the effects of herd behavior on stocks.  However, he remains focused on a business's intrinsic value, which, unlike the stock, remains fairly constant.  He is entirely agnostic about the short-term direction of the market and determines what is likely to happen in a business, not when it'll be reflected in the market.  He notes, after receiving a few calls from panicked investors, that people only seem to fear uncertainty in falling markets, as if the future is crystal-clear after a buoyant period in the stock market. 
Toward the end, investing has become a widespread, "chain letter" pursuit, and the frequent attention that the average Joe focuses pays to the market has further compressed timeframes.  Indeed, he reprints a commentary from an investment advisory firm claiming that investing has become so complex and fast changing it must be "studied in a minute-by-minute program."  Accordingly, the funds that perform the best in the short-term receive large boosts in investment dollars, which always chase yesterday's returns.
On Diversification versus Concentration
Even in the early years, Buffett didn't shy away from concentrating large proportions of his funds in a single position, even though it may result in short-term underperformance.  Indeed, he warns partners that under highly favorable conditions he would commit up to 40% to a single idea, and ends up doing just that.  He's thought very carefully about the ideal conditions, though, including the probability of permanent loss, the attractiveness of competing ideas, the variance of likely outcomes etc.  As his assets grow and the market continues to rise, this willingness to concentrate becomes not only logical, but necessary.  On the flipside, he blames the mediocre performance of large investment funds in part on over-diversification. 
On Relative versus Absolute Results
Counterintuitive to some, Buffett puts a heavy emphasis on relative results.  He states clearly that he would judge his performance to be better if his funds fell by 15% and the market fell by 30%, than if both rose by 20%.  After all, shooting 3 on a par 4 is better than par on a 5, and over time you'll have plenty of par threes and fives, he reasons.  Some partners must have been puzzled by this philosophy, since he returns to it repeatedly, and attempts to explain it in a number of different ways.  It's not as if he didn't appreciate the desire for absolute results, though.  He reasoned that the market would trend upward over time, and that relative outperformance on a year-to-year basis would eventually add up to satisfying absolute returns.
On Management Aligning Their Incentives with Shareholders
In the case of Sanborn Map, a company that produced ultra-precise maps for insurers, Buffett witnessed an entrenched board acting in their own interest, not in the interest of shareholders.  Part of the reason for the apathy toward shareholders, he argues, is explained by the board's limited holdings in the company.
Given his "eat-your-own-cooking" philosophy, it's not surprising that the vast majority of his family's net worth is tied up in the partnerships, as well as large amounts from extended family, friends and other people well-known to the Buffetts.  To this day, he has never sold a share of Berkshire stock, nor did his late wife.
On the Use of Leverage
Buffett has long warned businesses, governments and investors to restrain their use of debt, since it makes them vulnerable to extreme pain, or worse, during difficult markets.  Surprisingly, he uses leverage in the partnership, though he doesn’t borrow more than 25% of equity.  However, he makes it clear that debt is used only to offset "workouts," situations where there is a high degree of predictability of long-term success and short-term market stability, such as merger arbitrage or liquidations.
On Thinking Logically and Independently
Buffett notes that the test of accuracy is not whether others - however numerous, important or vocal - agree with you, it's whether your hypothesis, facts and reasoning are correct.  He acknowledges the influence of emotions on investment decisions, and advocates for a clear-eyed understanding of the thought process that guides investments. 
A long bull run in the later years gives him the chance to show the courage of his conviction.  He maintains his fact-driven independence, even in an ever-expanding bubble where everyone is convinced that "trees grow to the sky."  Buffett wisely refuses to abandon a proven system for a new, unproven one that ignores any standards of value.  He was right, just as he was in a similar tech-driven mania in the late 1990s.
On Keeping Costs Low
Buffett praises managers that keep costs low and profits high.  At Dempster Mill he parachuted in an outsider, who successfully made cuts undreamed of by the previous management, earning Buffett's jubilant praise.
Buffett also practices what he preaches.  Only in 1962, when he had 90 partners and was managing over $7 million (much more, obviously, in today's dollars) did Buffett move into a proper office.  At first, he employed just a couple of staff, with administrative expenses costing partners just half of 1% of partnership equity.  Until then, he operated out of his home and did the administrative work himself.  Today, despite  250 000 employees, Berkshire's headquarters, still located in the same building, employs only two dozen or so.
On Large Institutional Funds
He repeatedly points out how mediocre most large investments funds are, few of which match, let alone exceed, the market return.  Furthermore, they do not compensate for substandard performance by achieving better-than-average results in down markets.  Adding hypocrisy to mediocrity, the funds refuse to compare their own performance to any benchmark, despite measuring all elements of potential investments.  However, he concedes that fund managers can't be expected to fare much better, given institutional constraints, and still fare better than most do-it-yourself investors would on their own.
From the beginning, Buffett compares his annual performance to four of the day's leading funds.  He trounces all four.
On Compound Interest
Buffett repeatedly illustrates the astonishing power of compound interest.  For numbers lovers, he produces compound interest tables with a range of percentage returns, compounded over a range of timeframes.  He highlights, in particular, how small per-annum differences - say, between 10% and 12% - can produce surprisingly large differences between final amounts over the long-term.  For readers more swayed by stories than numbers, he estimates the present-value of various historical financial transactions, including the decision to backstop Columbus’s voyage to America.

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