Mad Markets: Buffett Partnership Letters (1957)
Buffett’s First Partnership Letter
Introduction
We are starting a new series of posts to run alongside the stock analysis posts. These will deep dive into what are considered by many to be some of the best fund or partnership letters, stock deep dives, and market musings. Hopefully we will find many interesting ideas in a deep review of these kinds of writings from expert investors.
We’ll begin with Warren Buffett, going back to the early days when he wrote annual letters to his investors in Buffett Partnership Ltd. (“BPL” or “the Partnership”). These letters are publicly available in various formats, both online and in print. These cover a period of time when he was managing millions rather than billions.
In particular we will take a look at the 1957 letter. We’ll look at the historical context, what was happening in the market, economy and wider world at the time, and see how Buffett responded. It’s a rare chance to observe an expert investor operating through bull and bear markets, shifting sentiment, and economic events, all in real time.
Representation of Sputnik 1 in low Earth elliptical orbit (distances not to scale).
The BPL Letter: 1957
“The General Stock Market Picture in 1957”
The general format of Buffett’s BPL annual letters was to begin with some introductory remarks, followed by a table showing the partnership’s performance and cumulative gains1. Since 1957 was the first full year of operation, he skips this section. He typically then compared results to a selection of open-end and closed-end funds (to illustrate just how much better he was doing). From there, he often described the partnership’s method of operation, highlighted specific stock results, and included broader reflections on types of investments, tax considerations, and investment philosophy.
This is the first Buffett Partnership letter that’s publicly available (unless someone out there knows better or was a BPL investor back in 1956). Buffett starts by saying that the general market level is priced above intrinsic value. At this point in time the market had been in a multi-year bull run since 1949, following the post-WWII recovery. 1957 marked the first major decline since then, with the overall market returning -8.4%, based on the Dow-Jones Industrial Average including reinvested dividends so as to be measure on a fair basis in comparison with the Partnership.
Despite this, Buffett states that the market is priced above intrinsic value reintroducing this concept throughout these and later letters. He doesn’t elaborate at this stage what he means by the statement, but he returns to it in more detail in later letters. Apart from a few comments about the “moderate” decline in stock prices he doesn’t provide much commentary about the overall market and economic picture of the day, but below is a very brief summary of the backdrop:
The “Eisenhower Recession” begins in Q3 of 1957, with GDP contracting by 3.7%.
Sputnik 1 launches in October 1957, triggering the Space Race.
The US Federal Reserve, concerned over inflation, tightens rates through 1956-1957.
“Our Activities in 1957”
Here, we begin to glean some insights into what Buffett is actually doing at this point and into aspects of his investment approach. He introduces the concept of a “work-out”, differentiating this from his “generals” (these buckets of investments are discussed more later). For the moment, he focuses on work-outs, what we would now refer to as special situations: investments where a known corporate action catalyst is being worked-out, such as sales, mergers and acquisitions, spin-offs, bankruptcies, or tender offers.
These were a small part of the BPL portfolio, but as we’ll see later, Buffett treated them differently to his other investments, stating that he would happily use leverage for these ideas. The main reason was that they were typically unaffected by general stock market movements; the primary risk being that the planned action didn’t take place.
The letter discusses two general positions. One of them, in particular, had grown to constitute between 10%-20% of the various partnerships2. Spoiler alert: this company was the Commonwealth Trust Co. of Union City, New Jersey, a name that will be discussed in more detail in his future letters. This is one of many times a position is obliquely referred to without being named, one of many habits that funds copy today (including ourselves!).
It is striking that Buffett calmly notes that these positions may take between three to five years to work, but as we’ll see (or you may already know if you have read these letters), they have exceptionally high return potential. The theme of the intrinsic or true value versus market price is already central to his thinking, and he’s careful not to reveal the names, as he is still building his positions, at what he believes are very large discounts to their true value.
“ Our performance, relatively, is likely to be better in a bear market than in a bull market…”
This stands out as one of the most interesting statements in the letter. Buffett is saying that his outperformance, alpha, or excess return, is likely to be greater in a bear market, or when the index declines, or produces a lower return, than when it performs well. We will see whether this turns out to be true. Is it that Buffett thinks he can’t outperform the Dow if it rises more than 10%, that work-outs won’t outperform beyond a certain level, or is he simply confident of generating positive returns under any market circumstance?
In the next post we will time-travel to 1958 and begin to find out.
As a general note, the reader and investor should be on their guard for any funds or investment vehicles that do not compare themselves to a total return, or return inclusive of dividends. If the comparison benchmark, is for example the S&P 500 index, it should be noted that the fund gets a 1-2% head start from dividends reinvested in the fund.
Early on, Buffett operated a series of partnerships each with smaller groups of investors, unlike today’s hedge funds and pooled vehicles. Many of Buffett’s early investors were friends, family and acquaintances and wanted visibility and comfort around who they were co-investing alongside. This changed as BPL grew, became more complex and Buffett built up more of a track record.