Video – Toby Carlisle, Q&A Notes at UC Davis Talk on Quantitative Value

Click here to watch the video (wear earphones and bring a magnifying glass)

UC Davis/Farnam Street Investments presents Toby Carlisle, founder and managing partner of Eyquem Investment Management and author of Quantitative Value, with Wes Gray.

Normally I’d embed a video but I can’t seem to do that with the UC Davis feed. Also, these are PARAPHRASED notes to the Q&A portion of Toby’s talk only. I ignored the “lecture” portion which preceded because I already think I get the gist of it from the book. I was mostly interested in covering his responses to the Q&A section.

The video is extremely poor quality, which is a shame because this is a great talk on a not-so-widely publicized idea. I wish there was a copy on YouTube with better audio and zoom, but no one put such a thing up, if it exists. I hope Toby does more interviews and talks in the future… hell, I’d help him put something together if it resulted in a better recording!

I had trouble hearing it and only thought to plug in some earbuds near the end. Prior to that I was contending with airplanes going overhead, refrigerator suddenly cycling into a loud cooling mode as well as my laptop’s maxed out tinny speakers contending with the cooling fans which randomly decided to cycle on and off at often the most critical moments. I often didn’t catch the question being asked, even when it wasn’t muffled, and chose to just focus on Toby’s response, assuming that the question would be obvious from that. That being said, I often conjoined questions and responses when there was overlap or similarity, or when it was easier for me to edit. This is NOT a verbatim transcript.

Finally, Toby recently created a beta forum for his book/website, at the Greenbackd Forum and I realize now in reviewing this talk that a lot of the questions I asked there, were covered here in my notes. I think he’s probably already given up on it, likely due to blockheads like me showing up and spamming him with simpleton questions he’s answered a million times for the Rubed Masses.

Major take-aways from the interview:

Q: Could we be in a “New Era” where the current market level is the “New Mean” and therefore there is nothing to revert to?

A: Well that’s really like saying stocks will revert down, not up. But how could you know? You could only look at historical data and go off of that, we have no way to predict ahead of time whether this “New Mean” is the case. I think this is why value investing continues to work, because at every juncture, people choose to believe that the old rules don’t apply. But the better bet has been that the world changes but the old rules continue to apply.

Q: So because the world is unknowable, do you compensate by fishing in the deep value ponds?

A: I like investing in really cheap stocks because when you get surprises, they’re good surprises. I find Buffett stocks terrifying because they have a big growth component in the valuation and any misstep and they get cut to pieces; whereas these cheap stocks are moribund for the most part so if you buy them and something good happens, they go up a lot.

Q: (muffled)

A: If you look at large cap stocks, the value effect is not as prevalent and the value premia is smaller. That’s because they’re a lot more efficient. There’s still only about 5% of AUM invested in value. But the big value guys portfolios look very similar; the value you have as a small investor is you don’t have to hold those stocks. So you can buy the smaller stuff where the value premia is larger. The institutional imperative is also very real. The idea of I’d like to buy 20 stocks, but I have to hold 45. That pushes you away from the optimal holdings for outperformance.

Q: (muffled)

A: The easiest way to stand out is to not run a lot of money. But no one wants to do that, everyone wants to run a lot of money.

Q: (muffled)

A: The model I follow is a bit more complicated than the Magic Formula. But there are two broad differences. I only buy value stocks, I only buy the cheapest decile and I don’t go outside of it, and then I buy quality within that decile. ROIC will work as a quality metric but only within the cheapest decile. ROIC is something Buffett talks about from a marketing perspective but I think in terms of raw performance it doesn’t make much sense. There’s definitely some persistence in ROIC, companies that have generated high returns on invested capital over long periods of time, tend to continue to do that.  If you have Warren Buffett’s genius and can avoid stepping on landmines, that can work. But if you don’t, you need to come up with another strategy.

Q: (muffled)

A: Intuition is important and it’s important when you’re deciding which strategy to use, but it’s not important when you’re selecting individual stocks. We can be overconfident in our assessment of a stock. I wonder whether all the information investors gather adds to their accuracy or to their confidence about their accuracy.

Q: (muffled)

A: All strategies have those periods when they don’t work. If you imagined you ran 4 different strategies in your portfolio, one is MF, one is cheap stocks, one of them is Buffett growth and one is special situations, and you just put a fixed amount of capital into each one [fixed proportion?] so that when one is performing well, you take the [excess?] capital out of it and put it into the one that is performing poorly, then you always have this natural rebalancing and it works the same way as equal-weighted stocks. And I think it’d lead to outperformance. It makes sense to have different strategies in the fund.

Q: (muffled)

A: QV says you are better off following an indexing strategy, but which market you index to is important. The S&P500 is one index you can follow, and there are simple steps you can follow to randomize the errors and outperform. But if you’re going to take those simple steps why not follow them to their logical conclusion and use value investing, which will allow you to outperform over a long period of time.

Q: (muffled)

A: Not everyone can beat the market. Mutual funds/big investors ARE the market, so their returns will be the market minus their fees. Value guys are 5% of AUM, can 5% outperform? Probably, by employing unusual strategies. Wes Gray has this thought experiment where he says if we return 20% a year, how long before we own the entire market? And it’s not that long. So there are constraints and all the big value investors find that once they get out there they all have the same portfolios so their outperformance isn’t so great. There’s a natural cap on value and it probably gets exceeded right before a bust. After a bust is then fertile ground for investment and that’s why you see all the good returns come right after the bust and then it trickles up for a period of time before there’s another collapse.

Q: (muffled)

A: I think the market is not going to generate great returns in the US, and I am not sure how value will do within that. That’s why my strategy is global. There are cheaper markets in other parts of the world. The US is actually one of the most expensive markets. The cheapest market in the developed world is Greece.

Q: Did you guys ever try to add a timing component to the formula? That might help you decide how to weight cash?

A: Yes, it doesn’t work. Well, we couldn’t get it to work. However, if you look at the yield, the yield of the strategy is always really fat, especially compared to the other instruments you could invest the cash in, so logically, you’d want to capture that yield and be fully invested. I think you should be close to fully invested.

Q: What about position sizing?

A: I equal weight. An argument can be made for sizing your cheaper positions bigger. I run 50 positions in the portfolio. In the backtest I found that was the best risk-adjusted risk-reward. That’s using Sortino and Sharpe ratios, which I don’t really believe in, but what else are you going to use? If you sized to 10 positions, you get better performance but it’s not better risk-adjusted performance. If you sized to 20 positions, you get slightly worse performance but better risk-adjusted performance. So you could make an argument for making a portfolio where your 5 best ideas were slightly bigger than your next 10 best, and so on, but I think it’s a nightmare for rebalancing. The stocks I look at act a little bit like options. They’re dead money until something happens and then they pop; so I want as much exposure to those as I can. I invest globally so the accounting regimes locally are a nightmare. IFRS, GAAP to me is foreign. You have to adjust the inputs to your screen for each country as a result of different accounting standards.

Q: digression

A: Japan is an interesting market. Everyone looks at Japan and sees the slump and says it’s terrifying investing in Japan but if you look at value in Japan, value has been performing really well for a really long time. So, if the US is in this position where it’s got a lot of govt debt and it’s going to follow a similar trajectory, you could look at Japan as a proxy and feel pretty good about value.

Q: (muffled)

A: I’ll take hot money, I am not in a position to turn down anyone right now. It’s a hard strategy [QV] to sell.

Q: (muffled)

A: Special situation investing is often a situation where you can’t find it in a screen, something is being spun out, you have to read a 10-K or 10-Q and understand what’s going to happen and then take a position that you wouldn’t be able to figure out from following a simple price ratio. It’s a good place to start out because it’s something you can understand and you can get an advantage by doing more work than everyone else. It’s not really correlated to the market. I don’t know whether it outperforms over a full cycle, but people don’t care because it performs well in a bad market like this.

Q: What kind of data do you use for your backtests?

A: Compustat, CRISP (Center for Research Into Securities Prices), Excel spreadsheets. You need expensive databases that have adjusted for when earnings announcements are made, that include adjustments that are made, that include companies that went bankrupt. Those kinds are expensive. They’re all filled with errors, that’s the toughest thing.

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Notes – Buffett Partnership Letters, 1957-1970

Recently I sank into my overstuffed armchair (in this situation, “sank” is used derisively to connote frustration and discomfort with regards to ideal reading conditions) with a copy of Buffett’s partnership letters from the 1957-1970 period in my hands. I found them on CSInvesting.org and had never taken the time to read them before, but figured it was about time as I was curious to consult a primary source on this period of Buffett’s investment career, having already read a 3rd-party recounting in The Snowball.

My interest was to read critically. Buffett’s letters have been read and analyzed and mulled over by thousands of investors and business people and have been discussed ad nauseum. But everyone seems to come away with the same lessons and the same pithy quotes that they throw up on their blogs when appropriate. I wanted to see if I could find anything original. From my own set of knowledge and understanding of Buffett and “how he did it”, I achieved my goal, but I can not guarantee creativity to anyone else who may be reading this. Somehow, somewhere in some overlooked nook of this vast interweb, I may have missed the discussion where someone went over these exact points.

Market timing, or the “value climate”

Amongst value investors, the sin of attempting to time the market is considered to be one of the greatest (for example, see the special note at the end of my recent review of The Intelligent Investor). Luminaries like Graham warn us that attempting to jump in and out of the markets according to their perceived price level being high or low is a speculative activity that will be rewarded as such, which is to say, it’ll eventually end in disaster.

However, while value gurus like Graham warned against market timing as a primary tool of analysis in an investment program, it’s also true that both Graham and Buffett were nonetheless intimately aware of market valuations and sentiment and both of them discussed the way their perception of market valuation influenced their portfolio orientation at any given time. For Graham and his intelligent investors, the response was to weight the portfolio toward bonds and away from stocks when the market was high and the opposite when the market was low. Similarly, Buffett advised in his 1957 letter:

If the general market were to return to an undervalued status our capital might be employed exclusively in general issues… if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio

This quote alone, along with many others just like it throughout the partnership letters, makes it clear the Buffett did not ignore broad market valuations. And not only did he not ignore them, he actively manipulated his portfolio in response to them. However, there are a few key things to note in terms of the heavily nuanced differences between what Buffett did and what the average market timer does:

  • Market timers are forecasters, they act on a perceived market level because of their anticipation about future market levels; Buffett refused to speculate about what the future of the market level might be and instead accepted it for what it was, changing what he owned and in what proportions, not whether he was invested or uninvested
  • Market timers are binary, choosing between “risk on” or “risk off”; Buffett responded to higher market levels by seeking to gain greater exposure to market neutral opportunities (special situations revolving around corporate action) while still continuing to make investments in individual undervalued businesses as he found them
  • Market timers always maintain the illusion of “full control” knowing they can always sell out or buy in any time they like in response to market valuations; Buffett acknowledged that many times he might desire to have greater market neutral exposure but that such opportunities might dry up in the late stages of a bull market, dashing his plans

The importance of relative performance

Another concept of Buffett’s money management style that stood out was his obsession with relative performance. I found this interesting again because the orthodox value investment wisdom is that it is not relative, but absolute, performance which matters– if you permanently lose a portion of your capital in a period, but your loss is smaller than your benchmark, you’ve still lost your capital and this is a bad thing.

Again, from the 1957 letter, Buffett turned this idea on its head:

I will be quite satisfied with a performance that is 10% per year better than the [Dow Jones Industrial] Averages

Because Buffett calculated that over the long-term the DJIA would return 5-7% to shareholders including dividends, Buffett was aiming for a 15-17% per annum performance target, or about 3x the performance of the Dow. But, as always, there was an important twist to this quest for relative out performance. In his 1962 letter, Buffett stated in no uncertain terms:

I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline in the Dow. Our performance in the rather mild declines of 1957 and 1960 would confirm my hypothesis that we invest in an extremely conservative manner

He went on to say:

Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%

And he concluded by noting:

Our best years relative to the Dow are likely to be in declining or static markets. Therefore, the advantage we seek will probably come in sharply varying amounts. There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory.

Specifically, if the market should be down 35% or 40% in a year (and I feel this has a high probability of occurring in one year in the next ten– no one knows which one), we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much

In his 1962 letter, he added further detailing, sharing:

Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative

Why did Buffett focus so much on relative out performance in down years? Because, as a value investor, he was obsessed with permanent loss of capital. In a broad sense, making money in the market is somewhat easy as over long periods of time as the market has historically tended to rise higher and higher. Every now and then, however, it corrects sharply to the downside and it is in these moments when the average investor panics and sells out at a loss, thereby permanently impairing his capital.

Buffett believed that by buying at a discount and taking a more conservative approach to the investment problem from the outset, he would limit any losses he might sustain in the inevitable downturns in the market. This by itself would put him ahead of other market participants because he’d have more of his capital intact. The real power behind this strategy is what comes afterward, as then the just-as-inevitable recovery would continue the compounding process again– with more of his original capital than the other guy, Buffett would enjoy greater pure gain over time as he would have a relatively shallower hole to climb out of each time.

True Margin of Safety: two pillars of value

Fellow value investor Nate Tobik over at OddballStocks.com has talked repeatedly about one of Ben Graham’s concepts which he refers to as the “two pillars of value”, namely, that a company which represents a bargain both on the basis of a discount to net assets and a discount earnings is the most solid Margin of Safety one can possess because you’re not only protected two ways but you also have two ways to “win.”

Reading the Buffett partnership letters, it’s clear that the reason Buffett was knocking it out of the park in his early years was because he relied upon the same methodology. Buffett later was critical of his own early practices and many others have derided the investment style as akin to picking up soggy cigar butts and taking the last puff before discarding them, but there is no denying in studying several of the investments Buffett disclosed that Buffett was buying things which were “smack you over the head” cheap.

For example, in the 1958 letter, Buffett disclosed the partnerships’ investment in Commonwealth Trust Company of New Jersey, a small bank. Buffett claimed the company had a computed per share intrinsic value of $125, which was earning $10/share and trading for $50. This meant that Buffett bought the company for 40% of book value, or at a 60% margin of safety to indicated value. And, in two pillar tradition, he was also buying at a 5x multiple of net earnings– by any standards, an incredibly cheap value. If one were to look at the company as a bond and study it’s earnings yield, this company was offering a 20% coupon!

Making good buys, not good sales

In the example of Commonwealth Trust Co. discussed earlier, though Buffett calculated an intrinsic value of $125/share, he ultimately sold for only $80/share. He did not sell out near intrinsic value but rather far below it. Still, because he had originally bought at $50/share, he nonetheless earned a 60% return despite the company trading at a still-substantial discount to intrinsic value.

As Buffett chirped in his 1964 letter:

Our business is making excellent purchases– not making extraordinary sales

Why does Buffett harp on this idea so frequently? There are a few reasons.

One, an excellent purchase price implies a substantial discount to intrinsic value and earnings power, therefore there is a built-in margin of safety and the downside is covered, a principle of central importance to sound investing.

Two, an individual has 100% control over when they buy a security but relatively little control over when and in what conditions they sell, particularly if they use margin. You may not always get the price you want when you are ready to sell but you will always get the price you want when you buy because that decision is made entirely by you and doesn’t require the cooperation of anyone else. Buying at a discount ensures you “lock in” a profit up front.

Three, buying at a discount gives one optionality. If a better deal comes along, it is more likely you can get back out of your original investment at cost or better when you buy it cheap. When your original purchase price represents a substantial discount you have a better chance of finding a buyer for your shares because even at higher prices such a sale would probably still represent a bargain to another buyer meaning both parties can feel good about the exchange.

This last point was critical in Buffett’s Commonwealth situation. He was happy to sell at only $80/share despite a $125/share intrinsic value because he had found another opportunity that was even more compelling and because his original purchase price was so low, he still generated a 60% return. Meanwhile, the other party who took this large block off his hands was happy to provide the liquidity because they still had a 56% upside to look forward to at that $80/share price.

Early activism, the value of control

Another lesson from Buffett’s partnership letters is the importance and value of activism and control. From an activism standpoint, the examples of Sanborn Maps and Dempster Mills are well-known and don’t require further elaboration in this post (follow the links for extensive case study analysis at CSInvesting.org, or even read Buffett’s partnership letters yourself to see his explanation of how these operations worked).

But activism is something that is best accomplished with control, and often is its by-product. On the topic of control, Buffett said in his 1958 letter with regards to Commonwealth:

we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal

By gaining a large ownership share in an undervalued company, an investor can play a more active role in ensuring that potential catalysts which might emerge serve to adequately reward shareholders. Similarly, time is money and when one has control,

this has substantial advantages many times in determining the length of time required to correct the undervaluation

An investment situation offering, say, a 30% return, offers a 30% annualized return if captured within a year, a 15% annualized return if gained after two years and only a 10% annualized return if it takes 3 years to realize value. Having control can often be the difference between a 30% and a 10% annualized return by allowing an investor to accelerate the pace at which they turn over their capital.

It is a myth, therefore, that Buffett only became a wholesale/control buyer as he employed greater amounts of capital in his later years. While many of his investments were passive, minority positions in the partnership years, Buffett never shied away from control and activism, even saying in his 1961 letter:

Sometimes, of course, we buy into a general with the thought that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen

In this sense, “value is its own catalyst” and something which is cheap and remains cheap for an extended period of time can actually be a unique opportunity to accumulate enough shares to acquire control, at which point the value can be unlocked through asset conversion, a sale or merger of the company or through a commandeering of the company’s earnings power.

Portfolio buckets: generals, work-outs and control

In his 1961 letter, as well as later letters, Buffett outlined the three primary types of investments that could be found in the partners’ portfolios, the approximate proportion of the portfolio to be involved with each and the basis upon which such investments should be chosen.

The “bread and butter” according to Buffett was his “generals”, businesses trading at substantial discounts to their intrinsic value which were purchased with the intent of eventually being resold at a price closer to the intrinsic value:

our largest category of investment… more money has been made here than in either of the other categories… We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen… Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price… individual margin of safety coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential… [we] are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner

While admitting that the particular and eventual catalyst was often not known with the average investment in a general security, Buffett also admitted in his 1963 “Ground Rules” letter section:

Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use

The next category was workouts:

our second largest category… ten or fifteen of these [at various stages of development]… I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior

The beauty of work-outs is that they relied on corporate action, not market action, to realize value. In this sense, they could provide a meaningful buffer to share price declines in generals during bear markets as their performance was largely “market neutral.” For example, in his 1963 (1962 being a bear market) letter Buffett said:

This performance is mainly the result of having a large portion of our money in controlled assets and workout situations rather than general market situations at a time when the Dow declined substantially

The final category was control, which started out as something of an after-thought or an accidental consequence of investing in certain generals which remained cheap, but later turned into an active category Buffett would search for opportunities in.

Buffett also mentioned the idea of the “two-way stretch” in control situations– if bought at a significant discount, there were generally two ways to profit from a control investment. Either the stock price remained low for a long period of time and control was acquired, in which case “the value of our investment is determined by the value of the enterprise,” or else the stock would move up in the process of consolidating a position in which case it could be sold at a higher level in the way one would normally “complete a successful general operation.”

Time horizons for performance

This particular point is more well-known but it bears repeating here. Buffett was obsessed with long-term performance and constantly advised his partners about appropriate timelines for judging investment performance, especially based-upon the particular type of investment being considered. For example, in his 1960 letter he said:

My own thinking is more geared to five year performance, preferably with tests of relative results in both strong and weak markets

In the 1961 letter, Buffett discussed “establishing yardsticks prior to the act” and again emphasized:

It is my feeling that three years is a very minimal test of performance, and the best test consists of a period at least that long where the terminal level of the Dow is reasonably close to the initial level

In other words, what did your performance look like after a three year period where the broad market index made no progress, or even reversed?

With control situations specifically, Buffett advised:

Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it

Diversification

It’s clear that Buffett had 15-21 “generals” or about 50-60% of his portfolio, with another 10-15 positions in workouts or another 15-30%, with the remainder in control situations. However, control situations could scale up to as much as 40% of the portfolio in an individual investment if the situation called for it in Buffett’s mind.

And while Buffett mentioned in an earlier letter of having approximately 40 positions in the portfolio in total, he later (around the time he started being influenced by Charlie Munger and other “quality over quantity” investment practitioners) became more critical of the idea of diversification. In the 1966 letter, Buffett lamented:

if anything, I should have concentrated slightly more than I have in the past

He also castigated “extreme diversification”:

The addition of the one hundredth stock simply can’t reduce the potential variance in portfolio performance sufficiently to compensate for the negative effect its inclusion has in the overall portfolio expectation

Buffett was learning the merits of “concentration” in areas outside the portfolio, as well. In discussing slight additions to the office space at Kiewit Plaza and the hiring of additional support personnel, Buffett added:

I think our present setup unquestionably lets me devote a higher percentage of my time to thinking about the investment process than virtually anyone else in the money management business

Of course, the results of this focus were obvious to all in time.

Sizing things up

Buffett dwelled on “the question of size” at length in his letters to partners. He made it clear that portfolio size and investment opportunity looked something like a continuum with small size on the left of the spectrum and large size on the right, with “generals” hanging near the left pole (size is a disadvantage), workouts inhabiting some kind of middle ground where they were neither benefitted nor impaired by size and control situations distinctly on the right where size was an enormous advantage.

Generals and control situations are, in this sense, almost opposites because Buffett warned that some generals were too small to buy meaningful stakes in for a large portfolio, whereas a small portfolio might never be able to acquire enough shares to gain control of certain investments.

Inflation-adjusting Buffett’s portfolio positions and capital at various points in time also gives important clues to the role size played in his operations. For example, Sanborn Maps was apparently around a $4.5M market cap when he mentioned the company in his letters. This would be about $35M or so in today’s dollars (this is not an endorsement of BLS/CPI measurement techniques, just a convenient rule-of-thumb), so clearly Buffett was hunting in a small/micro-cap space at least at this time.

In a similar vein, Buffett started with $105,000 in capital in 1956, which is about $893,000 in 2012. In his 1966 letter, he complained that the amount of capital being managed at the time, $43,645,000, was beginning to be burdensome in terms of size versus opportunities. This would be about $312,000,000 in 2012, to put it into perspective.

Apparently, the value investment framework Buffett created could work quite well even at a scale that we might consider to be decently large.

Serendipity: the reason for Buffett’s rise, and retirement

Few ever think to mention the incredible role serendipity played in Buffett’s early fortunes, but Buffett himself was well-aware. Not only did he begin his career at the outset of an astounding decade-long-plus bull market, but in 1952,

and for some years subsequently, there were substantial numbers of securities selling at well below the “value to a private owner” criterion we utilized for selection of general market investments

As the bull market started to grow gray hairs in the late 1960s and Buffett began contemplating an exit from the business, he similarly remarked in his 1967 letter:

Such statistical bargains have tended to disappear over the years. This may be due to the constant combing and recombing of investments that has occurred during the past twenty years, without an economic convulsion such as that of the ’30s to create a negative bias toward equities and spawn hundreds of new bargain securities

The comment on the aftermath of the 1930s bears repeating. The primary reason for the prevalence of bargain issues in the market around the time Buffett started investing was due to a massive psychological paradigm shift in attitudes about the stock market following the crash of 1929 and subsequent depression of the 1930s. By the late 1960s, a new inflationary thrust had managed to erase this psychology and great gains were actually made in sending it in the reverse direction. Buffett was convinced of

the virtual disappearance of the bargain issues determined quantitatively

the kind whose figures “should hit you over the head with a baseball bat”, which were being replaced by

speculation on an increasing scale

So how did Buffett respond to these new market conditions where his toolkit didn’t seem to work as well? Did he compromise his standards, or try to shape-shift his style into the “New Era” of investors and keep going? Well, anyone who has studied Buffett already knows the answer. Buffett knew his circle of competence and he knew what worked. When what he knew worked stopped working (because the opportunities weren’t available), he quit.

Despite writing in his 1968 letter that the answer to a potential phase out of the partnerships was “Definitely, no.” Buffett nonetheless in his 1969 letter suggested that “the quality and quantity of ideas is presently at an all time low” and that “opportunities for investment that are open to the analyst who stresses quantitative factors have virtually disappeared” and for this reason, he decided to close up shop.

There’s a lesson for all of us here. As Joel Greenblatt has argued, value investing doesn’t work all the time, which is why it works. We should respect this, just as Buffett did– when the deals dry up, we should go fishing (or at the very least, look for bargains in other markets that are in a different stage of psychology/sentiment/valuation). Trying to make great long-term returns when valuations won’t support it is a fools game and more likely to end in failure.

A few miscellaneous notes

In the 1968 letter, Buffett referred to 10-12% as “worthwhile overall returns on capital employed”.

With regards to dividends, although Buffett always described the return of the Dow for each annual period inclusive of dividends earned, and although when describing his investment in Commonwealth he specifically mentioned that the company was not paying dividends, and although we know from an anecdote in The Snowball that Buffett was receiving substantial dividend checks from his partnership portfolios because his wife Susie accidentally through a few away one time, I noticed that Buffett makes no specific mention in any of the letters of the importance of dividends nor that dividends impacted his investment decisions or philosophy.

Notes – Sanborn Maps, Dempster Mills, Nintendo’s Rise

Warren Buffett & Sanborn Map: An Early Balance Sheet Play

  • Buffett first got involved with Sanborn Map in 1958 because it represented a relative undervaluation compared to his then current holding in “Commonwealth”, even though he still thought “Commonwealth” was undervalued
  • Beginning in 1958, it represented 25% of the partnerships assets and BLP was the largest shareholder which “has substantial advantages many times in determining the length of time required to correct the undervaluation”
  • By 1959, represented 35% of partnership assets
  • Buffett recognized that the business operated in a “more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort”
  • Sanborn faced a changing business environment which beginning in the 1950s which “amounted to an almost complete elimination of what had been sizable, stable earning power” (after-tax profits: 1930s, $500,000; late 1950s, <$100,000)
  • Buffett estimated the reproduction value of Sanborn’s map assets at tens of millions of dollars
  • In addition, Sanborn Map carried a valuable portfolio of marketable securities which it began accumulating in the 1930s
  • Buffett: “Our bread and butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action”
  • The margin of safety was based on the fact that the investment portfolio was worth far more than the company was selling for in the market
  • Additionally, Buffett took a control position which gave him an added margin of safety
  • Buffett made roughly a 50% profit, according to Roger Lowenstein

Warren Buffett & Dempster Mills: Control Investing And Asset Conversion In A Net-Net

  • In 1962, BLP owned 70% of Dempster Mills’ shares (with another 10% controlled by associates), representing approximately 21% of partnership assets
  • Buffett: “Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from [general market overvaluation during a strong bull market]”
  • Buffett: “When control is obtained, obviously what then becomes all-important is the value of assets”
  • Buffett chose to value the partnerships shares based on a discounted estimate of what the assets would gather in a prompt sale (discounted liquidation value)
  • Buffett originally hoped he could turn around the company with existing management; when this failed, he brought in Harry Bottle on the advice of Charlie Munger
  • Bottle, at Buffett’s behest, proceeded to liquidate the balance sheet, converting assets from the manufacturing business (a poor business) into marketable securities, which BLP saw as a good business
  • Buffett: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake”
  • Buffett’s first purchases of DMM began in 1956 when it was a net-net trading at $18 with $72 in book value and $50 in NCAV per share; the company had had profitable operations in the past but was a break even at the time of purchase
  • Buffett: “Experience shows you can buy 100 situations like this and have perhaps 70 or 80 work out to reasonable profits in one to three years… [due to] an improved industry situation, a takeover offer, a change in investor psychology, etc.”
  • Harry Bottle’s effect:
    • Reduced inventory by 75%, reducing carrying costs and risk of obsolescence
    • Correspondingly freed up capital for investments in marketable securities
    • Cut SG&A by 50%
    • Cut factory overhead expenses by 25%
    • Closed 5 unprofitable branches leaving the company with 3 profitable branches
    • Eliminated production lines tying up capital but producing no profits
    • Adjusted prices of repair parts to yield additional annual profits
  • Buffett: “It is to our advantage to have securities do nothing price wise for months, or perhaps years, while we are buying them. This points up the need to measure our results over an adequate period of time. We suggest three years as a minimum.”
  • Other notes:
    • In 1961, Buffett committed $1M to DMM (his biggest investment yet), buying the controlling interest and staking 20% of BLP’s assets in the process
    • Sold the company as a going concern in 1963 for a $2.3M profit, nearly tripling his investment
    • Bottle’s employment agreement was based on a percentage of profits

Harvard Business School: Nintendo’s Competitive Advantage In The Early Home Video Game World

  • Prior to Nintendo’s dominance, the home video game market was led by Atari and suffered a number of boom-bust cycles where as much money was lost on the way down as was made on the way up
  • The cost of video game consoles has been falling in real terms since the 1980s:
    • 1977, Atari VCS $200, game cartridges $25-30 retail, $5-10 cost to mfger
    • 1983, Commodore, Casio and Sharp game systems sold for around $200-350
    • 1983, Nintendo launches Famicom system at $100 retail price (believed to be at or below cost), and had extracted a rock-bottom chip price of $8/chip by placing an order for 3M units
  • Home video game systems were a growing market:
    • 1982, 17% of US households had a video game system
    • 1990, Nintendo Famicom/NES console was in 1 out of every 3 households in the US and Japan and home video games represented a $5B worldwide industry
  • Nintendo’s development costs were up to $500,000 per title (Y100M) and marketing expenses were several hundred million yen
  • Nintendo’s approach was to focus R&D on developing one or two hit titles per year rather than several minor successes
  • Manufacturing of cartridges was subcontracted at a unit cost of $6-8, which then retailed for $40
  • Part of Nintendo’s value was in hit franchises such as Super Mario Brothers (1985), the Legend of Zelda (1987) and Metroid (1987), the first two of which were developed by hit designer Shigeru Miyamoto
  • Demand for games soon outstripped supply, so Nintendo allowed six firms to be licensed software makers, paying royalties of 20% of the $30 wholesale price per game:
    • Namco
    • Hudson (later acquired by Nintendo and brought in-house)
    • Taito
    • Konami
    • Capcom
    • Bandai
  • By 1988, 50 licensees, who were also charged the 20% royalty rate and had to absorb Nintendo’s manufacturing costs
  • Cumulative sales of Famicoms from 1983-1990 = 17M, Nintendo had gained 95% market share of 8-bit home video game market
  • On average, Japanese consumers bought 12 games for every Famicom system purchased
  • Nintendo, via Nintendo of America subsidiary, rolled out NES (Famicom) in the US in 1985 at $100/system
  • NOA limited licensees to producing 5 NES titles per year; had to place orders for manufacture through NOA at a cost of $14/game cartridge which wholesaled for $30 and were then marked up an additional $15 at retail
  • By 1991, 100 licensees with only 10% of software development in-house at Nintendo
  • Nintendo began licensing Mario and other characters to TV shows, cereal packets, T-shirts, records and tapes, books, board games, toys and other media
  • NOA’s highly targeted ad budget was about 2% of sales and promotional partners were utilized extensively
  • WMT did not stock competing video game systems
  • In 1989, NOA proposed creating a proprietary online network for its game consoles, allowing users to play games, trade stocks, do e-banking and other activities that would later become common place throughout the late 90s but which Nintendo itself failed to capitalize on with its own later systems repeatedly!
  • 1989, Nintendo releases Game Boy handheld game console in Japan, retail price $100, games $20-25, designed to broaden the appeal of their systems (another strategy Nintendo would later utilize with the Wii)
  • By 1992, 32M Game Boys shipped worldwide and consumers bought on average 3 games per year
  • In 1991, Nintendo signed a consent decree with the FTC ending many of their dominant licensing, manufacturing and wholesaling/retailing practices, completely changing the economics of Nintendo’s business