Reading the Letter to Partners of Buffett Partnership 24 Jan 1962

In 1961, the DJIA overall gain 22.2% (including dividend), where Buffett Partnership had 45.9% gain.

Buffett emphasized of all partners using the same yardstick - DJIA to measure the partnership's performance:

In being sure that we all have the same ideas of what is good and what is poor; retrospectively, almost anything can be made to look good in relation to something or other. If my performance is poor, I expect partner to withdraw, and indeed, I should look for new source of investment for my own funds.

Did your investment manager established such a yardstick to measure his performance?

Buffett further elaborate the reasoning of using DJIA as the yardstick:

1. While the Dow is not perfect (nor is anything else) as a measurement of performance, it has the advantage of being widely known, has a long period of continuity and reflects with reasonable accuracy the experience of investors generally with the market.
2. Most partners, as an alternative to their investment in the partnership would probably have their funds invested in a media producing results compared to the Dow, therefore, I feel it is a fair test of performance.

The partnership's investment break down into three categories:

1. Generally undervalued securities ("generals"); The largest category, 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.
2. "Work-outs"; Second largest category, securities whose financial results depend on corporate action such as mergers, liquidations, reorganizations, spin-offs, etc. rather than supply and demand factors created by buyers and sellers of securities. They are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what may upset the applecart. This category will produce reasonably stable earnings from year to year, to large extent irrespective of the course of the Dow.
   
3. "Control"; Control situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. "Generals" bought might develop into a control situation if the price remains low for a long period.

I believe a full-time professional investor need to have skill to acquired profitable "work-outs".

Buffett further comments:

In a raging bull market, operations in control situations will seems like a very difficult way to make money, compared to just buying the general market. However, I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.

I believe this means of insulation is the key to conservative investors being sleep well.

For conservatism of his manner of investing, Buffett comments:

I feel the most objective test as to just how conservative of our manner of investing is arises through evaluation of performance in down markets. Preferably these should have 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. We have never suffered a realized loss of more than 1/2 of 1% of total net assets, and our ratio of total dollars realized gains to total dollars realized losses is something like 100 to 1.

Wow! That's true conservatism! I am happy to place major portion of my investment funds to partnership similar to Buffett Partnership, if not all.

In Buffett opinion, larger funds tug in two directions:

1. From the standpoint of "passive" investments, where we do not attempt by the size of our investment to influence corporate policies, larger sums hurt results
2. However, in the case of control situations increased funds are a definite advantage. A "Sanborn Map" cannot be accomplish without the wherewithal.

Reading Buffett's Letter to Partners was a pleasant experience to me, if you following my blog posts of Buffett Partnership Letters, you will find out that I am very much summarizing the content of the letter and I may express my opinion in a point or two, this will be the way I write about Buffett Partnership Letters in the future posts, I'd love to hear your comments about this way of writing.

In closing, I will borrow a quote by Buffett from his letter:

You will not be right simply because a large number of people momentarily agree with you. You will be right, over the course of many transactions, if your hypotheses correct, your facts are correct, your reasoning is correct. True conservatism is only possible through knowledge and reason.