Warren Buffett’s 1959 Letter to Partners

Our study of Warren Buffett continues with his letter to the partners of the six partnerships of Buffett Partnership Limited reviewing the partnerships’ results for 1959.
The letter begins, as usual, with an overview of the general market.  In 1959, the following notable world events happened:

  • Fidel Castro assumed power in Cuba
  • Soviet Premier Nikita Khrushchev toured the United States, meeting with President Eisenhower at Camp David (and the Premier debated with Nixon on the merits of capitalism and communism)
  • Unemployment was nearly 7%
  • Interest rates were below 3%
  • Inflation was below 1%
  • Hawaii became the 50th state

By the standards of 2022, I’m sure 1959 seems like a relatively quiet year but we have the benefit of hindsight because we know that those events did not have immediately disastrous consequences for the country.  At the time, however, I’m sure there was plenty of panic in the press.

The market-at-large, measured then by the Dow Jones Industrial Index, advanced 19.9% for the year (dividends included).  Buffett notes that investment trusts in the U.S. underperformed the market as the largest, Tri-Continental Corp., had a gain of 5.7%.  Investment trusts were the precursors to today’s mutual funds.

Buffett still believed the market to be overvalued, writing that, 

“Perhaps other standards of valuation are evolving which will permanently replace the old standards.  I don’t think so.  I may very well be wrong; however, I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a “New Era” philosophy where trees really do grow to the sky.”

Investment fund managers would have done well to print this quote off and tape it to their bathroom mirrors over the last few years as valuations were really out of control.  The average NASDAQ 100 PE Ratio was 35 and even “blue chip” securities in the S&P500 Index held an average PE of 30; both are roughly half right now.

I often think about valuation standards for securities and find it interesting that some commentators and fund managers are convinced of the accuracy of their valuation practices.  Ultimately, value is what you get out of the investment and you could be wrong about timing, investment return or the path to that return.  I recently read the annual letter of an investment fund which stated that “…our valuation metric for this company assumes 25x earnings in a normalized, non-Covid environment”.  Now, I understand that there are growth stories out there, but if you do the math on this you begin to realize that in Year 1 (PE 25) that means that on $10/share in revenue, pre-tax earnings would be $0.25/share or a whopping 2.5% profit margin.  Now, anyone who has actually run a business will tell you that a business earning less than, say, 5% pre-tax is on life support.  Think about the growth that must happen for this company to realize that PE 25 and ensure a strong margin of safety if (when) your analysis is incorrect.  Investing in this manner is often referred to as “margin expansion” where the bet is that a company typically trades at, say, PE 25, is currently at PE 15, and when things normalize you’ll make money.  And that is certainly a way to invest, but I can’t find the margin of safety in that bet because if things change then you’ve overpaid for the business.

Moving on…

Buffett Partnerships Limited beat the market by a bit in 1959, averaging returns of 25.9% against 19.9% for the overall market.  The partnership assets were about 35% invested in one opportunity – an investment trust made up of other securities – and Buffett believed that the investment trust was undervalued compared to the market value of the securities it held.  The remaining portfolio was in “undervalued and work-out operations” or cigar butts and special situations.

As he ended the letter, Buffett reiterated one of the most important principles of investing:

“[Our] policy [of investing in undervalued stocks] should lead to superior results in bear markets and average performance in bull markets.”

In other words, a key to investing is not to beat the market in all markets, but rather, when the market is down you want to be less down – when the market is up, the sea of madness should carry you along just fine.

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