Buffett's 50-Year-Old Principles Are Still Sound

Includes: BRK.A, BRK.B
by: David Van Knapp

Last week, a young author here (Tim McAleenan), who writes frequently on dividend and value investing, was chided by a commenter for being so risk-averse at such a young age. Coincidentally, a MarketWatch article about a complete collection of all of Warren Buffett s Letters to Shareholders came to my attention. The collection includes letters all the way back to 1957, which, if my math is right, is when Buffett was pretty young himself, 27 or so.

I have read quite a bit about Buffett's early investment philosophies, and I have often consulted his letters for insights, but I could not recall actually reading any all the way back from 1957. So I began reading them, and I was struck by how, at his early age, he was formulating and articulating principles that now stand as timeless investment theories. Here are a few that jumped off the page at me. Quite often, the reason they jumped off the page was that I have recently seen these topics debated on Seeking Alpha.

I have added my own brief thoughts after each quote. The date at the beginning of each quote refers to the year that the letter is addressing. From 1957 to 1960, the actual Letters were annual and went out early the following year. In 1961, Buffett introduced semi-annual letters to placate investors who had little or no information about their investments for 12 months at a time. Even though sent in mid-1961, the first of these was still entitled "1960," and I have so labeled them here.

[1957] All of the above [referring to a brief review of the market in 1957] is not intended to imply that market analysis is foremost in my mind. Primary attention is given at all times to the detection of substantially undervalued securities.

This has been a hot topic recently. I have participated in debates here about the relative value of focusing on individual stocks versus what "the market" is doing. In my own dividend growth investing, I pay little attention to the overall market or even to segments of it. My focus is on individual stocks.

[1957] Our performance, relatively, is likely to be better in a bear market than in a bull market…

This is true of value investing generally. Value stocks tend to have lower betas than growth stocks, so value stocks tend to outperform in price when the market is doing poorly and underperform when it is doing well. Again, market action is not really Buffett's main focus, but here he was trying to explain to his early investors what they should expect from his investing partnership.

[1957] Obviously during any acquisition period, our primary interest is to have the stock do nothing or decline rather than advance. Therefore, at any given time, a fair proportion of our portfolio may be in the sterile stage. This policy, while requiring patience, should maximize long term profits.

This has been another hot topic, as dividend growth investors have been criticized for rooting for price declines or showing relative satisfaction if a stock "goes nowhere" for several years. The idea, of course, is that if you are accumulating stocks for long-term performance objectives, you are better off if the stock's price stagnates, or even declines, while you are in purchasing mode.

[1958] I make no attempt to forecast the general market - my efforts are devoted to finding undervalued securities.

A repeat and reinforcement of the first quote above.

[1958] …our performance for any single year has serious limitations as a basis for estimating long term results. However, I believe that a program of investing in such undervalued well protected securities offers the surest means of long term profits in securities.

A clear statement of the difference between a long-term focus and a short-term one. Note the mention of "undervalued" securities as being his primary aim. Buffett learned from Benjamin Graham, and two pillars of value investing are valuation and margins of safety. These are recurring themes in Buffett's Letters.

[1959] Perhaps other standards of valuation are evolving which will permanently replace the old standard. 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.

This sort of philosophy would get Buffett severely criticized 35 years later, during the dot-com bubble. But his principles of valuation survived better than most of the tech darling companies.

[1960] I have pointed out that any superior record which we might accomplish should not be expected to be evidenced by a relatively constant advantage in performance compared to the [DJIA]. Rather it is likely that if such an advantage is achieved, it will be through better-than-average performance in stable or declining markets and average, or perhaps even poorer-than-average performance in rising markets…. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur….The above dose of philosophy is being dispensed since we have a number of new partners this year and I want to make sure they understand my objectives, my measure of attainment of these objectives, and some of my known limitations.

While Buffett was clearly shooting for total performance superiority, this quote resonated with me as a dividend growth investor, particularly the part in the middle about not getting enthused or depressed over the short term and the last part about objectives. The objectives of most dividend growth investors revolve around attaining superior income flows, and the measurements of success involve income metrics. Over the past couple of years, it has become clear that many fellow investors find this objective to be confusing if not nonsensical. Nevertheless, to me, any investment strategy begins with the investor's objectives. A general "I want to make money" is too vague to be of much help in formulating investment strategies or the metrics by which to measure them.

[1960] After allowing for any money added or withdrawn, [our method for determining partnership returns] gives results based upon what would have been realized upon liquidation of the partnership at the beginning of the year and what would have been realized upon liquidation at year end and is different, of course, from our tax results, which value securities at cost and realize gains or losses only when securities are actually sold.

This has been another warm topic recently on SA, the difference between investment performance and tax results. The differences are important in an investment scheme that does not see much actual turnover in portfolio holdings.

[1960]...four years is entirely too short a period from which to make deductions…

Another example of a long-term perspective, suitable for a young investor, I think. At the time he wrote this, he had trounced the DJIA for the four years his investing partnerships had existed, so he was not making excuses for short-term mediocrity. Instead of crowing about his performance, however, he was treating his approach as if it were untested and unproven, which I think was a good idea at that stage of his career. It is better to beat modest but achievable expectations than to fall short of unrealistically high expectations.

[1960] In the past, partners have commented that a once-a-year letter was "a long time between drinks," and that a semi-annual letter would be a good idea. It really shouldn't be too difficult to find something to say twice a year....Hence, this [mid-year] letter...will be continued in future years….Let me, however, emphasize two points. First, one year is far too short a period to form any kind of an opinion as to investment performance, and measurements based upon six months become even more unreliable. One factor that has caused some reluctance on my part to write semi-annual letters is the fear that partners may begin to think in terms of short-term performance which can be most misleading. My own thinking is much more geared to five year performance, preferably with tests of relative results in both strong and weak markets. The second point I want everyone to understand is that if we continue in a market which advances at the pace of the first half of 1961, not only do I doubt that we will continue to exceed the results of the DJIA, but it is very likely that our performance will fall behind the Average. Our holdings, which I always believe to be on the conservative side compared to general portfolios, tend to grow more conservative as the general market level rises. At all times, I attempt to have a portion of our portfolio in securities at least partially insulated from the behavior of the market…

This quote resonates with me for a couple of reasons. The first is its continued emphasis on the long-term compared to the short term, even though Buffett was trouncing the DJIA every year. Second is the line at the end about being "at least partially insulated from the market," because it mirrors my own preference for low-beta stocks and for "disintermediating" the market by looking at results through the lens of income performance rather than price performance.

[1960] We have…begun open market acquisition of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year.

Reinforcement of the idea that when you are acquiring a stock, you are perfectly content to have it stagnate while you are acquiring it.

[1961] I have continuously used the Dow-Jones Industrial Average as our measure of par. 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. While the Dow is not perfect (nor is anything else) as a measure 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…. You may feel I have established an unduly short yardstick in that it perhaps appears quite simple to do better than an unmanaged index of 30 leading common stocks. Actually, this index has generally proven to be a reasonably tough competitor. Arthur Wiesenberger's classic book on investment companies lists performance for the 15 years 1946-60, for all leading mutual funds….Wiesenberger lists 70 funds in his "Charts & Statistics" with continuous records since 1946. I have excluded 32 of these funds for various reasons since they were balanced funds (therefore not participating fully in the general market rise), specialized industry funds, etc…. Of the remaining 38 mutual funds whose method of operation I felt was such as to make a comparison with the Dow reasonable, 32 did poorer than the Dow, and 6 did better….None of the six that were superior beat the Dow by more than a few percentage points a year.

I conclude with this quote, because it reflects that many investors' dissatisfaction with mutual fund performance is not a recent phenomenon. I made an investigation of dividend-oriented ETFs earlier this year, and I could not find any that could match what I felt I and many other individuals accomplish on a regular basis by investing in individual stocks.

A trigger for this article was the comment to a young investor that at his age he should be taking on more risk. The implication was that more risk leads to greater rewards. Value investing posits quite the opposite; the best rewards come when you minimize risk and create margins of safety. I would suggest that what the young investor should do instead of take on more risk is articulate his own objectives and plot out ways to meet them in ways that do not seem too risky to him. In fact, that would be my suggestion to investors of every age.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.