In last year's letter to partners, I said the following:
My view of the general market level is that it is priced above Intrinsic Value. This view relates to Blue-Chip Securities. This view, if accurate, carries with it the possibility of a substantial decline in all stock prices, both undervalued and otherwise. In any event I think the probability is very slight that current market levels will be thought of as cheap five years from now. Even a full-scale , however, should not hurt the market value of our substantially.
Bear Market
Work-Outs
If the general market were to return to an undervalued status our capital might be employed exclusively in General Issues and perhaps some borrowed money would be used in this operation at that time. Conversely, 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.
All of the above 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.
The past year witnessed a moderate decline in stock prices. I stress the word "moderate" since casual reading of the press or conversing with those who have had only recent experience with stocks would tend to create an impression of a much greater decline. Actually, it appears to me that the decline in stock prices has been considerably less than the decline in Corporate Earning Power under present business conditions. This means that the public is still very bullish on blue chip stocks and the general economic picture. I make no attempt to forecast either business or the stock market; the above is simply intended to dispel any notions that stocks have suffered any drastic decline or that the general market, is at a low level. I still consider the general market to be priced on the high side based on Long-Term Investment Value.
Our Activities in 1957
The market decline has created greater opportunity among Undervalued Situations so that, generally, our portfolio is heavier in undervalued situations relative to work-outs than it was last year. Perhaps an explanation of the term "work-out" is in order. A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally. At the end of 1956, we had a ratio of about 70-30 between general issues and work-outs. Now it is about 85-15.
During the past year we have taken positions in two situations which have reached a size where we may expect to take some part in corporate decisions. One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%. Both of these will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return with a minimum of risk. While not in the classification of work-outs, they have very little dependence on the general action of the stock market. Should the general market have a substantial rise, of course, I would expect this section of our portfolio to lag behind the action of the market.
Results for 1957
In 1957 the three partnerships which we formed in 1956 did substantially better than the general market. At the beginning of the year, the Dow-Jones Industrials stood at 499 and at the end of the year it was at 435 for a loss of 64 points. If one had owned the Averages, he would have received 22 points in dividends reducing the overall loss to 42 points or 8.470% for the year. This loss is roughly equivalent to what would have been achieved by investing in most Investment Funds and, to my knowledge, no investment fund invested in stocks showed a gain for the year. This is the foundation for the letter's discussion of Relative Performance.
All three of the 1956 partnerships showed a gain during the year amounting to about 6.2%, 7.8% and 25% on yearend 1956 net worth. Naturally a question is created as to the vastly superior performance of the last partnership, particularly in the mind of the partners of the first two. This performance emphasizes the importance of luck in the short run, particularly in regard to when funds are received. The third partnership was started the latest in 1956 when the market was at a lower level and when several securities were particularly attractive. Because of the availability of funds, large positions were taken in these issues. Whereas the two partnerships formed earlier were already substantially invested so that they could only take relatively small positions in these issues.
Basically, all partnerships are invested in the same securities and in approximately the same percentages. However, particularly during the initial stages, money becomes available at varying times and varying levels of the market so there is more variation in results than is likely to be the case in later years. Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages, so in respect to these three partnerships, 1957 was a successful and probably better than average, year.
Two partnerships were started during the middle of 1957 and their results for the balance of the year were roughly the same as the performance of the Averages which were down about 12% for the period since inception of the 1957 partnerships. Their portfolios are now starting to approximate those of the 1956 partnerships and performance of the entire group should be much more comparable in the future.
Interpretation of Results
To some extent our better than average performance in 1957 was due to the fact that it was a generally poor year for most stocks. Our performance, relatively, is likely to be better in a Bear Market than in a Bull Market so that deductions made from the above results should be tempered by the fact that it was the type of year when we should have done relatively well. In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.
I can definitely say that our portfolio represents better value at the end of 1957 than it did at the end of 1956. This is due to both generally lower prices and the fact that we have had more time to acquire the more substantially undervalued securities which can only be acquired with patience. Earlier I mentioned our largest position which comprised 10% to 20% of the assets of the various partnerships. In time I plan to have this represent 20% of the assets of all partnerships but this cannot be hurried. 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.
I have tried to cover points which I felt might be of interest and disclose as much of our philosophy as may be imparted without talking of individual issues. If there are any questions concerning any phase of the operation, I would welcome hearing from you.