Buffett's 1960 Insights: Navigating Market Drawdowns and Unearthing Hidden Value
Highlights
Significant value can be added by protecting your portfolio from significant market drawdowns.
Markets can behave irrationally at times, pricing securities far below their intrinsic values.
Bet big when the odds are heavily in your favor.
Board of Director interests are not always aligned with shareholder interests.
1960 was the opposite of 1959. Markets pulled back, and the Dow Jones Industrial Average (the “Dow”) was down 9.3% before dividends.
Buffett reminds investors that his goal is to outperform the Dow over long periods of time; he feels the Dow is a good proxy for the leading investment companies available to investors (note: today that’s a different story).
Buffett also reminds investors that if he does outperform, 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.
In today’s lingo often used by investment advisors, the idea is to expect to “capture/participate in some, or all, of the market’s upside, while not capturing/participating in the market’s downside.”
The philosophy behind this idea is that if your portfolio does not fall as sharply as the market in down markets, your portfolio can recover more quickly. If your portfolio were to fall, say, 50% from $1M to $500K, it would take a 100% gain, or $500K, to bring yourself back to even with your starting value.
“The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole, and it is unrealistic to assume we are not going to have our share of both par threes and par fives.” - Warren Buffett
As you can see, Buffett delivered positive results in each of his first four years since the inception of his partnerships (despite two down years for the market). He also delivered positive outperformance in each of the four years, with significant outperformance in the two down years. This resulted in his portfolio beating the market by 98% cumulatively!
In the second half of the letter, Buffett discusses the investment he replaced Commonwealth Trust Co. with.
The company was called Sanborn Map Company, and it was established in the 1800s. Its core business was the publication and continuous revision of extremely detailed maps of all cities in the United States. These weren’t just any maps…a single city’s maps could weigh 50 lbs. They provided immense details of structures, such as fire hydrant and water main locations, structural materials used, roof compositions, etc. New maps were released every 20-30 years, but the maps were updated annually, and it would cost a customer $100 to stay current.
The maps were largely used by insurance companies to underwrite insurance policies by helping determine if risk was properly rated, the degree of conflagration exposure in an area, advisable reinsurance procedure, etc. Outside of insurance, these maps were used by public utilities, mortgage companies, and taxing authorities.
In Sanborn’s early years, insurance customers feared that Sanborn’s dominant position might make them too powerful, and they were able to get prominent insurance figures on the board of directors to be “watchdogs.” On top of this, in the 1950s, a new underwriting method known as “carding” was developed, and after-tax profits of the business fell from $500K in the late 1930s to $100K in the years leading up to Buffett’s purchase.
So why in the world would he buy a company whose after-tax profits fell by over 80% in 30 years? Well, in the early 1930s, Sanborn began to build an investment portfolio in addition to their core business. It was about $2.5M in size, half stocks and half bonds.
In the 1930s, when the map business was booming, the stock traded at $110/share. In the late 1950s, it was trading at $45/share. So, let’s think about this…I just told you that the after-tax profits of the business fell about 80%, but the stock only fell by about 60%. Some might look at that and say, “well, the bad news isn’t even fully priced in by the market.”
But what if I told you that over that same period, markets boomed, and the value of Sanborn’s investment portfolio grew from $20/share to $65/share? If the value of the stock portfolio is $65/share, but it’s only trading at $45/share in the open market, that implies that you are effectively paying “nothing” and getting the dying map business for “free,” so to speak. In other words, you get the investment portfolio for 70 cents on the dollar ($45 current price divided by $65 investment portfolio value) plus you pay nothing for the map business, which, even though it was a depressed business, was still generating profit.
Even though this new “carding” technique existed, over $500M in fire protection insurance premiums were still written using the older “mapping” technique. As I mentioned in past blog posts, this was an example of a “heads I win, tails I don’t lose much” value proposition.
Sanborn’s management had overlooked the need for rejuvenation of the map business because the investment portfolio had done so well. Buffett notes that while the business was doing fine financially, the company still cut dividends five times in an eight-year span, all while management and board compensation were never cut. Furthermore, only 0.04% of the shares outstanding were owned by the board, which consisted of very prominent men from the insurance industry.
In late 1958, the son of a deceased president of Sanborn was unhappy with the company’s direction and demanded a top position in the company. He was turned down and resigned. Buffett made a bid to his mother (the widow of the president) for her shares, which totaled about 15,000, and she accepted. This resulted in Buffett owning about 14% of the company.
He later bought another 24,000 shares on the open market, bringing the total shares owned to 39,000 or 37% of the overall company. Buffett’s plan was to separate the company into two businesses: 1) the investment portfolio and 2) the maps business that they planned to reinvigorate.
However, the board of directors showed reluctance to change despite an outside management consultant making the same recommendations that Buffett did. Buffett could have launched a proxy fight (a shareholder voting process that can effect change), but it is a timely process, and the investment portfolio also contained a handful of highly valued blue-chip stocks that Buffett didn’t care for at current market prices. He was willing to walk away, and so were other shareholders.
The board devised a plan in which the owners of Sanborn’s stock could exchange their shares for the investment portfolio securities at fair value. About 72% of the stock portfolio, or 50% of the shareholders, took advantage of this opportunity.
Buffett ended the letter reminding investors that their 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. More ideal opportunities would likely become available in “control situations” where Buffett could build up large stakes and join the boards to effect change, but he reminded partners that they could be infrequent in nature.