Warren Buffett's 1958 Letter: A Masterclass in Value Investing
Warren Buffett, one of the most successful investors of all time, has consistently emphasized the importance of identifying undervalued securities rather than attempting to forecast the general market. As he aptly stated:
"I make no attempt to forecast the general market - my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, prices, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected."
Key Takeaways from the Letter
Focus on identifying undervalued securities rather than forecasting the market.
Market exuberance can persist for extended periods but typically ends unfavorably.
Technical factors can diverge from fundamentals, affecting prices but not the intrinsic value of businesses.
Be prepared to make significant investments when the odds are favorable, with risk managed through thorough research.
Effective capital allocation is crucial: Re-deploy capital into your best ideas.
Case Study: Commonwealth Trust Co.
In his 1958 partnership letter, Buffett discusses his investment in Commonwealth Trust Co., a bank with $50 million in assets located in New Jersey. Despite generating earnings of $10 per share, the company paid no dividend. The stock was trading at $50 per share, resulting in a P/E ratio of 5 ($50 stock price divided by $10 earnings per share). Using conservative estimates, Buffett estimated the intrinsic value to be at least $125 per share, or a 12.5x P/E ratio on the current earnings of $10 per share. In other words, Buffett believed the intrinsic, or "true", value of the business was at least 150% higher than the current market price.
Of course you might be thinking, "That seems way too good to be true, what if his estimates are wrong?" Let's quickly step back 7 years. Buffett became a disciple of a man named Benjamin Graham, whom he met in 1951 after enrolling in his class at Columbia Business School. Graham's principles of value investing, particularly the concept of "margin of safety," became foundational to Buffett's own investment strategy. Graham taught Buffett to focus on the intrinsic value of companies and to invest with a margin of safety to protect against market volatility. Said simply, an asset worth $100 and bought at $50 has a significantly better margin of safety than the same asset purchased at $95. If Buffett was wrong about what he believed was a massive discount in the stock price, he had still built in enough of a margin of safety, or cushion, to protect his principal investment.
"The margin of safety is the difference between the intrinsic value of a stock and its market price. It is a cushion against errors in judgment or unforeseen events."- Benjamin Graham
Commonwealth Trust Co. was 25.5% owned by another bank that desired a merger, but personal reasons prevented the merger from happening. Buffett anticipated that a merger would eventually occur and acquired a 12% stake in the bank at an average price of $51 per share. Buffett and his partners became the second-largest shareholders, gaining sufficient voting power to be consulted on merger proposals.
Despite facing competition in purchasing the stock, they ceased buying or selling when the price reached $65, even though they still believed it was worth at least $125.
Later that year, they encountered a special situation where they could become the largest shareholder of another company. While the potential return was comparable to other stocks he and his partners held, the ability to influence management was highly significant.
Buffett ultimately sold their block of shares in Commonwealth Trust Co. for 20% more than the market quote at the time, achieving a sale price of $80 per share. The $80 sale price divided by the $51 average purchase price resulted in a 57% gain on the investment.
Although someone could still profit by purchasing the shares at $80, given Buffett's valuation estimate of $125, the value proposition differed from buying at $50. Buffett believed his capital could be more effectively re-deployed elsewhere, leading to the purchase of a different special situation stock.
Conclusion
Warren Buffett's investment approach underscores the importance of identifying undervalued securities and building in a significant margin of safety between the purchase price and true intrinsic value. His experience with Commonwealth Trust Co. highlights the significance of capital allocation and the value of being a substantial shareholder. As Benjamin Graham once said:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
It's important to understand that stocks are not merely ticker symbols; they represent ownership stakes in businesses, no matter how insignificant in size. The underlying value is in no way dependent on a company's stock price.