Fund Performance
There is an issue with this performance: many funds fail to outperform the market. Why? They already possess:
Intelligent and energetic employees, Almost unlimited resources, Extensive business connections, "In reality, centuries of investment experience?" (A candidate who claimed to have 20 years of experience - but a former employer corrected that it was "one year of experience repeated twenty times.")
Buffett's advice:
My opinion is that the first job of any investment management organization is to analyze its own techniques and results before pronouncing judgment on the managerial abilities and performance of the major corporate entities of the United States.
The primary task of any investment management organization should be to analyze its own techniques and results before evaluating the management capabilities and performance of major American corporate entities.
Buffett provides the following reasons for the above question (why many funds cannot outperform the market):
Group decision-making - perhaps due to bias, but Buffett believes that a group with multiple members participating in decision-making is almost incapable of producing excellent investment management; The desire to conform with the policies of other large and prestigious institutions (and, to some extent, portfolios); A system that views "average" as "safe," under which the personal rewards of independent action are far out of proportion to the attendant risks; An adherence to certain irrational diversification practices; Finally, and importantly, inertia.
On conservatism
Buffett has committed more than 90% of his net worth to BPL (Buffett Partnership Ltd., hereinafter referred to as BPL), and most of his family members have similar proportions. Of course, this only proves Buffett's sincerity in his views —— not their correctness.
These qualities may lead to traditional actions, but often they also lead to unconventional choices. Somewhere in the world, they might still be holding regular meetings of the "Flat Earth Society." (The Flat Earth Society was an actual group whose members insisted on believing that the Earth is flat rather than spherical. Despite the scientific proof that the Earth is spherical, the existence of this group reflects some people's rejection of scientific consensus and their adherence to non-mainstream views.)
We should not feel comforted by the approval of important figures, fiery speakers, or large crowds. Nor should we feel uneasy if they do not approve. Public opinion polls cannot substitute for careful thought. What truly gives us peace of mind and brings a smile to our faces is when we encounter a situation that we can understand, where the facts are clear and the course of action is obvious. In such cases, regardless of whether others consider us traditional or unconventional, and regardless of whether they agree with us or not, we should believe that we are moving forward in a conservative way.
standards.
Regarding compound interest
This old man Buffett really doesn't tire of talking about compound interest; it's in every annual letter to shareholders. This year, there's a little positive story:
The legendary tale of the Manhattan Indians' trading acumen came when they sold their island in 1626 to that notorious spendthrift, Peter Minuit. They netted $24. Minuit, meanwhile, acquired 22.3 square miles of land, or about 621,688,320 square feet. While it's hard to make precise valuations based on similar transactions, at $20 per square foot, the current value of the land is approximately $12,433,766,400 (about $12.5 billion). For beginners, this might sound like a great deal. However, the Indians needed only to achieve a return rate of 6.5% (something representatives of a tribal mutual fund would have promised them) to leave Minuit speechless. At a 6.5% return rate, $24 would become $42,105,772,800 (about $42 billion) after 338 years, and if they had gained just half a percentage point more, reaching a 7% return rate, the current value would reach $205 billion.
Financial advantage:
Longevity (in the professional jargon of financial experts, this is called "Methuselah technology," named after Methuselah from the Bible, who was known for his longevity of 969 years.) I once watched a video where Buffett shared regarding Long-Term Capital Management, he High compound interest rate The combination of both (highly recommended)
It is worth noting that even a relatively small increase in annual yield can bring substantial returns. Although Buffett hopes to significantly outperform average investment results, he still believes that every percentage point above the average investment return is meaningful.
Goal
Although the IRR over the past 8 years has been very high, Buffett believes that such figures are unreasonable in the long term:
Any significant amount of money growing at such a high compound rate will reach the scale of national debt at an astonishing speed. (It seems that now, Buffett has already become one of the largest creditors of the United States. As of mid-2024, Berkshire Hathaway's holdings of short-term U.S. Treasury bills increased from $129.6 billion at the end of 2023 to $234.6 billion, with an increase of as much as $105 billion. This holding scale even exceeds the Federal Reserve's holdings of short-term Treasury bills.)
In the history of eight years, the general revaluation of securities has brought about the average annual return across all stocks, which Buffett believes will be difficult to replicate in the coming decades. For time spans of 20 or 30 years, Buffett expects the Dow Jones Index's overall annual return to be more likely in the range of 6%-7%, rather than the 11.1% seen in this brief 8-year history. This factor alone could reduce the annual compound rate by approximately 4 percentage points. A single -20.5% annual performance in the Dow Jones Index in 1965 would have brought its nine-year average return down to 7%. Investors in equities should expect that such years (or even worse) will occasionally occur. If a 20% or 30% decline in the market value of an investor's stock investments (such as BPL) causes emotional or financial distress, then the investor should avoid investing in common stock assets. As poet Harry Truman said, "If you can't stand the heat, stay out of the kitchen." Of course, it's best to consider this before entering the 'kitchen'.
Buffett believes that maintaining a 16.6 percentage point advantage for the partnership or an 11.2 percentage point advantage for limited partners over the long term is impossible. In the past eight years, Buffett's capital pool has consistently outperformed the Dow Jones Index, although in one year, due to profit distribution arrangements, the returns for limited partners were lower than the Dow Jones Index. BPL will definitely have several years (note the plural) where the partnership's performance falls below the Dow Jones Index, which will greatly distress general partners (and hopefully not overly worry the limited partners). When this happens, BPL's average advantage will sharply decline. Of course, Buffett also believes that BPL will still have some years with a fairly substantial edge. However, so far, BPL's high return performance has benefited from not experiencing truly mediocre (or worse) years, which obviously cannot continue indefinitely.
Much of what Buffett says is largely speculative, and Buffett's own investment philosophy has evolved to the point where he believes that prophecies reveal more about the prophet's fragility than the true nature of the future. Nonetheless, Buffett still hopes that BPL's long-term experience will unfold based on the following foundation:
(1) The overall return of the Dow Jones Index (including dividends, of course) averages about 7% per year, with significant fluctuations when achieving this average—such as extreme cases ranging from -40% to +50%, while most years fall within the range of -10% to +20%;
(2) BPL has an average annual advantage of 10 percentage points before allocating to the general partner—again, the magnitude of this advantage varies greatly, potentially being 10 percentage points lower than the Dow Jones Index in bad years and up to 25 percentage points higher when everything goes smoothly;
(3) The combined result of the above two assumptions is an average return of 17% for BPL, with an average return of about 14% for limited partners. This number will vary significantly each year, with the ultimate fluctuation range naturally depending on the interaction of the extreme scenarios assumed in (1) and (2).
and his
operation mode
Therefore, BPL now has four categories:
"Generals - Private Owner Basis": This category typically includes undervalued stocks determined by quantitative criteria, but also places significant emphasis on qualitative factors. In most cases, these stocks show no signs of immediate market improvement. They lack market appeal or support. Their main advantage is a low price, meaning that the overall valuation of the enterprise is far below the value assessment derived from careful analysis as if it were privately owned. Similarly, Buffett emphasizes that while quantitative analysis is primary and essential, qualitative factors are equally important. Buffett appreciates excellent management, a decent industry, and a certain degree of "fermentation" among previously silent management or shareholder groups. However, BPL demands value. In this category, BPL often finds itself in an ideal "double-stringed bow" state, either achieving market price enhancement through external factors or profiting by acquiring controlling stakes in companies at low prices. Although the former usually dominates, the latter serves as an insurance policy that most investment operations lack. BPL has continued to increase its holdings in three companies described in the mid-year report of 1964, where BPL is the largest shareholder. All three companies are increasing their intrinsic value at a very satisfactory rate. BPL remains completely passive in two of these companies and only engages in some very small-scale active operations in the third one. Buffett believes that BPL is unlikely to take a truly proactive role in policy-making in any of these companies, but if necessary, BPL will be ready to act.
"Generals - Relatively Undervalued": This category includes securities that are relatively cheaper compared to similar quality securities. BPL requires these securities to have a significant difference from current valuation standards, but (usually due to larger size) does not consider private owner value to be a meaningful concept. Of course, in this category, it is important to make comparisons within the same class—apples should not be compared with oranges, for which BPL makes great efforts. For most situations, BPL lacks sufficient understanding of a particular industry or company to make reasonable judgments—in such cases, BPL chooses to abandon. As mentioned earlier, this new category is growing and has already produced very satisfactory results. BPL recently started implementing a technique that promises to significantly reduce the risk brought about by changes in overall valuation standards; for example, when BPL purchases certain securities at a 12x P/E ratio, and similar or lower-quality companies sell at a 20x P/E ratio, but then a major revaluation occurs, causing these companies to sell at only a 10x P/E ratio. This risk has always troubled BPL because, compared to the "Generals - Private Owner Basis" or "Workouts" categories, BPL may find itself in a helpless situation. With the reduction of this risk, BPL sees a bright future for this category.
"Workouts": These securities have a clear timetable. They arise from corporate activities—sales, mergers, reorganizations, spin-offs, etc. In this category, BPL discusses not the rumors or "inside information" related to these developments, but publicly announced activities of this kind. BPL waits until this information can be read in newspapers before taking action. The risk mainly does not come from overall market behavior (although there may sometimes be some correlation), but from sudden changes in circumstances that prevent the expected development from being realized. These sudden factors may include antitrust or other negative government actions, opposition from shareholders, delays in tax rulings, etc. Many special situations yield gross profits that appear quite small, somewhat like looking for parking meters that still have time left. However, predictability combined with a shorter holding period still produces a fairly good average annual return after considering occasional large losses. Compared to common stocks, this category generates more stable absolute profits annually. In years of market decline, it usually accumulates a significant advantage for BPL; during bull markets, it may drag down performance. From a long-term perspective, Buffett expects the returns from special situations to achieve the same advantage relative to common stocks as compared to the Dow Jones Index.
"Controls": This situation is very rare, but when it happens, it is usually on a large scale. Unless BPL initially purchased a large amount of stock, control usually evolves from the "Generals - Private Owner Basis" category. This situation typically arises when an undervalued security shows no price change over a long period, allowing BPL to purchase a large number of shares in the company. At this point, BPL may be in a position to influence the company's activities or fully control its operations. Whether BPL becomes actively involved or relatively passive at this point depends on the evaluation of the company's future and the judgment of management capabilities.
BPL does not wish to be active merely for the sake of activity. If all conditions are equal, Buffett would prefer others to do the work. However, when active participation is necessary to optimize capital deployment, BPL will not stand idly by.
Whether active or passive, there should be an inherent profit safeguard in Controls-type investments. The necessary condition for this operation is an attractive purchase price. Once control is obtained, the value of BPL's investment depends on the intrinsic value of the business, rather than the irrational fluctuations commonly seen in the market.
BPL is currently the largest shareholder in all three situations mentioned under "Generals - Private Owner," which have two-way development potential:
They may transform into Controls-type investments. But if their market prices rise to levels closer to intrinsic value, allowing BPL to sell smoothly and complete a successful "Generals - Private Owner" operation.
The results of Controls-type investments need to be measured over at least several years. Proper acquisition takes time. If needed, enhancing management, re-planning the use of capital, and even potentially conducting a satisfactory sale or merger are all factors that make this type of business measured in years rather than months. Therefore, in Controls-type investments, BPL pursues a broad profit margin—if the prospects are unclear, BPL will relinquish its claim. Such investments mostly correspond with the Dow Jones Index during the purchase phase. In later stages, their performance is more similar to "Workouts" operations.
The allocation of BPL's portfolio across various asset categories largely depends on the randomness of availability. Therefore, in any given year, the mix between "Generals," "Workouts," or "Controls" is mostly accidental, and this capricious factor will significantly influence BPL's performance relative to the Dow Jones Industrial Average. This is one of many reasons why the performance of a single year, whether good or bad, should not be overemphasized.
To illustrate how important the randomness of allocation among these categories can be, Buffett cited examples from the past three years. Using a method entirely different from measuring the overall performance of BPL—calculating the average monthly investment based on the market value of each category, excluding borrowed funds and office operating expenses (this method provides the most accurate basis for inter-group comparisons but does not reflect BPL's overall results)—here are the performances of "Generals" (including two existing categories), "Workouts," and the Dow Jones Index:
Clearly, it was the "Workouts" (and also "Controls") that saved the day in 1962. If BPL had invested less in this category that year, despite the favorable market conditions, the outcome might have been much worse, even though the final result was still quite good. In fact, BPL could have allocated less capital to "Workouts" that year; this decision was driven by the availability of opportunities rather than Buffett's prediction of market direction. Thus, it is crucial to recognize that BPL's category mix in 1962 was purely a matter of luck.
In 1963, BPL experienced an exceptionally strong "Workout," which had a significant impact on the results, and "Generals" also performed well, making it a brilliant year. If "Workouts" had performed normally as they did in 1962, BPL might have underperformed compared to the Dow Jones Index. Here, what played a decisive role was not BPL's portfolio composition but the exceptional opportunity.
Finally, in 1964, "Workouts" were a considerable drag on overall performance. This is typical in years when the Dow Jones Index sees a substantial rise, such as in 1964, but due to mediocre performance, "Workouts" dragged more than expected. Looking back, if BPL had been fully invested in "Generals," the results might have been more satisfying, but Buffett cannot make decisions based on hindsight.
It can be seen that the results of each year are affected by many variables - some of which are difficult for BPL to control or predict. BPL believes all categories are good businesses, and it is very pleased to be able to rely on multiple categories rather than just one. This allows BPL to be more selective in each category while reducing the risk of having to shut down completely if an opportunity in one category disappears.
Tax
Buffett has never understood why paying taxes is such a big blow to so many people, especially since the tax rate on long-term capital gains is lower than that of most other industries (tax policies indicate that bricklaying 🧱 is considered less worthy of encouragement in society than trading stock certificates).
Buffett knows there are many pragmatists in the audience, so it's best to stop the idealistic preaching. Ultimately, there are only three ways to avoid paying taxes:
(1) Die with your assets - for Buffett, this method is a bit too ultimate, as even fanatics might have mixed feelings about this "cure".
(2) Give away your assets - in this way, you don't have to pay taxes, but you will also be unable to cover any living expenses, such as buying groceries or paying rent;
(3) Lose all your gains - if you are drooling over this tax avoidance method, Buffett has to admire your courage; you indeed have firm beliefs.
Therefore, the policy BPL will continue to adhere to is maximizing investment returns rather than minimizing taxes. BPL will make its utmost effort to generate the greatest revenue for the treasury at the lowest tax rate allowed by the rules.
Others
Office Expansion
According to a December 21 issue of AUTOMOTIVE NEWS, Ford Motor Company plans to invest $700 million in 1965 to add 6,742,000 square feet of facilities worldwide. BPL follows closely behind, planning to add 227 1/4 square feet of office space in the spring of 1965. 😂 (Boldly expanding from 682 square feet to 909 1/4 square feet.)
Team
A very capable new member has joined BPL to manage administrative and other certain functions, freeing up more time for Bill Scott to focus on his expertise in securities analysis. Bill (who has been doing an outstanding job) and his wife have invested $298,749 in BPL, which constitutes the vast majority of their net worth. The new colleague at BPL (whose name will remain undisclosed temporarily to allow his current employer time to find a replacement) and his family have also made a significant investment in BPL. Susie and Buffett currently have $3,406,700 invested in BPL, almost all of Buffett's net worth except for his remaining shares in Mid-Continent Tab Card Co., a local company he purchased in 1960 when there were fewer than ten shareholders. Additionally, Buffett's relatives, including his three children, mother, two sisters, two brothers-in-law, father-in-law, four aunts, four cousins, and six nieces and nephews, have directly or indirectly invested a total of $1,942,592 in BPL. So our entire family continues to eat what we cook ourselves.
Audit
The accounting firm of Peat, Marwick, Mitchell excelled in its usual important role, ensuring clarity in the ownership of all assets. BPL continues to set them nearly impossible deadlines — yet they still perform exceptionally well. You will notice that this year their report mentions a new measure: in addition to the regular year-end audit, they now conduct unscheduled inspections twice a year.