Buffett's Letter to Shareholders 1963

It's been a while since the last update on the Buffett series. Today, let's take a look at the evolution of this master's investment letters.

Fund Performance

As usual, it outperformed the market, and compared with other investment firms, it performed better than its peers:

The key points I found interesting in this letter are:

: The convenience of operation, the freedom from decision-making, and the advantage of automatic diversification. Perhaps most importantly, they provide isolation to avoid temptation and prevent many investors from adopting clearly inferior techniques.

. The other day, in my notes on the beauty of systems, this is a leverage point for an enhancement loop. The old man also gave an example: In 1540, Francis I of France purchased Leonardo da Vinci's "Mona Lisa" for 4,000 écus (20,000 dollars). If Francis had kept his feet on the ground, and he (and his trustees) could have found a post-tax investment return of 6%, then the value of his estate today would exceed 10 trillion dollars, more than 3,000 times the current national debt, all stemming from the power of 6% compound interest.

. If all other things are equal, he would rather have someone else do the job. However, when active participation is necessary for optimizing capital deployment, investors can be sure that Buffett will not sit on the sidelines. I once read "Good Strategy Bad Strategy," where journalists asked many executives of large companies about their corporate strategies and heard words like globalization, diversification, and various fancy terms; when they asked Jobs, what's your strategy, he simply said wait, wait for the next big opportunity.

is sometimes an advantage and sometimes a disadvantage. Whether the asset base of Buffett's investment company is $1 million or $5 million, the current investment portfolio cannot be improved. The idea bank seems to always be 10% ahead of the bank account. If this changes, investors will certainly hear from Buffett.

: Buffett has all his eggs in the BPL basket and intends to keep them there. The outcome cannot be guaranteed, but a shared fate can. Moreover, Buffett's three children, mother, father, two sisters, two brothers-in-law, father-in-law, four aunts, four cousins, and five nieces and nephews have collectively invested $1,247,190 directly or indirectly in BPL.

is too well controlled.

TEXAS NATIONAL PETROLEUM

background

This is a typical case of reorganization, originating from the top source of reorganizations in recent years—the sale of oil and gas production companies.

TNP was a relatively small producer that Buffett had heard of over the years. In early 1962, Buffett heard rumors about its potential sale to Union Oil Company of California, but he never acted based on such information. However, this rumor turned out to be true. More money could have been made if one got involved during the rumor stage rather than waiting for the announcement stage. Nevertheless, that's someone else's business, not what Buffett thought he could make. (Make the money you can make 💰)

TNP Investment

In early April 1962, the basic terms of the deal were announced. TNP then had three classes of outstanding securities:

1. : They can be redeemed at a price of 104 1/4, and will continue to pay interest until the transaction is completed, at which point they will be redeemed. The total amount of these bonds is $6.5 million, and Buffett purchased $264,000 worth of principal before the transaction was completed.

2. : Approximately 3.7 million shares, of which about 40% are held by executives and directors. The proxy statement estimates liquidation proceeds of $7.42 per share. Within six months from the announcement to the completion of the deal, Buffett purchased 64,035 shares of common stock.

3. : A total of 650,000 warrants, each allowing the purchase of one share of common stock at $3.50. Based on the estimated liquidation price of $7.42 per common share in the proxy statement, the liquidation price for each warrant is estimated at $3.92. Within six months, Buffett purchased 83,200 warrants, representing approximately 13% of the total issued.

This operation demonstrates the strategy of Buffett's investment institution in restructuring deals, which involves diversifying investments across different types of securities to maximize potential returns.

The risk of shareholder rejection is virtually zero. The deal was negotiated by the controlling shareholder, and the price is reasonable. Any similar transaction would require due diligence investigations and legal opinions, but these risks can almost be ignored. There are no antitrust issues. The only issue is obtaining the necessary tax ruling. Union Oil used a standard ABC production payment financing method. USC is the holder of the production payment, and its charitable status caused some delays. This is a new issue for the tax bureau, but Buffett learned that USC was willing to waive this right and could still achieve satisfactory profits after borrowing all the funds from the bank. Although resolving this issue caused delays, it did not threaten the deal.

The outcome of the TNP deal

When Buffett spoke with the company on April 23 and 24, they estimated the deal would close in August or September. Ultimately, the expected dividend remained at $7.42 per share. The ruling was received in late September, and the deal closed on October 31. Buffett's bonds were redeemed on November 13. Buffett then converted the warrants into common stock and received a payment of $3.50 per share on December 14, 1962, $3.90 per share on February 4, 1963, and $0.15 per share on April 24, 1963. Buffett might receive another $0.04 per share within one or two years. For the 147,235 shares held (after exercising the warrants), even $0.04 per share is meaningful.

It fits the usual pattern:

(1) The transaction took longer than originally planned;

(2) The amount paid was often better than estimated. For TNP, it took a few more months, but Buffett also earned a few more percentage points.

The financial results of TNP are as follows:

1. : Buffett invested $260,773, with an average holding period of slightly less than five months. Buffett received 6.5% interest and realized a capital appreciation of $14,446. This is equivalent to an overall annual return of approximately 20%.
2. : Buffett realized a capital appreciation of $89,304, with the current valuation of his holdings at $2,946. From an initial investment of $146,000 in April, by October, the value of Buffett's holdings reached $731,000. Based on the time the funds were employed, the annual rate of return was approximately 22%.

In both cases, the returns are based on fully equity-financed investments. Buffett believes that moderate borrowing is reasonable for a portfolio of reorganization stocks, but it is a very dangerous practice for common stocks.

Buffett does not consider TNP to be a stunning victory. He has had better reorganization deals and worse ones. It is a typical example of Buffett's day-to-day operations. Buffett strives to obtain all possible facts, monitors developments continuously, and evaluates them based on his experience. Of course, Buffett does not participate in every transaction that arises — their attractiveness varies considerably. When a reorganization deal fails, the result is a significant decline in market value. Therefore, Buffett cannot afford too many mistakes, although he constantly emphasizes to investors that occasional errors will occur (adjusting expectations).

DEMPSTER MILL MFG.

In 1961, after taking control of the company, Buffett promoted the executive vice president to president to observe how he would perform without the constraints of previous policies. The results were unsatisfactory, so on April 23, 1962, Buffett hired Harry Bottle as president. (Mentioned in past letters)

Harry took the following several key measures:

1. : Reduced inventory from over $4 million (much of which was slow-moving) to less than $1 million, significantly decreasing holding costs and obsolescence risks.
2. : Released capital accordingly for the purchase of marketable securities, generating gains of over $400,000.
3. : Reduce management and sales expenses from $150,000 per month to $75,000.
4. : Decrease factory overhead costs from $6 per direct labor hour to $4.5 per direct labor hour.
5. ：Closed five loss-making branch operations, retained three profitable ones, and replaced them with more productive distributors.
6. ：Cleaned up the operation of an affiliated plant in Columbus, Nebraska.
7. ：Cancelled capital-intensive production lines that did not generate profits, allowing the funds to be more advantageously employed in securities investments.
8. : The price of repair parts was adjusted, resulting in an additional profit of about $200,000 without significantly reducing sales volume.
9. : Through these and many other measures, profitability was restored to a level commensurate with the capital employed.

These measures significantly improved the company's financial condition and operational efficiency, demonstrating Harry's exceptional talent in management and restructuring.

Dempster's handling in 1963

In 1963, due to the company facing heavy corporate taxes (Harry quickly exhausted the tax loss carryforwards), and excessive liquid assets within the company, Buffett had to choose between dissolving the company or selling the business. Buffett planned to complete one of these by the end of 1963. Dissolving the company had many issues but would effectively double the partners' returns and eliminate the corporate capital gains tax issue on Dempster securities.

name from the new company) is now almost entirely cash and tradable securities. In BPL’s year-end audit, the First Beatrice shares were valued at their asset value (securities at market value) minus a $200,000 contingency reserve.

Subsequent Expectations

Buffett believed the buyer would do well with Dempster. The new buyer made a strong impression on Buffett, clearly being a capable person with solid plans to expand the business and improve profitability. Buffett would have been happy to operate Dempster on a non-corporate basis, but selling it at a reasonable price also left him very satisfied. Buffett's business is about making great purchases—not extraordinary sales.

Harry works in the same way as Buffett—he likes big carrot rewards. He is currently a limited partner of BPL, and the next time Buffett has a similar streamlined operation, he will be one of the top candidates. (Talent Card ✅)

The Dempster event brought several lessons:

1. : Buffett's approach to business has little in common with the high-flying hot stock combinations. During the period when the latter is popular, Buffett's investment institution may appear rather staid. For Buffett, it is advantageous if securities remain unchanged in price for months or even years, as this allows continuous purchasing over time. This emphasizes the need to measure results over a sufficiently long period; Buffett recommends at least three years.

2. : Such an open policy will never improve outcomes and can, in some cases, severely harm Buffett’s investment institution. Therefore, if anyone, including partners, asks Buffett whether he is interested in a particular security, Buffett instructs his team to invoke the "Fifth Amendment" and decline to answer.