First half of 1961
Fund Performance
Including dividends, the Dow Jones Industrial Average increased by approximately 13%, and the partnership's performance still kept pace with or exceeded the overall market.
Investment Principles
Buffett hopes that investors will take a long-term perspective in viewing investments, preferably in five-year units rather than focusing on a six-month time span. If the market performs well in the second half, the partnership’s performance may lag behind the market. Buffett continues to maintain a conservative attitude, hoping that the securities he holds will be unaffected by the market, and as the market grows, the proportion of these isolated securities should increase. Despite the tempting statements presented by amateur investors, Buffett insists on maintaining his independent judgment. He is still quietly accumulating stocks in the market and has the potential to become a major shareholder. There will be no major moves in the near term, which may have an adverse impact on earnings in the short term, but will bring good returns in the long term.
Profit Distribution
For new partners, there are three optional profit distribution arrangements:
: For profits below 4%, limited partners receive all the profits; for profits exceeding 4%, 75% goes to the partners and 25% goes to Buffett. : In cases where the market performs poorly or uncertainty is high, the partnership can choose a more conservative profit distribution method to protect the partners' capital. : Adjust the profit distribution ratio according to the specific situation of the partnership and the market environment to maximize long-term returns.
| (1) Conservative | (2) Standard | (3) Flexible | |
|---|---|---|---|
| Interest Clauses | 6% | 4% | None |
| Excess Returns Allocated to GP | 1/3 | 1/4 | 1/6 |
| Excess Returns Allocated to LP | 2/3 | 3/4 | 5/6 |
| LP Returns at 2% Gains | 2% | 2% | 1.67% |
| LP Returns at 5% Gains | 5% | 4.75% | 4.17% |
| LP Returns at 10% Gains | 8.67% | 8.5% | 8.33% |
| LP Returns at 20% Gains | 15.33% | 16% | 16.67% |
In case of losses, there will be no retrospective deductions from the General Partner (GP)'s previous gains, although losses will carry forward into future excess returns. The Buffett couple will be the largest single investor in the new partnership, potentially accounting for one-sixth of the partnership's total assets, and the family will not purchase any tradable securities through other channels. The new partnership will represent all of Buffett's investment operations in tradable securities, avoiding the "agent problem." (The agent problem refers to the conflict of interest that arises when agents do not act entirely in the best interests of their principals but instead pursue their own maximum benefit. This issue is particularly common in corporate governance and investment management.)
Tax Treatment
There is an interesting tax treatment: Buffett submitted a proposed agreement to Washington, seeking a ruling on whether the merger would be tax-free and whether the partnership would be considered a partnership under tax law.
: This ruling means that if the merger meets certain conditions, the merger of the partnership will not be considered a taxable event. This is very advantageous for the partnership because it avoids double taxation issues arising from asset transfers during the merger process.
: The merged entity will continue to be regarded as a partnership rather than a corporation, which has important implications for tax treatment. Partnerships typically enjoy lower tax burdens and more flexible income distribution methods.
This semi-annual letter to shareholders also includes some details about the investment agreements, which I won't elaborate on here.
Full year of 1961
Fund Performance
The market rose by 22.2% for the entire year, while Buffett's fund achieved a growth of 45.9%.
Operational Methods
Buffett divides investments into three types:
| Category | General Investments (Generals) | Special Situations (Work-outs) | Control Investments (Control Situations) |
|---|---|---|---|
| Description | Typically undervalued securities, we have no say in company policy and no clear timetable for valuation correction. | The financial results of these securities depend on corporate actions rather than market supply and demand factors. | We control the company or hold very large positions and attempt to influence company policy. |
| Investment Characteristics | Typically holding significant positions in 5-6 main securities (accounting for 5%-10% of total assets), and smaller positions in another 10-15 securities. | Typically involves mergers and acquisitions, liquidations, restructurings, spin-offs, and other corporate events. | This operation usually needs to be measured in years. |
| Range of Returns | - | 10% - 20% (excluding additional returns from borrowed funds) | - |
| Risk | Performs as poorly as the Dow Jones Index when the market falls overall. | This type of investment has high security in terms of final results and intermediate market behavior. | This type of investment is relatively unrelated to the behavior of the Dow Jones Index. |
| Current Status | Currently our largest investment category. | Currently our second largest investment category. | Currently acquiring stocks that may become control investments in a few years. |
Impact of Growth in Investment Partnership Size on Performance
Impact of Scale Growth on Passive Investments：
For "passive" investments that do not attempt to influence company policies through investment size, the larger the capital, the worse the investment performance. For mutual funds or trust departments investing in broad market securities, the impact of scale growth on results is negligible. For example, buying 10,000 shares of General Motors stock costs only slightly more than buying 1,000 or 100 shares.
Illiquid Securities：
For some illiquid securities, buying 10,000 shares is much more difficult than buying 100 shares, sometimes even impossible. Therefore, for this part of the investment portfolio, the growth of capital is clearly disadvantageous.
"Work-outs" and "Generals"：
For most "work-outs" and some general investments, the increased capital is only slightly disadvantageous.
“Control Situations”：
For control investments, increased capital is a definite advantage. For example, making an investment like "Sanborn Map" requires sufficient capital support. As capital increases, opportunities increase because competition decreases sharply with increased input, and there is an important positive correlation between company size and lack of stock concentration.
Which is more important: the decline in profitability prospects for passive investments or the rise in profitability prospects for control investments?
Buffett believes that this largely depends on the type of market we are in. He currently believes that these two factors should offset each other. If his view changes, he will inform the partners. He also emphasizes that the results of 1960 and 1961 indicate that even a larger capital size did not affect performance; on the contrary, if he were still operating with the smaller capital sizes of 1956 and 1957, the results would not be better.
Case Analysis: Dempster Mill Manufacturing Company
Investment History
Initial Investment：
Five years ago, Buffett first purchased Dempster Mill stock, which was then considered a generally undervalued security.
Gradual Control：
Subsequently, a block of stock became available, and Buffett used this opportunity to further increase his holdings and entered the company's board four years ago.
Final Control：
After several years of gradual accumulation and strategy implementation, Buffett obtained majority control of Dempster Mill in August 1961. Buffett and his partners currently hold 80% of Dempster Mill's shares, with the partnership holding 70% and related parties holding 10%. This high percentage of ownership gives Buffett absolute control.
Company Situation
Business Situation：
Dempster is a manufacturer of farm tools and water systems. Sales in 1961 were approximately $9 million.
Profitability Situation：
In recent years, the profits generated from company operations have been nominal compared to the invested capital. This reflects both poor management and tough industry conditions. However, Buffett believes that with his control and strategic management, this investment will eventually yield reasonable returns. This approach not only ensures the safety of the investment but also provides a stable foundation for future returns.
Financial Data：
Consolidated Net Assets (Book Value): Approximately $4.5 million, or $75 per share. Consolidated Working Capital: Approximately $50 per share. Our valuation of the holdings at year-end: $35 per share.
Investment and Valuation：
Buffett's average purchase price when obtaining controlling interest was approximately $28 per share, and currently valued at $35 per share, this holding accounts for 21% of the partnership's net assets.
Quotes
You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism.
Independent Judgment：
Buffett emphasizes that correct judgment should not rely on the agreement of the majority or the support of authoritative figures. True correctness stems from independent analysis and judgment based on facts and logic.
Temporary Consensus：
Even if, at a given moment, a large number of people and important figures simultaneously support a particular viewpoint, this does not mean that the viewpoint is correct. Such consensus may be temporary and cannot serve as evidence of correctness.
Misunderstanding of Conservatism：
In many cases, people believe that if an action receives widespread support and appears to meet the standards of conservatism, it should be taken. However, this conservatism may not truly align with reason and logic.
You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.
Correct Assumptions：
Before making investment decisions, they must be based on correct assumptions. These assumptions should be based on thoughtful consideration and solid analysis, not emotions or popular opinions.
Correct Facts：
Decisions must be based on accurate and comprehensive factual information. Incorrect information or partial data can lead to wrong conclusions and poor investment decisions.
Correct Reasoning：
On the basis of correct assumptions and facts, reasonable reasoning is key. This requires clear logic and rational analysis, not relying on intuition or blindly following others.
Take Aways
Adherence to Principles, Maintaining Resilience：
Buffett emphasizes setting clear and correct rules in investment and adhering to these rules without being influenced by external short-term fluctuations and market sentiment.
Long-termism and Expectation Management：
Buffett hopes that investors will take a long-term perspective in viewing investments, preferably in five-year units rather than focusing on short-term performance. What matters is consistently outperforming market standards, rather than getting excited or discouraged by short-term fluctuations.
Maintaining Independent Judgment：
Despite other amateur investors possibly presenting very tempting reports, Buffett still insists on his independent judgment, choosing undervalued securities and patiently waiting for the market to correct.
Avoiding the "Agency Problem"：
The Buffett family concentrates all its tradable securities investments in the partnership, avoiding conflicts of interest that might arise from agents, ensuring that investment decisions are highly aligned with family interests.
Tax Treatment and Merger Arrangements：
Submitting the proposed agreement to seek tax-free mergers and confirmation of partnership status to avoid double taxation and enjoy flexible income distribution methods.
Conservative Strategy and Risk Management：
Preferring to bear the penalty of excessive conservatism rather than face permanent capital loss due to pursuing high-risk returns. Increasing shareholding ratios and gradually controlling companies ensure steady returns over the long term.
Long-term Planning and Execution：
All planning is done on an annual basis; the operations of Dempster Mill stock are the result of years of effort, ultimately achieving majority control of the company. This shows that many of Buffett's investment operations are not accomplished overnight but are the result of long-term planning and execution.
Independent Judgment：
Buffett emphasizes that correct judgment should not depend on the agreement of the majority or the support of authoritative figures. True correctness stems from independent analysis and judgment based on facts and logic.