Berkshire Hathaway was born as a result of a merger between Hathaway manufacturing co., a manufacturer of synthetic & cotton textiles and Berkshire fine spinning, a giant producer of fine cotton textile products in the year 1955. At the time of the merger, Berkshire Hathaway’s book value of total assets was $55 Million. The business performed so poorly over the next decade that book value dropped to just $27 Million in the year 1964.
That year, a young 34-year-old Nebraskan, took management control of the company by acquiring majority ownership in the business. He was a millionaire already by then. But his total wealth at that point in time was quite-frankly ‘chicken-feed’ compared to his total wealth today. Yes, yes, it is Warren Buffett we are talking about.
Today, Berkshire Hathaway is not a textile company at all. Every single textile operation was shut down by the year 1985. But that didn’t lead Buffett into ruin. The company is worth $500 Billion today! An amount of $10,000 invested in the company that year in 1965 would have equalled $274 Million as of the end of 2019. But how did he do it? And what can we learn from him?
To look for answers, it is imperative that we study the annual letters Buffett sent to his shareholders in Berkshire Hathaway since 1965 and before that to the limited partners in Buffett Partnership. This weekly column will capture brief summaries from each of those letters from 1957 to 2020. Our objective – Understand Buffett’s investing style.
Annual letter to limited partners – 1957
The 3 different Buffett partnerships that existed as of 1957 were launched during different years. They were invested in the same stocks in the same % and operated on the basis of 2 investment strategies.
General-issues, which are minority investments in undervalued stocks
Work-outs, which are investments made with the intent to gain management control and unlock value through mergers, liquidation, tender etc.
In 1957, the partnerships was predominantly invested in general-issues (85%).
NOTE : The third partnership which clocked in 25% returns was launched the year before in 1956 when markets were at a lower level and stocks were attractive. Two additional partnerships were launched in 1957.
Intrinsic value vs. Market value
WB opens the letter by saying that the general market level is expensive and priced above intrinsic value. He says that if his view is accurate, then there is a possibility of substantial decline in stock prices. Buffett’s plan was to deploy more money into the markets if prices corrected significantly. If they did not, WB suggested that the partnership will book profits on the stocks and increase investments in ‘work-out’ portfolio. Buffett says that the primary objective of the partnership was to invest in companies that were substantially undervalued.
To offer some context, the year 1956 witnessed a moderate decline in stock prices. However, it was Buffett’s opinion that earning potential of businesses had declined substantially. So, in essence the investing public was much more bullish about stocks than the general economic picture warranted. We draw a parallel to a time like now when stock prices have significantly recovered. However, earning potential in several businesses have substantially decreased following the pandemic. Could it be true then that the intrinsic value of the businesses are overvalued and we could expect a correction in stock prices? If it does, then as Buffett says, are we ready to invest more money into the markets?
Growth stocks vs. Value stocks
Due to the nature of Buffett’s investment style (value investing), he says that during bear markets he’d expect his portfolio to do better than the index. But he’d be quite happy to just match the index during bull markets. This is a statement he’d repeat several times over the next few years.
Why is that? Value stocks tend to do better in bear markets. This is because in value investing, the main objective of the fund manager is to identify such stocks where the difference between market capitalisation and book value of assets is quite low. And this book value of assets provides a cushion to stock prices during bear markets. Growth stocks on the other hand will suffer the most in bear markets as growth outlook becomes more grim and the stock market valuation premium attributed to profits growth gets erased. The euphoria around growth stocks works both ways. So in bull markets, value stocks typically tend to appreciate less in prices compared to growth stocks. This is why Buffett makes that statement several times.
To be continued...