Annual letter to limited partners – 1958
Have you heard of the phrase ‘people with mercurial temperament’? It is reserved for people who undergo sudden and unpredictable changes in mood. More or less those with an unstable mind. In the 1958 letter, WB says that the market is filled with such people more than ever. He says, “during the past year almost any reason has been seized upon to justify “Investing” in the market.” And by saying that, for the second year in a row, WB states that the markets are overvalued and it may come down crashing sooner or later.
WB continues to forecast in this letter too that the results from the partnerships will be above average in a declining market, but it will be “all we can do” to keep pace with a rising market. Read our previous issue to find out why he says that.
Commonwealth Trust Co. – 60% return in 2 years
The Buffett partnerships at that time had a near 20% stake in a bank called Commonwealth Trust Co. of Union City. It was about half the size of one of the biggest banks in Omaha at that time. The intrinsic value of Commonwealth Trust, according to WB, was about $125 at the time the partnerships started acquiring shares in the business. The stock was trading at $50 apiece while the business was earning $10 per share. (PE of 5X).
Why did WB invest in Commonwealth Trust? – Two reasons.
- The stock was undervalued compared to its intrinsic value
- More importantly, there was a potential merger in the cards between the bank and another bigger bank which owned about 25% of Commonwealth. This merger had the potential to unlock massive value.
But the merger just wasn’t happening due to ‘personal reasons’ and Buffett believed it would have to happen sooner or later. The stock of Commonwealth was very thinly traded and hence buying a substantial quantity without letting the price run-up was a challenge. And this is why Buffett says that it is important to make sure there is no ‘leakage’ of information.
In the year 1958, while the merger still hadn’t happened, the price of Commonwealth’s stock had run up to $80/share. The partnerships sold out its holdings making 60% gains. They sold out NOT because the price had run-up, but because Buffett had identified another more promising opportunity where the partnerships could take up a more substantial position with a higher certainty of being able to unlock value. And this is such a key trait to adopt. People often buy in and sell out of stocks on the basis of price movements. But there should really be only 2 reasons to sell out of a stock
- The fundamental thesis on the basis of which the investment was made has changed
- There is another opportunity which offers a higher return/more certainty of value unlocking.
Let’s keep that in mind!
At the end of the letter, Buffett says, that given the extremely high valuations in the market, he will struggle in finding attractive investment opportunities. This is because his investment style, value investing, requires him to find stocks that are significantly undervalued compared to the business’ intrinsic value. And that is a hard thing to do when markets have run-up.
To be continued...