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Weekend Investor

Warren Buffett's winning ways, 50 years on

Reuters

SAN FRANCISCO (MarketWatch) -- Warren Buffett doesn't usually make market predictions, but in an early July letter to shareholders, the legendary investor offered insights to help them through a treacherous stretch for stocks.

"I think you can be quite sure that over the next ten years there are going to be a few years when the general market is plus 20% or 25%, a few when it is minus on the same order, and a majority when it is in between," Buffett wrote. "I haven't any notion as to the sequence in which these will occur, nor do I think it is of any great importance for the long-term investor."

This letter hasn't received much attention lately, for good reason: It's dated July 6, 1962.

Half a century on, Buffett's advice to ignore market gyrations still resonates. Yet many investors have trouble looking ahead 10 days, let alone 10 years. Of course, investors nowadays have justifiable fears about their money and who's minding it. The safe return of capital is paramount, while the idea of losing your shirt in a bid for a meaningful return is paralyzing.

So what's new? Risk aversion is hard-wired in human nature. A greedy market feeds on fear. Otherwise Buffett wouldn't have needed to remind investors to keep a lengthy time horizon.

Investors in 1962 had something to be scared about. The Cuban Missile Crisis wouldn't take the world to the nuclear brink until October, but the Cold War between the U.S. and the former Soviet Union was heating up. The Dow Jones Industrial Average (DJIA) tumbled 23% in the first six months of 1962, erasing its 22% gain of the year before. That May 29 a "flash crash" shaved almost 6% off the Dow in a single day.

Cool under pressure

Through it all Buffett stayed cool. Stock buyers need a long lens, he counseled. "Six months' or even one-year's results are not to be taken too seriously," Buffett said in that July letter to his Buffett Partnership Ltd. investors. He added that "investment performance must be judged over a period of time, with such a period including both advancing and declining markets."

The 1962 letter is online along with other Buffett shareholder communications from the late 1950s and 1960s, including his May 29, 1969 letter informing investors of his intent to dissolve the limited partnerships (and offering them a stake in its Berkshire Hathaway Inc. holding) (BRK.A) (BRK.B)

Seen with the benefit of 50-year hindsight, Buffett's 1962 letter and another written in January 1963 are relevant for today's investors, who face a global economy on the brink, if not of disaster, then certainly of profound change.

"There are lessons [in the partnership letters] on temperament, value and being a voracious learning machine," said Jeff Auxier, who has long included Berkshire shares in his Auxier Focus Fund (AUXFX) .

"All of the great investors do it the way Buffett does," he added. You've got to do massive amounts of homework and have the patience to wait for the right price. Anyone dealing with their own money should study that before they invest."

The early 1960s correspondence shows that Buffett, who turns 82 on Aug. 30, hasn't lost the essence of his younger self. Then, as now, he stressed preserving capital in down markets, not chasing the market in runaway years, and focusing on long-term challenges and results.

But what many investors fail to grasp is that the long-term according to Buffett has never been about passive buy-and-hold; it's buy-on-the-cheap, hold and monitor. That goes for the undervalued common stock, opportunistic workout situations, and wholly or majority-owned "control" businesses that are Buffett's hallmarks.

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results," Buffett wrote in a January 1963 shareholder letter.

Buffett started his first limited partnership in May 1956, a 25-year-old disciple of pioneering value investor Benjamin Graham with $105,000 from family and friends to invest. By the start of 1963, Buffett's several partnerships controlled $9.4 million -- about $70 million in inflation-adjusted dollars, according to the Bureau of Labor Statistics -- including $1.4 million of Buffett's own money.

Buffett's success wasn't hard to fathom: Over the previous five years, the Dow had returned 8.3% on average annually; Buffett's partners had gained 21% a year, after fees.

Buffett wasn't as forthcoming then about investing mistakes as he's been in recent years, but he did repeatedly caution his partners that his deep-value strategies would most likely thrive in flat or down markets and lag in bull markets.

Indeed, in 1962 the Dow shed 10.8%, excluding dividends. Buffett's common stock portfolio didn't make money either. But Buffett's partners gained 11.9% for the year after fees thanks to workouts and control situations that were relatively untouched by the overall market. (The privately held investments would drag down returns in other years.)

Writing in the January 1963 letter, Buffett said that clobbering the Dow by 13 percentage points over five years exceeded his own goal of beating the benchmark by 10 points annually on average over many years, and he encouraged his partners to "mentally modify" their expectations.

Buffett repeated his mantra about performance: "Our job," he wrote, "is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a given year are a plus or a minus." (By late 1967, Buffett, finding fewer bargains, would trim his hoped-for margin of Dow outperformance to 5%.)

'The Ground Rules'

In the 1963 letter, Buffett also laid out seven requirements for his partners, which he called "The Ground Rules." Two are housekeeping-related; five bear repeating:

-- "In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that -- withdrawing."

-- "Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year," Buffett wrote. Although Buffett's portfolio differed greatly from the Dow and his investing style hardly matched that of mutual funds, the Dow and several big U.S. funds nonetheless were Buffett's ultimate measures. He noted: "If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes."

-- "While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to put our money."

-- "I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership."

-- "I cannot promise results to partners," Buffett stated. "What I can and do promise is that our investments will be chosen on the basis of value, not popularity; that we will attempt to bring risk of permanent capital loss…to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments, and my wife, children and I will have virtually our entire net worth invested in the partnership."

Decades from now, what will still be most striking about Buffett's letters from the early 1960s is their openness. Not in terms of portfolio holdings -- Buffett didn't divulge that -- but in the honest reveal of an investment philosophy. Investors today, accustomed to marketing materials that rarely divulge a manager's decision-making process, can only marvel at Buffett's bluntness. He treats partners like the adults they are.

That's one reason why Berkshire Hathaway's shareholder letters are required reading among informed investors, and why so many others with fear-and-greed products to peddle want to portray Uncle Warren as doddering and out of touch.

Don't believe it. People will follow Buffett's advice long after today's doom-sellers are forgotten.

As Buffett told partners in his January 1962 letter. "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.

"You will be right," he wrote, "over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct."

Buffett early on recognized the secret of successful investing: Any kid can make a buck; grown-ups know how to keep it.

Jonathan Burton owns Berkshire Hathaway Class B shares in a retirement account.