1958 Annual Letter to Partners
Buffett's third annual letter featuring the Commonwealth Trust Co. case study — a masterpiece of patient value investing and special situation analysis.
1958 Annual Letter to Partners
Warren E. Buffett | February 11, 1959 | Omaha, Nebraska
The General Stock Market in 1958
A friend who runs a medium-sized investment trust wrote:
"The mercurial temperament, characteristic of the American people, produced a major transformation in 1958 and 'exuberant' would be the proper word for the stock market."
This summarizes the psychology dominating the stock market in 1958 at both amateur and professional levels. During the past year, almost any reason has been seized upon to justify "Investing" in the market.
Buffett's view:
"I make no attempt to forecast the general market — my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble."
Results in 1958
1958 was a bull market year where Buffett expected to merely match the averages — and he did:
| Metric | Value |
|---|---|
| Dow-Jones Industrials (Start of 1958) | 435 |
| Dow-Jones Industrials (End of 1958) | 583 |
| Dow-Jones with Dividends | +38.5% |
| Partnership Range | +36.7% to +46.2% |
| Partnership Average | Slightly better than 38.5% |
Given that substantial assets were invested in securities that benefited very little from a fast-rising market, these results were considered reasonably good.
Forecast maintained: Results would be above average in a declining or level market, but in a rising market, keeping pace would be considered satisfactory.
The Commonwealth Trust Co. Case Study
The Opportunity
Commonwealth Trust Co. of Union City, New Jersey presented the following characteristics:
| Attribute | Detail |
|---|---|
| Intrinsic Value (conservative) | $125 per share |
| Market Price | ~$50 per share |
| Earnings per Share | ~$10 per share |
| Cash Dividend | None |
| Valuation Discount | 60% |
A well-managed bank with substantial earnings power selling at a large discount from intrinsic value. The lack of cash dividend despite strong earnings was the primary reason for the depressed price.
The Catalyst
Commonwealth was 25.5% owned by a larger bank (Commonwealth had assets of about $50 million — about half the size of First National in Omaha). The larger bank had desired a merger for many years, but personal reasons prevented it. There was evidence this situation would not continue indefinitely.
Three Key Characteristics
- Very strong defensive characteristics
- Good solid value building up at a satisfactory pace
- Evidence that eventually this value would be unlocked — though it might be one year or ten years
If ten years, the value would presumably have built up to a considerably larger figure — say, $250 per share.
The Accumulation
Over a period of a year or so, the partnership obtained about 12% of the bank at a price averaging about $51 per share. It was definitely to their interest to have the stock remain dormant in price. As the block of stock increased in size and they became the second largest stockholder, they had sufficient voting power to warrant consultation on any merger proposal.
Commonwealth only had about 300 stockholders and averaged only two trades per month — illustrating why general market activity had very little effect on some portfolio holdings.
The Exit
"Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share although the quoted market was about 20% lower at the time."
The buyer at $80 could expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value of $135 was quite different from a price of $50 with an intrinsic value of $125.
Lessons Learned
"The year when a situation such as Commonwealth results in a realized profit is, to a great extent, fortuitous. Thus, our performance for any single year has serious limitations as a basis for estimating long term results."
However, Buffett believed:
"A program of investing in such undervalued well protected securities offers the surest means of long term profits in securities."
New Position
The capital from Commonwealth was reinvested in a new situation, somewhat larger than Commonwealth, representing about 25% of partnership assets. While the degree of undervaluation was no greater than many other securities owned, the partnership was the largest stockholder — a substantial advantage in determining how long required to correct the undervaluation.
Current Situation
"The higher the level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments."
Buffett was attempting to "create my own work-outs by acquiring large positions in several undervalued securities" — a policy that should lead to above average performance in bear markets.
Related
- partnership-letter-1957 — Previous year establishing the General/Work-out framework
- partnership-letter-1959 — Following year discussing market levels and partnership performance
- warren-buffett — The author
- margin-of-safety — Buying at 60% discount to intrinsic value