Portfolio manager’s Letter November 2001
Bull markets are great for investors that like to buy and hold, but bull markets do not go on forever.
Since the end of World War II the Stock market has experienced two great bull markets. The first of these ran from early in 1950 to March 1966 or for about 16 years. The Dow started this period with a breakout above 200 and ran to just short 1000 in 1966, for net gain of about 400%. The next great bull market started in August of 1982 when the Dow made a decisive breakout above the 1000 mark that it first approached in 1966. It now looks to have ended in spring of 2000 with the Dow just short of 12,000.
These two bull markets where separated by 16 year period where the Dow first approached 1000 in 1966, but was unable to stay above 1000 until late in 1982. It has been suggested that we may now be entering a similar period. Reinforcing this view is Warren Buffett’s prediction of low returns from stocks for the next ten to fifteen years, and the general perception that stock prices have run ahead of their ability to generate earnings to support the prices reached in early 2001.
My own personal view is that it is usually foolish to make predictions about market trends, but I do not believe that one quick bear market will solve our long term valuation problems. It took a seventeen years of bull market to get us to where we are today and one, two or three-year bear market is not likely to correct all the problems it took seventeen years to create.
The late sixties and seventies are a period that I remember well. With what can only be described as exquisite timing, I took a job as a trainee for Merrill lynch in late 1967 and therefore had a front row seat as the market did its best to imitate a roller-coaster for the next fifteen years.
The trading range for the Dow ran from 600 at the lows – 1000 at the highs, and the market went back and forth between these two extremes regularly during this period. While these swings of 300 – 400 points in the Dow may seem innocuous by today’s standards they were in fact gut wrenching. There were four of five bear markets in the 20% – 50% range each followed by a brief bull that would carry back to the old highs, but no further. The swings from bottom to top would take a year or two, and even though the averages eventually recovered there were many sectors in each bear that suffered a fate similar to what is happening to the Tech stocks today.
It was a rough time for the buy and hold people. At least those that bought to hold at the wrong time. If you bought in the 1950’s you probably did all right. The companies that were popular in the fifties where blue chips and the valuations were cheap. But, if you brought in late sixties or any time in the seventies you either bought junk or you paid too much.
If you bought and held you probably lost a lot of your capital. Most of the late comers were out of the market by 1982, having given up in disgust and promising never to invest in stocks again. This, of course, gives rise to a wonderful irony. Whether buy and hold turned out to be good or bad probably was mostly a matter of timing.
What I remember about the seventies can be summed up as follows:
So what was Warren Buffett doing during this period? In the late 1960’s, he was winding down his Partnerships with returns as follows:
In the case of Berkshire Hathaway from 1966 through 1982, Berkshire Hathaway’s book value increased by an average of 23% per year (Warren Buffett beat the Dow for the 17-year period 391% to zip). The most remarkable thing is there were no down years for Berkshire Hathaway during the entire 17 years while the Dow had six.
So why was Warren Buffett doing so well during this period while the market averages were going nowhere and the small investor was getting killed? An even more interesting question is what lessons does his trading offer for those of us who would like achieve double digit returns on our investments in the years ahead?
We do not have a good trail of Warren Buffett’s behavior during the early 1970’s because the chairman’s letters are only available since 1977, but if we look at what is available in the Letters from 1977 – 1985 we see behavior very much in the traditional value investor – Ben Graham pattern. Buying stocks when they are undervalued and selling them as they approach full value. Rarely were positions held more than a year or two.
The partnership letters do not list specific position changes, but the management style was aggressive, it included the use of some leverage and a lot of arbitrage, but the stock trading appears to be similar to what we saw at Berkshire Hathaway ten years later. While value investing, in this traditional sense, is not a vehicle for market timing. It works well in markets like the 1970’s because the value approach encourages purchase when markets are down and sales when stock approach full value.
The lessons for today’s investors are pretty simple. It is just basic Ben Graham, buy value, and do not get greedy. Can we expect to get a return like Warren Buffett did from 1966 – 1982? Of course not. Can we expect the 20% – 25% returns that we saw in the 1990’s? I doubt it. Can we expect 12% to 15%, as opposed to the 5% – 7% that Warren Buffett expects from the over all market? With careful stock selection and lots of patience this sounds reasonable to me.