This is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please see our previous articles for more details.

There are 3 separate letters detailing the occurrences of 1962:

• July 6, 1962 – interim (mid-year) letter
• December 24, 1962 – brief update with preliminary tax instructions
• January 18, 1963 – annual (year-end) letter

A slightly off tangent random fact: in 1962, Buffett into new office space stocked with – hold on to your knickers – “an ample supply of Pepsi on hand.”

Benchmark

“In outlining the results of investment companies, I do so not because we operate in a manner comparable to them or because our investments are similar to theirs. It is done because such funds represent a public batting average of professional, highly-paid investment management handling a very significant $20 billion of securities. Such management, I believe, is typical of management handling even larger sums. As an alternative to an interest in the partnership, I believe it reasonable to assume that many partners would have investments managed similarly.”

We’ve discussed in the past the importance of choosing a benchmark. It seems Buffett chose to benchmark himself against the Dow and a group of investment companies not because of similarities in style, but because they represented worthy competition (a group of smart, well-paid, people with lots of resources) and realistic alternatives to where Buffett’s clients would otherwise invest capital.

“Our job is to pile up yearly advantage 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. I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%.”

Interestingly, the quote above implies that Buffett focused on relative, not absolute performance.

Trackrecord

“Please keep in mind my continuing admonition that six-months’ or even one-year’s results are not to be taken too seriously. Short periods of measurement exaggerated chance fluctuations in performance… experience tends to confirm my hypothesis that investment performance must be judged over a period of time with such a period including both advancing and declining markets…While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance…If any three-year or longer period produces poor results, we all should start looking around for other places to have our money.”

In other words, short-term performance doesn’t mean anything so don’t let it fool you into a false sense of investment superiority. A three-year trackrecord is the absolute minimum upon which results should be judged, although five or more years is best in Buffett’s opinion. Additionally, the last sentence seems to imply that Buffett was willing to shut down the Partnership if return goals were not met.

“If you will…shuffle the years around, the compounded result will stay the same. If the next four years are going to involve, say, a +40%, -30%, +10%, and -6%, the order in which they fall is completely unimportant for our purposes as long as we all are around all the end of the four years.”

Food for thought: the order of annual return occurrence doesn’t impact the final compounding result (as long as you stick around for all the years). Not sure what the investment implications are, just a fun fact I guess – one that makes total sense once Buffett has pointed it out. Basic algebra dictates that the sequential order of figures in a product function doesn’t change the result.

Clients, Time Management

“Our attorneys have advised us to admit no more than a dozen new partners (several of whom have already expressed their desire) and accordingly, we have increased the minimum amount for new names to $100,000. This is a necessary step to avoid a more cumbersome method of operation.”

“…I have decided to emphasize certain axioms on the first pages. Everyone should be entirely clear on these points…this material will seem unduly repetitious, but I would rather have nine partners out of ten mildly bored than have one out of ten with any basic misconceptions.”

Each additional moment spent on client management, is a moment less on investing.

Keeping down the number of clients keeps things simple operationally – at least according to Buffett. I have heard contradicting advice from some fund managers who claim to prefer a larger number of clients (something about Porter’s Five Forces related to Customer Concentration).

For his existing clients, Buffett smartly set ground rules and consistently reminded his clients of these rules, thereby dispelling any myths or incorrect notions and (hopefully) preventing future misunderstandings.