Buffett Partnership Letters
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Buffett Partnership Letters
“You will not be right simply because a large number of people momentarily agree with you.”
“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct.” (Jan. 1962 letter, page 7) - Warren Buffett
Having amassed a fortune that surpasses one-hundred billion dollars, Warren Buffett’s ageless career has been scrutinized from top to bottom. However, with the majority of his wealth acquired throughout the latter half of his career, we feel recent attention has been heavily focused on Berkshire Hathaway and consequently diverted from the wild successes of the Buffett Partnership, which he operated from 1956-1969. As a result, it may be beneficial to re-examine some the partnership’s strategies and principles regarding their relevance to the equity markets of the modern era.
Strategy by Category
Generals – Private Owner Basis – “A category of generally undervalued stocks, determined by quantitative standards, but with considerable attention paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation of the enterprise substantially below what careful analysis indicates its value to the private owner to be. Again, let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management – we like a decent industry – we like a certain amount of “(ferment)” in a previously dormant management or stockholder group. But, [sic] we demand value (Jan. 1965 letter, page 9).”
Generals tend to move, more or less, in correspondence with general market activity. This category was the best performer within the partnership’s portfolio throughout rapidly rising markets, and vice-versa “the most vulnerable in a declining market (Jan. 1962 letter, page 5).” As the Dow advanced and partnership assets increased, opportunities became scarce in this area (Jan. 1966 letter, page 7).
Since the amount of portfolio turnover is dependent on idea generation, these experiences incentivized the adoption of a buy-and-hold mentality when a controlling interest became attainable. When a business achieves “worthwhile overall returns on capital employed (say, 10 - 12%),” Buffett expresses how “it seems foolish to rush from situation to situation” in order to earn a few more percentage points (Jan. 1968 letter, page 5). As long as high-grade individuals continue to operate the organization, disrupting the compounding process appears unnecessary under these circumstances.
Generals – Relatively Undervalued – “This category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept. It is important in this category, of course, that apples be compared to apples – and not to oranges, and we work hard at achieving that end. In the great majority of cases [sic] we simply do not know enough about the industry or company to come to sensible judgements – in that situation we pass.
“As mentioned earlier, this new category has been growing and has produced very satisfactory results. We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a revaluation takes place so the latter only sell at 10 times. This risk has always bothered us enormously because of the helpless position in which we could be left compared to the “Generals – Private Owner” or “Workouts” types. With this risk diminished, we think this category has a promising future (Jan. 1965 letter, page 10).”
Unfortunately, Buffett provides no details of the technique utilized to mitigate risk regarding an overall downward shift of valuation standards. But Jeremy C. Miller, in his book Warren Buffett's Ground Rules, describes it this way: “This new investment method was somewhat riskier because there was no potential for the Buffett partnership or any other private owner to acquire control in these companies; Buffett mitigated some of that risk by hedging them, meaning when he bought one he would sell short the more expensive peer company.”
Workouts – “These are securities with a timetable. They arise from corporate activity – sell outs, mergers, reorganizations, spinoffs etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc. The gross profits in many workouts appear quite small. It’s a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss.
This category produces more steady absolute profits from year to year than generals do. In years of market decline it should usually pile up a big edge for us; during bull markets it will probably be a drag on performance. On a long-term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals (Jan. 1965 letter, page 10).”
While Buffett is not particularly known for utilizing a large amount of leverage, from time to time he strategically financed purchases with debt. When lending rates were relatively low in 1962, the partnership’s annual interest payments totaled $75,000 on $1,500,000 of borrowed funds (equivalent to a five-percent interest rate). Considering the category’s nature regarding predictable returns paired with a comparatively brief holding period, the intention was to off-set a portion of the capital committed to “workouts.” By limiting aggregate borrowings to twenty-five percent of the partnership’s net worth, Buffett continued to favor a conservative portfolio despite the arbitrary twenty-five percent ceiling (Jan. 1963 letter, page 7).
Perhaps a future white paper on Joel Greenblatt’s book, You Can Be a Stock Market Genius, would be appropriate due to its focus on special situations and their case-by-case intricacies.
Controls – “These are rarities, but when they occur [sic] they are likely to be of significant size. Unless we start off with the purchase of a sizable block of stock, controls develop from the general – private owner category. They result from situations where a cheap security does nothing price wise for such an extended period of time that we are able to buy a significant percentage of the company’s stock. At that point we are probably in a position to assume a degree of, or perhaps complete, control of the company’s activities. Whether we become active or remain relatively passive at this point depends upon our assessment of the company’s future and the management’s capabilities (Jan. 1965 letter, page 11).”
During strong markets, “control situations” were expected to be a drag on performance resulting from methodological differences when calculating year-end valuations. “Underscoring this concept is the fact that controlling interests frequently sell at from 60% to 500%” of their minority held quotations (Nov. 1966 letter, page 2). While minority positions are exclusively valued based on market prices, which are susceptible to containing speculative components in rapidly rising markets, the partnership’s 1966 “control” gains were predominately attributable to the following: (1) retained business earnings applicable to the partnership’s holdings; (2) open market purchases of additional stock below the controlling interest valuation and; (3) unrealized appreciation in marketable securities held by the controlled companies (Jan. 1967 letter, page 7).
Additionally, Buffett was tasked with assessing the following elements and their impact on the majority stake’s value each year: earning power, assets, industry conditions, accessibility to financing solutions, and competitive position to name a few. These factors became increasingly relevant as discounted cash flow valuations gained traction in the financial economic community.
Among the partnership’s strategies, the majority of investors consider “control situations” to be the least practical due to the significant sums of capital required. As a result, we anticipate our audience would deem further examination of this category to be an unwarranted use of their time.
Final Thoughts
A share of stock represents part ownership of a business. Therefore, as the business world evolves, logic suggests our investment strategies must evolve alongside it. Society’s rate of change may appear astonishing at times. However, be assured the world’s evolution will not hesitate for approval. It will not wait for academic studies to be published. And it will certainly not wait for you. In our opinion, one critical development relevant to the strategies discussed involve the availability of information and the speed with which it travels.
With the click of a button, the digital age has enabled access to information previously difficult to come by. As a result, the market has arguably become more competitive than ever. Two potential solutions to overcome this increased competition include: (1) directing focus toward stocks with market capitalizations under $300 million and; (2) concentration. By focusing on micro and nano-caps, individual investors can obtain a structural advantage over their institutional counterparts due to liquidity restraints. The odds of uncovering statistical bargains vastly increase as fewer eyes focus on the same idea. While analyzing businesses with little to no media coverage may require additional effort, there is no easy path to consistently earning outsized returns.
The latter solution predominately pertains to capital allocation. Since great ideas are typically few and far between, concentration may be an additional option for the diligent analyst. While there is nothing wrong with taking comfort in a widely diversified strategy, let us offer you some insight from Joel Greenblatt himself. There are two types of risks, market risk and non-market risk. If you owned “9,000 stocks, you would still be at risk for the up and down movement of the entire market (Greenblatt 20).”
Since Buffett could not avoid the inherent risks of market swings through simple diversification, “workout” situations likely attracted him due to their isolation from broad market activity. Ground rule number six of the partnership states, “I am not in the business of predicting general stock market or business fluctuations (July 1966 letter, page 5).” However, Buffett did believe “that wide-spread public belief in the inevitability of profits” would result in eventual trouble (February 1959 letter, page 1). This leads us to conclude that directing a higher percentage of funds toward “workouts” is a conservative strategy offering similar results that diversification aims to accomplish during times of exuberant valuations. Be forewarned that this strategy takes a great deal of effort and experience to successfully implement.
Non-market risk includes the risks unattributable to the general market’s directional action. While risk of this type can be diversified by owning more stocks, “statistics say that owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock (Greenblatt 20).” Supposedly, non-market risk is “reduced by 72 percent with a four-stock portfolio, by 81 percent with eight stocks, 93 percent with 16 stocks,” and so on (Greenblatt 21).
Without focusing too heavily on the precision of these numbers, they illustrate the fact that a one-hundred stock portfolio is unnecessary. Eight to fifteen stocks in a variety of industries should offer satisfactory diversification when allocated appropriately. The largest portfolio concentrations should not be the companies that offer the highest potential return, but rather the one’s that offer the least chance of permanent loss of capital. The conviction required for such concentration can only be created by conducting your own due diligence, and perhaps picking up an accounting textbook along the way.
Greenblatt, J. (1999). In You can be a stock market genius: uncover the secret hiding places of stock market profits (pp. 20–21). essay, Fireside.
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