Warren Buffett: “The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing in peanuts back then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
#01. MEASURING UP
Imagine being a duck sitting on a lake. When the water level rises, up goes the duck, and when the water level goes down, so does the duck. It is easy to fool yourself into believing that you are moving up in the world, you know, that you are some duck when actually, all that is happening is that it is raining heavily. In fact, the duck can only take credit when it is his own flapping of his wings that makes him take off. During the 12 full partnership years, Buffettnever had a down one, or even a year when he performed worse than the market overall– although he prepared his fellow investors to expect both. He repeatedly tried to teach his partners that being down 10% a year when the market declines 35%, is a splendid year. And a year when the market is up 20%, and the partnership only advances 15% is not nearly as good. Therefore, the result in 1957 is better than the one in, for instance, 1959. This way of thinking was clearly a bit disruptive to the partners, as it was a recurring subject in his letters at the time. If you don’t really like ducks, here's a metaphor from golf for you: “the important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.”
Relative performance is way more important than absolute performance when it comes to measuring your stock market accomplishments. Always use a benchmark, such as the S&P 500 or the Dow Jones Industrials to see how you compare. Don’t fool yourself into believing that you are a genius when all that is happening is that we’re in a bull market. Moreover, don’t bash yourself for losing money in a year when the market is crashing.
#02. BUFFETT'S EARLY TOOLBOX
During the Buffett Partnership Ltd era Buffett saw opportunities everywhere and most of the time he had more ideas than he had money to invest. The opportunities were comprised of three main categories - Generals, Workouts, and Controls.
The Generals were investments in undervalued common stocks, and usually made up the biggest part of BuffettPartnership Ltd’s, or BPL’s investments. Buffett’s main dish here was tiny, obscure, and off-the-radar companies, which often traded below liquidation value. Many of the generals were “cigar-butt” like investments. The analogy is that a cigar butt found on the street oftentimes has one more good puff left in it and that the average pedestrian doesn’t notice that, mistaking it for trash. This can be true for businesses too; even though they may be in a tough situation, they can be even cheaper than that. To be fair – Buffett was still looking for businesses with competitive advantages in good industries, with good management running them, but above all, he wanted to buy at a low price. As always, price is what you pay, value is what you get.
Within this category, there were two sub-categories – “private owner basis” and “relatively undervalued”. The distinction was simply made because of the market caps of the companies he bought into.
Companies within the “private owner basis” category were so small that, eventually, BPL could seize control over the whole business if management didn’t do its job well.
In the “relatively undervalued” category, the companies were too big for Buffett to be able to have this backup of sorts.
An important investment from the first category was Dempster Mill Manufacturing. From the second category, the most famous example is probably the financial service company American Express.
Next up is what Buffett calls the Workouts. These are special arbitrage resembling situations. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc. lead to these workout situations. Within this area, Buffett also consistently used leverage, up to a maximum of 25%. However, beware, this is an area where mistakes oftentimes are punished quite hard. Buffett tended to focus more on Workouts as the market was rising, as the expected return on the Generals at the same time was shrinking. This gave his portfolio a cushion in bad years, sort of like a hedge, but it also had a dampening effect on his results during really good years – this is because the Workouts have little or no correlation with the general market. A bank called Commonwealth Trust Co.had some workout potential, and we’ll go through this investment more in detail in takeaway 4. “Give a man a fish and you feed him for a day. Teach a man to arbitrage and you feed him forever.”
The third and last of the categories was the so-called Controls. This is where Buffett bought a controlling stake of a company, and where he saw no choice but to take on an active role himself. Typically, Buffett only did this if the management continued to stubbornly reinvest cash in a business with dismal prospects. Rather, he wanted that money to be put to use elsewhere, perhaps in entirely different industries. This is how he built Berkshire Hathaway from a textile manufacturer into the gigantic conglomerate that it is today. Berkshire was the ultimate Control situation. So, these were the three different types of investments Buffett juggled with, in order to create those stellar results. The Workouts are something I know that at least I can be better at in including in my own toolbox. How about you?
#03. (OVER?) - DIVERSIFICATION
When it comes to portfolio sizing, it is generally seen as a conservative thing to have a lot of different stocks, and only a few percentages in each one of them. Buffett, on the other hand, is convinced that when the right conditions are met, it is stupid to not load up heavily on your best plays. Although he would have loved to have 50 different stocks in which he saw the same level of opportunity, the stock market just doesn´t work that way. There aren’t 50 great opportunities present in the stock market at all times, and more importantly, there’s no way that neither you, me, nor even Buffett himself, would be able to identify all 50 of them even if they were out there. The keyword here is opportunity cost and you should always remember that spending time, effort, and money on your 18th most attractive idea subtracts time, effort, and money from your top 5 ones.
Consider this: - In 1958, 20% of the partnerships’ money was invested in that bank which we shall talk about later – the Commonwealth Trust - In 1960, no less than 35% of the assets were invested in the mapping business of Sanborn Map - In 1966, a whopping 40% was invested in American Express This is what a somewhat older Buffett has to say about diversification: You know, we think diversification is - as practiced generally - makes very little sense for anyone that knows what they’re doing. Diversification is a protection against ignorance.
Sure, having some diversification does make sense as it is impossible to foresee every potential risk of an investment, even if you spend tons of time with it. However, if you can find, say, 6 – 8 diverse companies, you can neutralize the bulk of these unforeseen and unknown consequences. This advice is perhaps not ideal for beginners, as a more concentrated portfolio will lead to higher volatility and therefore a higher degree of psychological stress. I´m going to use the same quote to end this takeaway that Buffett used in 1966 to wrap up his writings about over-diversification: “If you´ve got a harem of seventy girls; you don´t get to know any of them very well.”
#04. COMMONWEALTH TRUST CO.
In Buffett´s 1959 letter to partners, Buffettwrites about a situation from 1958, in order to teach his partners how he thinks about a typical investment. If Buffett thought his partners could learn something from the example, I´m sure we can too! The example is regarding his investment in commonwealth Trust Co. of Union City. I will highlight specific parts from the case and sometimes add my own comments in between. Last year I referred to our largest holding which comprised 10% to 20% of the assets of the various partnerships. I pointed out that it was in our interest to have this stock decline or remain relatively steady so that we could acquire an even larger position and that for this reason, such security would probably hold back our comparative performance in a bull market. This stock was the Commonwealth Trust Co.of Union City, New Jersey. Let´s pause there. So, in Commonwealth Trust Co., Buffett invested a big chunk of his partnerships’ money. He was clearly not afraid of a concentrated portfolio, which we’ve discussed earlier. What also strikes me is how he wanted the stock to remain steady, or even decline somewhat, so he could build up the position even more. This demonstrates his long-term perspective. Back to Buffett. At the time we started to purchase the stock, it had an intrinsic value of $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend at all despite earnings of about $10 per share, which was largely responsible for a depressed price of about $50 per share. Stop, stop! Notice that margin of safety. He thought it was worth $125 right now but it was selling for just $50. He had also identified what he thought was the main issue for the depressed share price.
Commonwealth was 26% owned by a larger bank, which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely. The risk of losing money on the investment looked minimal. Buffett wanted a buyout, that would unlock the value of the investment quick, but he was fine with waiting many years too as he saw that value would most likely build up in that case too. After all, the investment was still earning money at a fast rate at a P/E of 5. So, heads, he wins big, and tails, he doesn´t lose. Let´s continue. Over a period of a year or so, we were successful in obtaining about 12% of the bank at a price averaging about $51 per share. Obviously, it was definitely to our advantage to have the stock remain dormant in price. Our block of the stock increased in value as its size grew, particularly after we became the second-largest shareholder with sufficient voting power to warrant consultation on any merger proposal. 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 Commonwealthobtaining $80 per share although the quoted market was about 20% lower at the time. Pause! Ok, so even though Buffett still very much liked the investment, he decided to sell out because an even more attractive situation showed up(which I think was Sanborn Map by the way). In order to maximize the expected performance of our portfolios, we too must be ready to leave a company which we know the ins and outs of, like Buffett in Commonwealth, in order to redeploy the capital where we see a better risk-adjusted return. Let´s hear his final remarks on the case. Pay extra attention to the implicit margin of safety. I might mention that the buyer of the stock at$80 can expect to do quite well over the years. However, the relative undervaluation at $80with an intrinsic value of $135 is quite different from a price of $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it. Wow, wasn´t that a gem?
#05. GO - GO YEARS
Simultaneously with Buffett’s success in value investing in the 1950s and 1960s, another, quite opposite investing approach was gaining in popularity. This era was dubbed the Go-Go years and a quote from a money manager at Wall Street at the time will have you understand what this new investing approach was all about. “The complexities of national and international economics make money management a full-time job. A good money manager cannot maintain a study of securities on a week-by-week or even a day-by-day basis. Securities must be studied in a minute-by-minute program.”
Buffett said that this type of thinking made him feel guilty for going out for a Pepsi (he hadn’t started drinking Coke yet). During the 1960s, speculation remerged after having almost completely vanished ever since the Great Depression some decades earlier. Growth funds became a big thing, and besides measuring performance on a day-to-day basis, sometimes “just spending a couple of nights together” with their stocks, Wall Street had found another love, or perhaps I should say one-night stand.
Conglomerates: During this Go-Go era, conglomerates practiced something that was called the “P/E trick”, nowadays referred to as “multiple arbitrages”. When a company trading at P/E 20 buys an equally sized company trading at P/E 10, you could argue that the combination should be trading at P/E 15. But during the Go-Go years, there was an overconfidence in synergies, people thought that 2+2=5 in every single merger, and the newly formed company usually traded at the acquirer’s initial multiple. Therefore, companies could “create value” by buying lower-valued companies. A certain Swedish casino/betting company that I owned between 2013-2017 incorporated this P/E trick too, so I don’t know, perhaps it's getting fashionable again. The P/E trick was a way to make trees grow to the sky, and the market loved it. But this only worked until it didn´t … The Go-Go years came to an end when one of its most famous followers, the money manager Gerald Tsai and his Manhattan Fund delivered a return of -6.9% for the year 1968, as the Dow returned 7.7% (and yea, Buffett returned 58.8%). The Manhattan Fund would lose more than 90% of its assets under management during the ensuing years.
After a decade of warnings from Buffett, the Go-Go funds became the No-Go funds. Buffett, and value investing, prevailed once again.
- Relative performance is more important than absolute performance - You need multiple tools in your investment toolbox. If you can’t find any undervalued companies currently, perhaps it is time to look for some arbitrage opportunities? - Diversification is a protection against ignorance - Okay, I admit it! The Commonwealth Trust case was just a sneaky way of pushing more than 5 takeaways into the 5 takeaways format. - Calculate, don´t speculate. Fads come and go.
If you just can’t get enough of Warren Buffett, here’s a post based on his letters to Berkshire Hathaway shareholders. Cheers guys!