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I was going over Buffett’s old letter to shareholders during his partnership years, and it blows me away the level of success he was able to achieve. For 11 years from 1957 to 1968, Buffett not only beat the market, he never had a down year. On a cumulative basis, his partnership achieved 2610.6% gains at a compounded rate of 31.6%!
Clearly no one has been able to follow suit, and a clear reason why we should stop fooling ourselves, because we are not Warren Buffett.
How did Buffett do it?
There are so many books on the types of companies Buffett likes to buy and how his holding period is forever, but few mention his strategy from the early days of his partnership where operations were run differently to today.
He had immaculate control and allocation of his positions and when he found a no brainer, was not afraid to dump 40% of the portfolio into a single company such as American Express following the salad oil scandal. Although the partnership results suggest that Buffett was able to find a no brainer once a year to go all in, I doubt that is true. What Buffett was kind enough to do was to provide his method of operations in most of his yearly letter to partnership shareholders.
Buffett’s Method of Operations
In the 1969 letter (pdf), there is a section showing the portfolio makeup of different categories. It goes like this.
What are these Categories?
An explanation of each of the categories is provided in the 1965 letter (pdf) to shareholders which I’ll reproduce here.
1. 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 tot he 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, we demand value.
2. 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 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 thing this category has a promising future.
Theses 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 ti 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 market it will probably be a drag on performance. on the long term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.
To learn more about workouts, here are some links you will be interested in.
- Special situations – spinoffs
- Special situations – stock tenders
- Special situations – going private transactions
- Book based on workouts
I haven’t participated in any workouts for a couple of years now. A small portfolio, and only being able to get involved in one at a time makes it very difficult as there certainly will be blowups. Having a basket of workouts is required for safety, but with just one or two, it could lead to serious damage.
These are rarities, but when they occur 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 tie 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.
Why Buffett is a Pure Investing Genius
He determined every investment into probabilistic terms. Rather than focusing on an absolute method of investing like Graham by just buying a basket of companies passing certain fundamental criteria, Buffett was much more opportunistic, probabilistic and circumstantial.
What I mean by this is that Buffett is not limited to a one dimensional investing process. He is fluid like water. To be able to hold such a large position in workouts and go activist in his control positions is not something everyone can do. The fact that Buffett was profiting so handsomely from special situations in his prime shows how far ahead he was from the rest of the pack. In terms of chess, Buffett would be ranked as a grandmaster capable of thinking 2-5 moves ahead in any situation.
Think about your portfolio makeup and investing strategy. I certainly have and I can identity that I have lots of things to improve. Especially my portfolio allocation. What about you?
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