Buffett’s Portfolio Strategy Secret to 31% Annual Gains

Written by

Jae Jun

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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%!

Buffetts Portfolio Strategy

Buffetts Portfolio Strategy

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.

3. Workouts

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.

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.

4. Controls

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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14 responses to “Buffett’s Portfolio Strategy Secret to 31% Annual Gains”

  1. Peter says:

    I have thought alot about portfolio construction the last two years. And thats mainly been the driver for my diversification process. Although I only have 10 companies I can divide them in 4 cleary different cathergories. Its something like this:

    25 % in assets play (i.e. large discount to NAV) but with improving earnings
    25 % in earnings plays (i.e. large discount to earnings power) with superior growth (“Buffett-companies”), very strong cashflow, very good earnings growth AND good dividend yield
    25 % in “FCF-plays” i.e. very high FCF/EV yield with very large cash balances
    25 % in cyclical earnings/asset plays with organic high growth, low debt, strong cashflow etc.

    This have held up my portfolio very well with -4 % YTD despite the fact that I invest around 40 % in Sweden that is currently minus 20% this year.

  2. somrh says:

    Nice article, Jae.

    I mentioned this one on the forum already but there is a workout open-end mutual fund. It’s the Arbitrage Event-Driven Fund. It goes under the ticker AEDFX and only requires $2000 for an initial investment.

    From their website:

    “The Arbitrage Event-Driven Fund, launched October 1, 2010, seeks to achieve capital growth through event-driven investing. Event-Driven investing is a highly specialized strategy designed to profit from the behavior of both equity and fixed-income securities trading within the timelines of specific corporate events, such as mergers, acquisitions, recapitalizations, restructuring, refinancing, corporate distress, and bankruptcy. The Arbitrage Event-Driven Fund takes an opportunistic and flexible multi-strategy approach to event-driven opportunities through the use of various investment strategies including, but not limited to, merger arbitrage, convertible arbitrage, and capital structure arbitrage. Water Island Capital utilizes active hedging methodologies and fundamental research in an attempt to provide low volatility, low correlation, capital growth, and absolute returns. Institutional investors have relied on event-driven investing for decades. Most often, the strategy is pursued in private accounts or hedge fund vehicles; however, the strategy is readily deployed in a mutual fund format. The Arbitrage Event-Driven Fund is available in two share classes: Retail (AEDFX) and Institutional (AEDNX).”

  3. Good break down of the various investing situations Buffett was primarily involved in during the partnership days.

    As with learning, i view investing as a life long journey. If one does not enjoy the journey more than its conclusion then it is not worth it. Or better said, one must enjoy the process much more than the proceeds.

  4. Jae Jun says:

    @ Peter,
    Very good portfolio construction. I need to do something similar.

    @ somrh,
    Yes I read about that fund from seeking alpha. It would be a good idea to a have a small position as an insurance of hedge. Just not certain about the fees though if I want to buy a small piece.

    @ Theodor,
    Very true indeed.

  5. somrh says:

    Jae, the fees are on the high side but the strategy itself is going to have high transaction fees. Most of their investments are short term (at least less than one year.) If I’m making trades that last for, say, 90 days, that will incur fees.

    So how much money would I have to allocate in order to incur less than 2% in fees per year employing this strategy?

    To give an example, suppose that I do 15 trades (to give me a diversified portfolio) every 6 months. If I pay $10 per trade ($20 to open and close), then I’ll be paying $300 every 6 months. At $600 per year in fees, I would need to allocate $30,000 to give that equivalent to 2% in fees.

    When you factor in that they do the research, find the opportunities and give you a diversified portfolio, it can make sense to go the fund route. If you have more money and to allocate and would prefer to do the research yourself, then the fund may not make sense. Otherwise, it seems to be a good option for a smaller player to have a diversified portfolio without having to do the research yourself.

  6. Zehua says:

    I heard that during those 11 years, Buffet has been an arbitrage trader, and he got most of the profits from trading instead of investing. Not sure if it is sure or not, but he briefly mentioned that in his book ‘corporate American’

  7. Jae Jun says:

    well you cant jump to conclusions like that. If investments kept working out for him for 11 years in a short time period, say 1 yr, and he did the work, then that is investing. Even day traders who stick to their principles and discipline can be labeled as investors. After all, the definition of an investment is to make money off your initial amount.

  8. Guest says:

    This saves me 4rm reading the whole letters 2 shareholders.

    Great info. Thanks @07b9dfc63343290c455d430a9d55ae5a:disqus

  9. Guest says:

    This saves me from reading all 152 pages of Buffett Partnerhsip, Ltd.

    Much appreciation @07b9dfc63343290c455d430a9d55ae5a:disqus

  10. Kalani King says:

    “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?”

    For me, I’m still learning from the greats: Warren Buffett & Charlie Munger. this is invaluable information.

  11. cledrag says:

    I believe he has been using the two-valuation method since 1950s until now. His investing style does not change at all. He did trade or bet on the index. However, his valuation methodology is applied before he trade or bet on the index. Warren Buffett is no ordinary investor. He started reading the financial statement at the age of ten. He submitted the income tax return at the age of 14. He is a genius.

  12. Kalani King says:

    Do you know Warren Buffett set up his management fee system??

  13. I’m sure he had a management fee. Not sure what it was. Don’t recall having read about it though.

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