Some Thoughts on Investment Strategies and Buffett’s 1966 Disney Investment

Posted on Posted in Investment Philosophy, Superinvestors, Warren Buffett

There seems to be a strange dichotomy in the value investing universe: those who buy so-called compounders, and those who buy so-called cheap stocks. I want to own businesses that are building value, but that doesn’t mean I don’t care about valuation. I pass on probably 99% of the ideas I look at, many of which are great businesses, simply because the current price won’t allow my investment in the stock to compound at the rate of return that I’m looking for over time.

However, I think there is far too much “compartmentalization” going on in the value investing world. I should say—I too tend to compartmentalize on occasion. And Buffett compartmentalized when he ran his partnership. (By this, I mean that investors tend to put stocks into categories such as compounders, cheap assets, net-nets, arbitrage, special situations, etc…)

I don’t think there is necessarily anything wrong with putting investments into these buckets, and when it comes to selling stocks, I think it might be useful.

However, I think when you rigidly define what type of stocks you invest in, you run the risk of pigeonholing yourself into a strategy that might negatively impact your investment results.

In other words, knowing what type of an investment you’re in is helpful, but limiting yourself to only a certain bucket of investments is not.

Focus on Things You Understand

This is not to say that you should go outside your area of competence… just the opposite. You should limit your investments to only those that you truly understand. Looking for businesses and investment situations that you can easily understand and can value is much more important than trying to fit all of your investments into a style box, just because that’s “what kind of investor you are”…

After all, to paraphrase what Alice Schroeder once said about Buffett: if you offered him a $1 bill for 50 cents, he would gladly accept it, despite the $1 bill having no competitive advantages over other dollar bills.

The reason this compartmentalization is counterproductive is because it can cause investors to make mistakes of omission (or failing to invest in a situation that is understandable and well within one’s circle of competence). Examples such as “I can’t pay 15 times earnings for this, I’m a value investor!” Or, “I wouldn’t buy that stock at any price because there is no moat!”

Instead, I think it’s helpful to understand that each investment is its own unique situation with unique risk/reward dynamics. I think portfolio management is an art form. There are no black and white rules that tell you when an undervalued stock should be sold, or how long a great compounding business should be held.

So although it’s helpful to understand what type of investment you’re in after you’re in it, I don’t think it’s a great idea to say “I’m looking only for net-nets”, or “only low P/B stocks, or “only great compounders with moats”, etc…

Just look for undervalued merchandise.

I prefer quality businesses, so I look for good businesses cheaply priced most of the time. But I too will happily accept a dollar from you if you are offering it at 50 cents.

To simplify everything, one of my favorite quotes is “Value investing is figuring out what something is worth and paying a lot less for it”. That’s the name of this game.

Buffett’s Disney Investment in 1966

These thoughts on investment tactics began percolating again this weekend, as I was visiting family and picked up my father’s copy of “Tap Dancing to Work”, a collection of Warren Buffett articles compiled by Carol Loomis.

I just happened to see the book on his end table, and opened it up randomly. The article that I opened to discussed Buffett’s investment in Disney. It was an article written in 1996, and describes how Buffett decided to accept stock in Disney (as opposed to cash) when Disney was buying Cap Cities/ABC.

The article got me thinking about how Buffett has often lamented the fact that he bought Disney at a bargain in 1966, only to sell it a year later in 1967 for a 50% gain. Not a bad gain in one year, but Buffett likes to point out that he bought the stock for $0.31 in 1966, sold for $0.48 in 1967, then watched it rise to $65 per share 30 years later in 1996.

He implies that selling Disney was a big mistake in 1967. However, I crunched some quick math yesterday. At the price Buffett sold at in 1967 (48 cents per share) until 1996 (when the article was written and Disney was trading at its then price of $65 per share), the stock compounded at 18.4% per year.

A fabulous compounder to be sure… but what’s interesting is that Buffett was able to compound that 48 cents per share much faster than Walt Disney. Buffett compounded Berkshire’s equity at around 24% in that 29 year period (and estimates show that his stock portfolio compounded at a rate even better than that).

So Buffett was able to compound the 48 cents that he received from selling Disney much faster in other investments over the 29 years between 1967 and 1996, suggesting that it was in fact a great decision to sell Disney (one of the all time great compounders) after a 50% gain.

The opportunity costs of owning Disney for that period instead of selling it were huge (Disney grew 135x during those three decades while Berkshire’s equity grew over 500x)!

So despite his appetite for buying and owning great businesses “forever”, Buffett outperformed one of the great compounders of the 20th century by occasionally trading fairly valued merchandise for undervalued merchandise.

The Point Please?

So these thoughts were mostly ruminations (a euphemism for ramblings) regarding some topics that have been on my mind lately. Maybe this post doesn’t have a hard conclusion, but one thing that comes to mind is “Invert, Always Invert”.

Buffett often talks about moats and great businesses, but he also was a great handicapper. He could do a decision tree in a few minutes and estimate the probabilities for various outcomes for many different investment situations. This led him to make investment decisions that don’t always match his general advice on holding great businesses. It’s not because Buffett is being cagey, I think it’s just because it’s impossible for him to explain to us mere mortals—in simple terms—all of the decisions he’s made (some of which might contradict one another).

So inverting the situation, I think you might be able to deduce that Buffett dealt with each situation differently, and he was very good at picking out a few simple things that mattered in each investment. Furthermore, he invested in things that he understood and knew how to value. And yes, they were primarily long term investments in quality businesses that were building value, even in the partnership days.

So I think the key is to focus on businesses that you understand and stocks that you can value. Worry less about trying to fit stocks into a specific subcategory.

I think understanding the business and the situation go a long way in investing.

11 thoughts on “Some Thoughts on Investment Strategies and Buffett’s 1966 Disney Investment

  1. Interesting take on Buffet and his decision to sell Disney. I wonder whether or not Disney reached Buffetts intrinsic value target at the time or he was satisfied with a 50% return and decided to cash out. Alternatively, he may have found another investment that he felt more profitable. Either way, It’s still an impressive gain at the time. Selling at the time probably made sense and he had very good rationale for doing it, if that is the case, which I suspect it probably is, I wouldn’t look at it as a failure. Great read and great take.

  2. My recurring thought on investment is I refuse to play difficult games like baseball. Buffett is good at it and he knows to wait for the perfect pitches. To use his strike zone. But it’s a difficult game full of highly-trained professionals.

    I want to watch a ping pong game as a passive spectator. Between amateur players, who are drinking on Friday, playing for fun in an obscure bar.

    Then once in a blue moon, when I find it convenient, I can do an investment operation. Lean in from the side of the table and hit the ball hard as it crosses the net, perpendicular to the line of play. It will be nearly impossible to field.

    When the players protest, I read them the fine print on the bar’s wall. The rules were non-standard and the play was legit.

    I don’t know about compartmentalization but I can’t see why anything matters in investment except the payoff probability density function, or more simply, the expected value. If someone wants to play poorly by using only a limited investment universe then that’s great for those who are rational.

    Investments don’t even need to be publicly quoted contracts. They just need positive expected value. By this definition, little everyday actions that save money are investment operations, and probably more sound than much that is written on say Yahoo Finance.

  3. Hi John,

    I have been working my way through your website (as I said I would). I think I have nearly managed to read everything and this article is the best article that you have written (and you always write very thought provoking articles).

    This one is the best because it suggests to: not to only invest in compartmentalized investments but keep your mind open. Sometimes value is available in a different forms (sometimes its a cigar butt and sometimes its an Apple over the last decade).

    Thank you again for doing this website.

    Michael, UK.

    1. Thanks Michael. I appreciate the nice words, and glad you find the site helpful. That’s one of the main objectives of writing.

  4. John,
    I think you’re incorrect in your conclusion that Disney would have been a drag on the overall BRK compounding over the years. BRK is a levered company where total assets are almost always at least 2x equity. The brilliance of BRK is that the leverage has been free. It would be like saying that I’d like you to manage $1M of my capital, but I’m going to calculate the returns as if the denominator is only $500K. In that case, you’d buy safe, cheap assets and let the compounding work over many years.

    Just using your figures, if you put Disney into the BRK portfolio and apply the leverage that BRK has typically used, you get at least 36% return on the underlying BRK equity (and in fact, BRK leverage has often been higher than 2:1). In order to really make the comparison you are talking about, you’d have to look at the unlevered returns of the BRK stock portfolio compared to Disney.

    1. Hi Spencer, the leverage and the concept of float is a good point, and it’s one that I thought about as well, but I don’t think you can compare it this way. Berkshire’s portfolio consists of far more than just stocks. There are certainly a lot of stocks, but stocks are just a portion. Berkshire’s assets also consist of fixed income securities, and of course wholly owned operating companies. All of these assets are together funded by float, equity, and some debt. So the leverage factor has to be considered across the entire asset base. And any given stock investment is just equity. It makes up a portion of the equity base that is altogether levered at whatever the ratio is.

      Plus, there are many estimates that the actual stock portion of Berkshire’s portfolio (in those earlier years) far outperformed the 18% that Disney did over those decades. Some estimates have been as high as 29% from the mid-60’s to the mid-90’s. Those are unlevered stock returns (remember, bonds and other lower producing assets made up part of Berkshire’s asset base which lowered returns on assets).

      I wrote a post on a talk Pabrai did, and I’m not sure how he crunched his numbers, but he breaks down Buffett’s stock performance over those years. I think it can be pieced together from studying Lowenstein’s book. There is also another study that goes from the mid-70’s to the mid-2000’s that shows over 20% annual returns from the stock portion of the portfolio.

      Anyhow, I don’t have the exact numbers, but I’m pretty confident that Buffett took the $0.48 he received from Disney and compounded it much faster than he would have if he just left it alone in Disney.

      Also, one thing I didn’t mention is taxes. Disney compounded at 18% pretax (you would have had to pay tax at some point at the end for selling it). Berkshire’s equity compounded after paying taxes on earnings and realized gains from securities portfolios, etc…

      All in all, I considered the float aspect, but I’m pretty confident that on an apples to apples comparison (stock portfolio), Buffett did better than 18% unlevered returns in those years.

      If anyone has other thoughts, numbers, different views, etc… I’m certainly open to it. It’s an interesting topic to consider. Regardless, I don’t want to get caught too much in the weeds here, is that my point generally is to just keep an open mind when it comes to compounders, cheap stocks, etc… there are no black and white rules… sometimes holding them forever works great, other times selling them to reinvest in more undervalued ideas works also.

      Anyhow, thanks for the comment Spencer.

  5. Thanks for the post. I am loathe to question what Mr Buffett said about regretting his sale. The difference between 18% and something in the 20s is significant, but not so large that you can ignore factors such as tax. As you say, the impact of tax would be significant over that time (I believe capital gains rates were higher then). Also, did you correctly acccount for all splits and the spin-off of ABC Radio? (I am sure you did, but just want to confirm — trust but verify!) Finally, DIS has paid a dividend of 0.5% to 1% for some time, so that would factor in as well. Not trying to focus on the details but just trying to understand why he would say something like that.

    Also one would want to consider Munger’s comments on Disney over the years which would suggest it is one of the great compounders that is able to raise prices.

    1. Hi Jonathan,

      I accounted for splits during that 3 decade time period. I didn’t put much time into trying to be precise… I don’t think dividends would have changed my conclusion, as I think Buffett significantly outperformed Disney’s rate of return over that time period in Berkshire’s common stock portfolio. There are lots of moving parts, and I touched on the leverage/float aspect in a previous comment, but remember, Berkshire’s 24% annual growth rate in book value is after tax, whereas Disney’s 18% during that time is pretax (you have a tax liability that is due upon the sale if you just owned Disney that entire time).

      But the general point here is not to try and be specific about whether or not Disney was better than Buffett’s portfolio, it’s just to keep an open mind about the tactics of buying, selling, compounders, cheap stocks, etc… obviously Disney was a home run investment during that time, and it’s not to say that one should not look for compounders. There are no broad conclusions to this idea other than to conclude that each situation is unique and each investment should be identified based on its own unique risk/reward characteristics, not some box that says “this is a compounder”, “this is a special situation”, etc…

      I don’t think Buffett really thought that way, he just kept things simple and looked at each situation. That’s really my (meandering) point here.

      I do think Buffett outperformed Disney even when factoring taxes/commissions, etc… but either way, it’s close and it wasn’t a glaring mistake to sell Disney.

      Thanks for the comment Jonathan… interesting thing to consider/discuss.

  6. Another thought I had on investment is the Internal Rate of Return (IRR) is more fundamental than the margin of safety. To determine the IRR, you need to figure out the payoff distribution and the time horizon of the investment. For example you could assume the time horizon is 6 months and the payoffs distribution is +$0.5 with 50% probability or -$0.2 with 50% probability on $1 risked. From this you can derive the expected value and variance of the IRR. From that in turn you can derive an appropriate margin of safety and selling rules.

    The IRR analysis is very similar analysis to the DuPont equation for ROE which is best explained by Joshua [1]. The profit margin and turnover effectively become the expected payoff distribution and time horizon, respectively.

    [1]. http://beginnersinvest.about.com/od/financialratio/a/aa040505.htm

    You always need a positive margin of safety to get a positive IRR (assuming fundamental valuation is the only factor impacting stock returns, and neglecting short-term effects like momentum). But the margin of safety and selling rules can be quite varied while still obtaining an equivalently good IRR.

    For example you could buy shoes at 95 cents and resell them online for 1 dollar. That is only a 5% margin of safety, but it might be an extremely sound investment operation because of the high turnover. Equivalently you could buy a forgotten Tajikistani company for a 90% margin of safety which will still be forgotten and give little annualized return even after 10 years. Or you could buy a turnaround situation which has an expected ROIC of 15% for a 40% margin of safety, and do quite well in expectation after 2-3 years. But a general investment with no catalyst might require a 2/3 margin of safety because of its longer time horizon of 5 years. The margin of safety and selling rules depend directly on the payoffs and the time horizon. I think this is also leads to rules of thumb like, “You need less of a margin of safety for high quality compounding companies.”

    As a side effect of IRR calculations, you can also figure out rules for when to sell long positions that have popped up unexpectedly over a short period of time. For example if historical IRRs of positions held for 1 month average 10% with a standard deviation of 100%, and you see such a position with a +1,000% IRR, it is probably statistically safe to sell it. I guess that is where Ben Graham was getting rules like his “always sell cigar butts if they appreciate by 50%.” Such rules are also a bit eerie because they remind me of short-term trading and might expose one to negative selection bias (sell your winners, hold your losers) if one does the math wrong.

    Even so, I think it illustrates that as a mental model it is useful to analyze all decisions made and forgone in terms of IRR.

  7. Bit behind in my reading so only just read this, very interesting thanks!

    One thing I’m considering more and more is how much effort active investing takes, and I’m sure it’s on Buffett’s mind more as he’s gotten way past the ‘comfortably rich’ point. If you can get 18% a year just by buying a stock and reading its 10-Q every few months a lot of people will take that over spending night and day searching for bargains for 22% a year.

  8. Hi John,

    I’d like a quick opinion from you regarding which stock screener you use and would most recommend. Do you prefer morningstar or value line and which service segment do you subscribe to?

    Thanks!

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