Investment PhilosophyShareholder Letters & ReportsSuperinvestorsWarren Buffett

Things You Didn’t Know About Buffett’s Strategy

Last weekend I spent a couple hours reading through Buffett’s old partnership letters (again). I was looking for something specific that I remembered him talking about, but then as I was flipping through them trying to find this comment, I just decided to read them again. I’ve always found it extremely valuable to read Buffett’s letters. Although I’ve read both the partnership letters and the Berkshire letters multiple times, I feel like I pick up something new each time I read them, or maybe I notice something helpful or relevant to a particular investment situation I’m currently working on.

I think the best way to learn and improve as an investor is by doing it—just invest. You learn a lot by reading about companies and researching situations. The second best thing you can do outside of investing itself is by reading and reverse engineering case studies. There aren’t many in the Buffett letters, but there are a few. (I found it interesting that he lists an oil stock arbitrage in an appendix to the 1963 letter, and discusses how it was very profitable to invest in merger arbitrage deals during that time—Buffett would buy stocks of smaller oil producers that were selling out to the larger integrated oil majors, with the objective of making 20% annualized returns on the investment operations).

Anyhow, maybe I’ll review a case study or two some other time. For now, I wanted to write a post with a few comments that Buffett made in those early letters that were thought provoking. Another thing for me personally, I think the partnership letters are interesting because Buffett was operating with a much smaller sum of capital, and was engaging in investment operations that were much different than he engaged in even a decade or two later at Berkshire.

For instance, he was managing $4 million in 1961, which was a small sum even then (however, it was large enough for Buffett to engage in activist investment operations even back then).

A good friend and I have considered writing a series of posts, or some sort of compilation at some point discussing these letters, but for now, here are just a few clips that made me think while flipping through them over the weekend.

1962 Letter

Buffett talks about his strategy here. I’ve always liked his approach to categorizing investment ideas. Although I’ve said before that I don’t seek out investments in any specific category, I do think it helps to know which investment idea belongs in which category—but the horse has to come before the cart (seek out value first, not categories of investments). As far as Buffett is concerned, he described his approach in the 1961 letter. I might summarize his portfolio strategy in a separate post, because I think it is generally misunderstood by the casual investing public, especially in the early years.

In the 1962 letter (and most letters thereafter), he briefly summarizes his portfolio strategy:

“Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon available factors.”

I’ll go into more detail in another post, but he lists his three categories of investments as:

  • Generals—plain vanilla investments in stocks that are undervalued without any specific catalyst
  • Workouts—special situations such as merger arbitrage, spinoffs, etc…
  • Controls—investments where Buffett became the largest or majority shareholder and pushed for change (a category that would now be referred to as activism).

Buffett and the Activist Put

Since the title of this post is “Things You Didn’t Know About Buffett”, here is the first comment I jotted down that I hadn’t noticed before (the title is presumptuous… maybe you did know!). Buffett, when discussing the general investment category said this:

“Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.”

This sounds like what has recently been referred to as the “activist put”. Basically, a large shareholder takes a stake in a company and announces the “changes” they’d like to see (usually, it’s something really creative like loading the company with debt to buy back stock in the name of “unlocking shareholder value”). Investors who believe in the merit of this “activist put” will then invest in this company under the assumption that if things get better and operations improve or the stock price rises, great… if the stock price falls, then the activist will buy more and continue rattling the cage until things do improve. The theory is that this creates a floor (or “put”) under the price.

I’ve never been a big fan of such a strategy, and I wouldn’t make an investment decision that is founded on this type of theory. But I do understand that in reality this type of situation exists. Heck, there was even talk of a “Buffett put” a year or two ago when Buffett announced he would buy back stock at 1.1 (later increased to 1.2) times book value.

So the activist put can be real—I just wouldn’t make it a primary reason for being interested in an investment. And as Buffett says, value has to be present, and probably most importantly when evaluating the activist put is to “be careful whose coat we are holding”.

Using Borrowed Money

The second thing that some people might not have known is that Buffett used borrowed money in his partnerships. He didn’t borrow a lot, and he didn’t borrow against the “general” investments, but he did use leverage when investing in special situations, or “workouts” as he called them.

Buffett describes workouts as “securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities… Corporate situations such as mergers, liquidations, reorganizations, spin-offs, etc… lead to workouts.”

He describes the benefits of investing in these special situations:

“This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout the year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year.”

So the workouts provide, as the portfolio academics would say, uncorrelated and attractive risk-adjusted returns. While any one deal could go sour, a basket of these investments over a period of time would provide quite predictable results.

This is why Buffett decided to add leverage:

“Over the years, workouts have provided our second largest category. At any given time, we may be in five to ten of these; some just beginning and others in the late stage of their development. I believe in using borrowed money to offset a portion of our workout portfolio, since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.”

Buffett goes on to say that these situations typically provide 10-20% annualized returns (before the benefits of leverage), and that he limits the leverage to 25% of the partnership’s assets.

Quick Comment on Buffett’s Evolution as an Investor

Obviously, Buffett uses leverage at Berkshire, but it’s interesting to read about how opportunistic he was during his partnership days as well. His plan was certainly not to buy and hold Coke for decades in the 1950’s and 60’s.

His thoughts on investing evolved, but I think the reason for the evolution was much more due to the rising asset base than for the more commonly attributed reason—Charlie Munger’s influence (and this is not a slight to Munger at all-he’ll tell you the same thing). The latter was certainly a big factor, but the former was (and still is) the driving reason behind Buffett’s continual evolution as an investor. We may be entering a new phase of Buffett’s career in present years as he gets more involved with 3G and their hands-on approach to the operational side of businesses.

Buffett has always taken what the defense has given him. I think deep down, he probably longs for the days of the cigar butts, the oil stock arbitrage deals, and the quantitative bargains. But that’s a moot point—Buffett has always been opportunistic, and has maximized his returns with a minimum of risk by investing in the opportunity set that was in front of him at any given time.

There are a number of other things I’d like to discuss, but we’ll save them for another post. The letters are good reads, and I think there are beneficial discussions on investment philosophy, portfolio strategy, and also some interesting case studies.

Have a great weekend!

6 thoughts on “Things You Didn’t Know About Buffett’s Strategy

  1. Any thoughts about 3G’s style yet? Seems like they do half of the usual Bain Capital sort of move: they buy a company and get it much more profitable by streamlining operations, but are more like Buffett than like Bain in that they only buy great brands and (I think) don’t plan to re-offer them to the public a few years later. I’m wondering whether Campbell’s stock is higher than it might ordinarily be, on the theory that it’s next in 3G’s crosshairs.

  2. I agree with your comment that Buffett has taken what the defense has given him, but it’s also about incentives right? During the partnership years, 100% of his compensation was based on pre-tax returns, so he worried little about the tax implications of the various investment strategies. I even recall him sort of chiding his investors in one letter for whining about their tax bills. Contrast that to running Berkshire, where 100% of his compensation was related to after tax returns (i.e. book value growth of his BRK shares). The non-economic angle of having a reputation/legacy to worry about was certainly a factor (more so in late years), but I think taxes played a large part in his investment strategy going forward. You certainly see that today with Berkshire Energy, Duracell, etc.

    1. Yeah he was compensated (as all investment managers who take performance fees) on pretax returns. There is really no way to do this otherwise as each investor gets their own K-1 and pays their own tax rates based on their own individual income levels.

      I really don’t think Buffett was focused on taxes at all in the partnership. He made over 30% annually before fees, and somewhere in the mid-20’s after fees. Most of his gains were long-term, but regardless, his strategy made many people extremely rich (after tax). So while I would agree that he worried little about taxes, it had nothing to do with how he was compensated, and everything to do with how much money he was trying to make (after all, he got his own K-1 just like his LP’s and paid taxes just like all of his investors on those capital gains and dividends).

      Thanks for the comment. Interesting to think about…

  3. Hi John, the internet provides a wealth of information. Luckily, I found you and your terrific contributions. Thanks. As for the Buffett letters, I have been looking at Buffett and other value (Burry) folks for a while (10+ years). I have given up on the idea a few times. Even bought Michael Covel package on Trend Following. But I keep coming back to Value – now I am enamored with Schloss and early Buffett. This post takes me there as well. The real question I have is can this be done in a world with +30,000’s CFAs. Are net nets out there to be discovered – as Buffett has often said, nobody will find them for you. Buffett has also said that he could replicate his early days if he started over – Munger discourages this fun chatter, but it is a hopeful position for the rest of us mortals. What do you think? Is net net’s a game to be played going forward.

    1. Thanks for the comment. I’m not sure about net nets specifically. But I am sure that if Buffett were starting over today with $1 million or whatever small amount he said, he would definitely be able to do 50% per year. He wasn’t necessarily doing net nets either. I would summarize his approach as a flexible, opportunistic approach to special situation investing. He bought some net nets, but also put 65% of his money in GEICO, only to sell it a year later to buy another cheap insurance company. He bought bus companies that were paying large special dividends, he invested in a cocoa bean arbitrage that led him to ride the coattails of what today would be considered an “owner/operator” or activist investor. He did all sorts of investments, and yes, he found them by turning over rocks. Two things that led him to 60% returns in the early 50’s, and 30% returns in his partnership: turnover (lots of ideas) and concentration.

      There are lots of opportunities out there…

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