This post is a continuation in a series on portfolio management and the Buffett Partnership Letters. Please refer to the initial post in this series for more details. Cash, Special Situations
“…if the market should go considerably higher our policy will be to reduce our general issues as profits present themselves and increase the work-out portfolio.”
His describes the “general issues” basket – mostly undervalued securities with no catalyst – in greater detail in later letters.
Interestingly, the quote implies that Buffett used his “work-out” basket as a quasi-cash equivalent. Theoretically, when a security has little/no downside capture, assuming there’s enough trading volume and liquidity, it can be utilized in a portfolio context as a quasi-cash equivalent with upside potential. This allows the portfolio manager to decrease exposure as underlying markets get expensive, while squeezing out some return potential greater than pure cash yields. Should the underlying market decline, accumulated performance is preserved as the “work-out” basket does not decline, and could be sold to serve as a source of liquidity to purchase other (now cheap) securities that have declined with the market.
A useful tactic for investors who wish to decrease exposure when markets get frothy, but don't want to blatantly lag if the rally continues. Of course, this is all predicated upon one's ability to identify "work-out" securities with 1957 attributes. Please see our 1957: Part 1 discussion for more details.
Sizing, Expected Return, Hurdle Rate
“One of these positions accounts for between 10% and 20% of the portfolio of the various partnerships and the other accounts for about 5%...will probably take in the neighborhood of three to five years of work but they presently appear to have potential for a high average annual rate of return…”
“Earlier I mentioned our largest position which comprised 10% to 20% of the assets of the various partnerships. In time I plan to have this represent 20% of the assets of all partnerships but this cannot be hurried.”
“Over the years, I will be quite satisfied with a performance that is 10% per year better than the Averages…Our performance, relatively, is likely to be better in a bear market than in a bull market…In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.”
Buffett left nothing to hope or chance, and thought very strategically about position sizing, the annualized expected return of these positions, and the estimated hurdle rate required to outperform his benchmarks by a margin of 10% annually.
Too often, investors are anchored to certain return figures (e.g., 8-15%+ for equities, etc.) regardless of current market conditions and entry price. Unpleasant negative surprises would occur less often if investors followed Buffett’s approach in examining portfolio holdings, percentage exposures, and assigning realistic expected returns based on present market conditions.
I do not wish to imply that the expected return of a portfolio can be extracted via a scientific formula involving the calculation of a weighted average return figure – false precision is equally as dangerous as false expectations. However, I do believe that knowing the general direction of potential future portfolio returns can be helpful in setting realistic expectations for portfolio managers, external fund investors, and assist with other portfolio related decisions such as fundraising, headcount expansion, etc.
Separate Accounts
“All three of the 1956 partnerships showed a gain during the year amounting to about 6.2%, 7.8%, and 25% on yearend 1956 net worth. Naturally a question is created as to the vastly superior performance of the last partnership, particularly in the mind of the partners of the first two. This performance emphasizes the importance of luck in the short run, particularly in regard to when funds are received. The third partnership was started in the latest in 1956 when the market was at a lower level and when several securities were particularly attractive. Because of the availability of funds, large positions were taken in these issues. Whereas the two partnerships formed earlier were already substantially invested so that they could only take relatively small positions in these issues.”
For those who manage separate accounts and have received inquiries from clients regarding performance discrepancies related to fund flow / timing differences, feel free to tell them that this would happen even if Buffett managed their account. Perhaps not in those exact words, but I thought to include this quote in case a Reader finds it useful.