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. For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of the second 1961 letter in its entirety, and to check out our previous posts on 1961.
Sizing
“The first section consists of generally undervalued securities (hereinafter called “generals”)…Over the years, this has been our largest category of investment…We usually have fairly large portions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.”
“…and probably 40 or so securities.”
Today, people often reference Buffett’s concentrated portfolio approach for sizing advice. Although Buffett wasn’t shy about pressing his bets when opportunity knocked (Dempster Mill was 21% of the total Partnership NAV), he didn’t always run an extremely concentrated portfolio, at least not in the partnership days.
The “generals” portion had 5-6 positions consisting of 5-10% each, and another 10-15 smaller positions. So the “generals” segment as a whole comprised approximately 25-60% of NAV in 15-20 or more positions. Also, see discussion on diversification of “generals” below.
The “work-out” segment usually had 10-15 positions (see next section).
At the end of 1961, his portfolio consisted of ~40 securities.
Catalyst, Diversification, Expected Return
“The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no time table as to when the undervaluation may correct itself…Sometimes these work out very fast; many times they takes years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid…This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.”
“Our second category consists of “work-outs.” These securities whose financial results depend on corporate action…with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc. lead to works-outs…At any given time, we may be in ten to fifteen of these, some just beginning and others in the late stage of their development.”
“Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low…for a long period, this might very well happen.”
Catalysts helped Buffett “predict within reasonable error limits, when [he] will get how much and what might upset the applecart.” Put differently, catalysts enhanced the likelihood of value appreciation and accuracy of expected returns.
In his “generals” basket, to compensate for the lack of catalysts (and inability to predict when price would reach fair value), Buffett employed diversification unconventionally. Investors usually diversify portfolio positions to mitigate portfolio losses. Here, Buffett applies the concept of diversification to portfolio upside potential through his “diversity of commitments.” By spreading his bets, Buffett smoothed the upside potential of his “general” positions over time – a few “generals” would inevitably encounter the catalyst and move toward fair value each year.
Lastly, Buffett believed that the lack of catalyst creates opportunity. As long as investors are short-term results driven, this tenet will remain true. He sometimes took advantage by acquiring large enough stakes in these no-catalyst-generals and creating his own catalyst through activism.
Leverage
“We believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.”
Here we observe the first evidence of Buffett employing leverage, nor was this to be the last. Despite warning others against the dangers of leverage, Buffett embraced leverage prudently his entire life – from the very beginning of the partnership, to his investments in banking and insurance, to the core spread structure of Berkshire Hathaway today.
Why he imposed the 25% limit figure, I do not know. (It would certainly be interesting to find out.) I suspect it is because he utilized leverage exclusively for the “work-out” segment which was a smaller portion of the portfolio. Also, the “work-outs” were already returning 10-20% unlevered, so leverage was not always necessary to achieve his return goal of 10% above the Dow.
Intrinsic Value, When to Sell
“We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.”
Don’t be too greedy.