Buffett Partnership Letters: 1961 Part 3

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.

Buffett Partnership Letters: 1961 Part 2

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. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The second of the two 1961 letters written is a treasure trove of portfolio management information, so robust in material that the summary (organized by topic) will require multiple installments.

For those interested in Warren Buffett’s portfolio management style, I highly recommend the reading of this second letter in its entirety.

Hurdle Rate, Expected Return, Volatility

“There are bound to be years when we are surpassed by the Dow, but if over a long period we can average ten percentage points per year better than it, I will feel the results have been satisfactory…Specifically, if the market should be down 35% or 40% in a year…we should be down only 15% or 20%. If it is more or less unchanged during the year, we would hope to be up about ten percentage points. If it is up 20% or more, we would struggle to be up as much.”

Buffett had a goal of beating the Dow by 10% annually, on average, over a long period of time. In order to achieve this, he had to seek investments that met a return hurdle of 10% higher than the Dow – no easy feat since the Dow itself is a moving target. Additionally, the portfolio had to have an asymmetric volatility profile that captured the Dow’s upside volatility, but only a fraction of the Dow’s downside volatility. As the history books have shown, he was certainly successful in achieving his goal, but the means of how he did so remains a mystery. I believe that Buffett’s partnership letters, in particular the second 1961 letter, holds some clues.

Part of the answer lies in Buffett’s strategy of segmenting his portfolio and analyzing the return potential and volatility contribution of each portion.

“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 generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.”

“[The work-outs] 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 a year with a large portion of our portfolio in work-outs, 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.” 

“The final category is “control” situations…Such operations should definitely be measured on the basis of several years…the stock may be stagnant market-wise for a long period while we are acquiring. These situations, too, have relatively little in common with the behavior of the Dow.”

“…I am more conscious of the dangers presented at current market levels than the opportunities. Control situations, along with work-outs, provide a means of insulating a portion of our portfolio from these dangers.”

We have written in the past that Buffett thought consciously about the expected return of his portfolio in our post on the 1957 Letter - Part 2, specifically, that he “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.”

The excerpts from the 1961 letter shown above, clearly demonstrate that he segregated his portfolio into three segments and assigned expected return figures to each. The percentage weighting of these segments then impacted the overall expected return of his portfolio.

Going one step farther, Buffett also monitored the expected volatility– yes, the forward looking volatility – of each of these segments by anticipating how each segment would behaved in different market scenarios relative to his benchmark (the Dow). For example, the “generals” moved in tandem with the Dow, whereas Buffett believed that the “work-outs” had a relatively uncorrelated volatility profile “to a large extent irrespective of the course of the Dow.”

I have written in a previous post on the 1958 Letter - Part 1 that Buffett “never ignored volatility because he recognized the impact of this phenomenon on his performance return stream.” His words above lend confirmation.

Today, Buffett preaches that permanent impairment of capital is what he’s most worried about. Perhaps that’s true for the billionaire Buffett with a permanent capital base and established trackrecord. However, back in the day, he was much more focused on avoiding impairment of capital of any kind – even that temporary type incurred via price movement (i.e., volatility). After all (roughly paraphrasing Buffett’s words, not mine, see quotes above), just because something is cheap, doesn’t mean it can’t go down more.

Buffett Partnership Letters: 1961 Part 1

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. During 1961, Buffett started to write semi-annual letters because his clients told him the annual letter was “a long time between drinks.” The summary below is derived from the first of two letters written about the results of 1961.

Separate Accounts, Fee Structure

The business underwent conversion from multiple separately managed accounts to a pooled partnership vehicle. Buffett grappled with housekeeping issues such as proper allocation of “future tax liability due to unrealized gains” during the transition process since all the different partnerships would contribute different tax liabilities to the new pooled vehicle.

More interesting is the fee structure of the Buffett Partnerships. The new pool vehicle would charge 0% management fees, 25% incentive fee above a 6% hurdle, and “any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back.”

Previously, the multiple partnerships had a number of different fee structures including:

1. 6% Hurdle, 33.33% incentive fee
2. 4% Hurdle, 25.00% incentive fee
3. 0% Hurdle, 16.67% incentive fee

Additionally, Buffett provides his clients with a unique liquidity mechanism to supplement the annual redemption window:

“The right to borrow during the year, up to 20% of the value of your partnership interest, at 6%, such loans to be liquidated at yearend or earlier. This will add a degree of liquidity to an investment which can now only be disposed of at yearend…I expect this to be a relatively unused provision, which is available when something unexpected turns up and a wait until yearend to liquidate part or all of a partner’s interest would cause hardship.”

AUM

“Estimated total assets of the partnership will be in the neighborhood of $4 million, which enables us to consider investments such as the one mentioned earlier in this letter, which we would have had to pass several years ago.”

Buffett was cognizant of the relationship between AUM and his fund’s investment strategy. I suspect the investment “mentioned earlier in this letter” was an activist situation which required him owning an influential or controlling stake in the company – therefore requiring a minimum amount of capital commitment, now made possible by the higher total partnership assets of $4 million.

Portfolio managers are not the own ones who should monitor the AUM figure. The relevance of the relationship between AUM and a fund’s investment strategy has wider implications. For example, investors who allocate capital to funds should also be monitoring AUM and asking whether the changes in AUM impact a fund’s ability to generate returns due to sizing, strategy shift / drift, changing opportunity sets, etc.

Expected Return, Catalyst, Risk

“We have also begun open market acquisitions of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year. Such a commitment may be a deterrent to short range performance but it gives strong promise of superior results over a several year period combined with substantial defensive characteristics.

The above quote highlights two important portfolio management topics.

First: the concept of “yield to catalyst.” Similar in concept to yield to call or maturity for bonds, it’s the annualized return between today to until the catalyst or price target occurrence – a sort of expected annualized return figure. In this situation, the price target was high enough that even if the security “does nothing for at least a year,” the “superior results over a several year period” was enough to make the investment worthwhile. For his basket of “work-outs” (see our 1957 Part 1 post for more details on this), the price target was usually lower, but the catalyst was usually not far away, therefore the yield to catalyst was still adequately high to justify an investment.

Second: the concept of risk-adjusted return. This one is slightly more difficult to estimate since “risk” is a squishy term and difficult to quantify. In the quote above, Buffett references the “substantial defensive characteristics” of the investment. This indicates that he is measuring the return against the risk profile. Unfortunately, he does not give any details as to how he defines risk, or does that math.

Buffett Partnership Letters: 1959 & 1960

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. Benchmark

“My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average…Unless we do achieve this superior performance there is no reason for existence of the partnerships.”

The term “benchmark” is often associated with relative performance. I believe that “benchmark” has a much wider definition and purpose – as a goal of sorts for each portfolio manager.

Early on, Buffett recognized the importance of identifying a benchmark and set investor expectations accordingly. Without a proper benchmark and reasonable investor expectations, there exists greater risk for potential discord and misunderstanding, as well as the risk of a portfolio manager shooting the proverbial arrow and painting the bull’s eye around where the arrow lands.

Separate Accounts, Time Management

“…the family is growing. There has been no partnership which has had a consistently superior or inferior record compared to our group average, but there has been some variance each year despite my efforts to keep all partnerships invested in the same securities and in about the same proportions. This variation, of course, could be eliminated by combining the present partnerships into one large partnership. Such a move would also eliminate much detail and a moderate amount of expense…Frankly, I am hopeful in doing something along this line in the next few years…”

Buffett grappled with the issue of having separate accounts versus a single pooled vehicle. A pooled vehicle would have eliminated investor questions about discrepancies in partnership returns. It also would have saved a great deal of time and effort in dealing with the operational details of having to oversee multiple accounts vs. the ease of managing one single vehicle. Given the scarcity of time each day, the topic of effective time management is one that will continue to receive coverage in future posts at PM Jar.

Activism

“Last year mention was made of an investment which accounted for a very high and unusual proportion (35%) of our net assets along with the comment that I had some hope this investment would be concluded in 1960…Sanborn Map Co. is engaged in the publication and continues revision of extremely detailed maps of all cities in the United States…”

Today, Buffett no longer discusses individual ideas or the rationale behind his thesis and analysis. This was not the case back in the Partnership days. In the 1960 Letter, there is a very detailed account of an activist position he took in Sanborn Map Co. which accounted for ~35% of the NAV of the partnerships and involved contentious negotiations with the Board of Directors.

Buffett Partnership Letters: 1958 Part 2

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. Selectivity, Hurdle Rate, Risk

“The higher level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments. I would prefer to increase the percentage of our assets in work-outs, but these are very difficult to find on the right terms.”

All investors practice some degree of selectivity, since not all ideas/securities/assets we examine makes it into our portfolios. Selectivity implies that, for each of us, there exists some form of selection criteria (e.g., hurdle rate, risk measurement, good management, social responsibility, etc.).

In 1958, Buffett talks about finding it difficult to locate “attractive investments” on the “right terms” as the market got more expensive. Perhaps it’s a comfort to know that Buffett grappled with problems just like the rest of us mere mortals!

Jokes aside, as markets rise, what happens to our standards of selectivity? Do we change our usual parameters (whether consciously or subconsciously) – such as changing the hurdle rate or risk standards?

It’s a dynamic and difficult reality faced by all investors at some point in our careers, made more relevant today as markets continue to rally. I believe how each of us copes and adapts in the face of rising asset prices (and whether we change our selectivity criteria) separates the women from the girls.

Intrinsic Value, Exposure, Opportunity Cost

“Unfortunately we did run into some competition on buying, which railed the price to about $65 where we were neither buyer nor seller.”

“Late in the year we were successful in finding a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth obtaining $80 per share…It is obvious that we could still be sitting with $50 stock patiently buying in dribs and drags, and I would be quite happy with such a program…I might mention that the buyer of the stock at $80 can expect to do quite well over the years. However, the relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price $50 with an intrinsic value of $125, and it seemed to me that our capital could better be employed in the situation which replaced it.”

Once a security has been purchased, the risk-reward shifts with each price movement. Any degree of appreciation naturally makes it a larger % of NAV, alters portfolio exposures, and changes the theoretical amount of opportunity cost (to Buffett’s point of his “capital could better be employed” in another situation).

So what actions does a portfolio manager take, if any, when a security appreciates but has not reached the target price, to a place where it’s neither too cheap nor too expensive, where we are “neither buyer nor seller”?

Unfortunately, Buffett offers no solutions in the 1958 letter. Any thoughts and suggestions from our Readers?

Buffett Partnership Letters: 1958 Part 1

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. Volatility

“…widespread public belief in the inevitability of profits from invest in stocks will led to eventual trouble…prices, not intrinsic value in my opinion, of even undervalued securities can be expected to be substantially affected.”

Price does not always equal intrinsic value, and the resulting impact is volatility due to price, not intrinsic value, movement. Unlike some value investors today, Buffett (especially in the Partnership days) never ignored volatility because he recognized the impact of this phenomenon on his performance return stream. Instead, he anticipated sources of possible price volatility and stood with cash or “work-outs” ready to deploy in case price, not intrinsic value, declined. Please see the 1957 Part 1 and 1957 Part 2 commentary for more details on “work-outs.”

Diversification, Liquidity, Catalyst, Activism

“Commonwealth only had about 300 stockholders and probably averaged two trades or so per month…”

“Over a period of a year or so, we were successful in obtaining about 12% of the bank at a price averaging about $51 per share…our block of stock increased in value as its size grew, particularly after we became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal.”

“This new situation is somewhat larger than Commonwealth and represents about 25% of the assets of the various partnerships. While the degree of undervaluation is no greater than in many other securities we own…we are the largest stockholder and this has substantial advantages many times in determining the length of time required to correct the undervaluation.”

“To the extent possible…I am attempting to create my own work-outs by acquiring large positions in several undervalued securities.”

Not surprisingly, Buffett was never one to preach the merits of diversification or liquidity, even in the pre-Berkshire days when he did not have permanent capital. (Side Note: At the 2012 DJCO Shareholders’ Meeting, Charlie Munger stated that the Volcker Rule would actually improve the markets by decreasing trading liquidity.) He seemed unafraid of liquidity constraints created by little/no trading activity, holding 12% of total shares outstanding of a company, or making a single position 25% of portfolio NAV.

In the Partnership days, Buffett conducted some degree of shareholder activism (this was to change down the road). In certain instances, he held the belief that the value of a holding increased once a large enough stake was accumulated due to the intangible control premium and higher potential to create your own catalyst, thereby controlling the expected annualized return.

Buffett Partnership Letters: 1957 Part 2

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.

Buffett Partnership Letters: 1957 Part 1

I have often told people that the Buffett Partnership Letters is my favorite investment book. As a young investor (26 years old when he started in 1956), Buffett was nimble, opportunistic, and far more candid in his discussion of ideas and portfolio management techniques. The Partnership Letters and the early Berkshire letters are a treasure trove of information, revealing the staggering genius behind the simple folksy manner he employs for mass media. Summaries and excerpts related to portfolio management will be posted in series form over the next few months. I hope our Readers will enjoy them. I will certainly enjoy going back through and articulating my thoughts in written form.

It may surprise some Readers that Warren Buffett was not always a “buy and hold” investor. Wait until you read the letter in which he talks about drinking – I hope you’re sitting down – Pepsi!

Special Situations, Volatility

“My view of the general market level is that it is priced above intrinsic value…Even a full-scale bear market, however, should not hurt the market value of our work-outs substantially."

“A work-out is an investment which is dependent upon a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline in general.”  

Buffett’s “work-out” names muted (improved) the volatility profile of the return stream while providing upside potential – offering upside capture with little or no downside capture – in essence the “holy grail” security of every portfolio manager’s dream.

Fast forward 55 years, our industry now uses the term “special situations” and “event driven” to describe Buffett’s “work-outs.”

I suspect the arbitrage and special situations space back in 1957 was a lot less competitive, and investors could extract decent returns with minimal downside exposure to overall markets.

Today, many investors hold work-out / special situations / event driven securities in their portfolios. As a result of the competitive nature of the investment management industry, these types of securities either (1) no longer shield portfolios from market volatility as effectively as in 1957 or (2) do not provide the upside return potential as they once did.

With all that said, I still believe that Buffett’s technique is valuable today because his general rationale for holding uncorrelated “work-outs” in a portfolio still holds true. Investors just need to think more creatively and seek “work-outs” disguised in different forms – beyond the special situation securities in which event driven investors usually traffic.