Warren Buffett’s Ground Rules by Jeremy Miller is a new book covering Buffett’s years before Berkshire Hathaway, when he ran Buffett Partnership Limited (“BPL”). These are years that many of us know very little about, mostly because Warren and Berkshire did not become widely famous until further in his career. Buffett ran the partnership from 1957 – 1969 with astounding results (see table at the end of this post). In these years, he was working with much less money than he is today, and therefore the universe of investment opportunities was much greater to him. Additionally, his investing philosophy was in it’s early stages. He was not focused on buying high quality businesses like he is today. Buffett went after very cheap stocks despite their lack of luster, still being sure he was finding opportunities that would give his investors the highest after-tax return over a few short years, and then move onto his next investment ideas. I believe this book is great for any investor out there trying to learn more about business and investing. The wealth of knowledge Buffett extends through his letters, in addition to his candidness and care for his shareholders shows his high intelligence and the integrity he has held throughout his life.
The book is written in the form of anecdotes form the partnership letters, followed by commentary from the author. The end of each chapter includes the more fulsome letters covering the respective chapter topic and again ends with some “Compounded Wisdom” that Mr. Miller gives us.
The Ground Rules
Below are the “Ground Rules” Buffett had all partners agree to before they joined the partnership (sourced directly from text):
- In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that–withdrawing. If we earn more than 6% per annum over a period of years, the withdrawals will be covered by earnings and the principal will increase. If we don’t earn 6%, the monthly payments are partially or wholly a return of capital
- Any year in which we fail to achieve at lease a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered
- Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at year end against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.
- Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
- While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any year or longer period produces poor results, we all show start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
- I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership
- I cannot promise results to the partners. What I can and do promise is that:
- Our investments will be chosen on the basis of value, not popularity;
- That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and
- My wife, children and I will have virtually our entire net worth invested in the partnership.
Warren ran his portfolio with a much different strategy than he does today. He focused on four different investment strategies.
THE GENERALS-PRIVATE OWNER: According to Mr. Miller, the Generals were a highly secretive, highly concentrated portfolio of undervalued common stocks that produced the majority of the Partnership’s overall gains. Buffett typically committed 5-10% of his total assets in five or six Generals with smaller positions in another 10-15%. These companies are downtrodden, out-of-favor companies that give no reason as to why they would appreciate in price. Buffet notes, “However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices.” Buffett bought these companies using the private owner method, being sure to buy at a steep discount to their intrinsic value. Often these companies were small, and therefore if their prices stayed low enough for long, Buffett would have a say in how the business was run.
THE GENERALS – RELATIVELY UNDERVALUED: The relatively undervalued companies focused on a comparable company approach, where he found companies that were trading at a discount compared to their peers. These investments were somewhat riskier because there wasn’t the potential for a private owner (or Buffett) to acquire control of these companies. At times, he would hedge his investments by going short in the peer that was relatively overvalued. In a declining market, the overvalued company would likely decline by a greater degree than the undervalued company.
WORKOUTS: Workouts are also known as merger arbitrage or risk arbitrage. This involves betting on the likelihood that an announced transaction will close. When a transaction is announced, the target company’s stock price will rise close to what the bid for the company was announce, but not all the way. The difference is known as the spread, and Buffett would go after workouts where the spread was wide and the probability of the deal closing was high. The average unleveraged return was ~20% per year using this method. Buffet’s outline for the Workouts including (1) what chance does the deal have of going through (2) how long will it take to close (3) how likely is it that someone else will make an even better offer , and (4) what happens if the deal breaks?
CONTROLS: For Buffett’s partnership years, controls were undervalued securities that remained undervalued for a significant period of time. Over this time, BPL would continue to buy stock in the company until they had a controlling stake in the companies. Since the companies were not unlocking their value, Buffett would gain control and enact change within the companies. Key examples were Sanborn Map Company, Dempster Mill and Berkshire Hathaway (while it was still a textile mill).
Buffet’s approach to investing during his partnership was much different than his investing approach today. This isn’t only due to the size of Berkshire Hathaway today, but also a change in his mindset toward investing in businesses. Many of his investments were what he would today call “cigar butts” where he would have one good puff out of the company and then had to move on to the next. He changed his thinking to buying higher quality businesses at fair prices and let them compound returns over many years. Buffet attributes his change in thinking to his business partner, today Vice Chairman of Berkshire Hathaway, Charlie Munger. Warren often quotes, “It’s far better to buy a wonderful business at a fair price, than a fair business at a wonderful price.”
The second half of the book focuses more on different topics, such as Buffett’s view on taxes, his difficulty with fund size vs. performance, commentary on the Go-Go era and ultimately how Buffett closed up the partnership and moved on to operating Berkshire Hathaway.
There is a lot to take away from this book. We get great insight into Buffett’s partnership years, the market environment he was investing in, his keen intelligence, as well as get additional insight into the candidness he had with his partners. One of the largest things I took away from this was that Warren was still a great teacher, adviser and person to those he invested for through his younger years. I would highly recommend this book for those of any experience level.
Selected quotes from Buffett’s partnership letters
“The availability of a quotation for your business interest (stock) should always be an asset to be utilized if desired. If it gets silly enough in either direction, you take advantage of it. Its availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgements.”
“There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from teaching of value investing over the last 30 years. It is likely to continue that way. Ships will sail around the world but the Flat Earth Society will continue to flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”
“I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime. You know what would happen? They would make sure that each buy was a good one. They would do lots and lots of research before they made the buy. You don’t have to have many 4X growth opportunities to get rich. You don’t need to do too much, but the environment makes you feel like you need to do something all the time.”
“You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.”
“We live in an investment world, populated not by those who must be logically persuaded to believe, but by the hopeful, credulous and greedy, grasping for an excuse to believe….I am not attuned to this market environment and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.”