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How Buffett Made 50% Per Year? By Thinking Differently...

Pop81165 views  2013-04-07 08:56   TagsInvestment  Concepts 

A few years ago at the Berkshire Hathaway Annual Meeting, Warren Buffett said something very interesting. He said that he personally knows of a half dozen or so people who could make 50% per year managing a relatively small amount of money. I came across a reference to this comment a few days ago and I began thinking to myself: I wonder who those 6 people are?

But even though it's interesting to consider, there are more important takeaway's from this comment than daydreaming about who Buffett regards as the best investors... namely, how can we-as smaller investors-think in a way that allows us to achieve far greater returns?

This Buffett comment at that shareholder meeting was prompted by a previous comment (now somewhat famous) that Buffett made in a Businessweek interview in 1999:

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

Wow! He guarantees it... and there is a good reason why he guarantees it. Because he did exactly that when he was managing around $1 million or less. He actually made about 60% per year in his early 20's in the 1950's prior to starting his partnership.

How To Make Big Returns

So assuming most of us manage 7-8 figures or less (or far less-it could be 5 or 6 figures... Buffett started his snowball with about $5,000), how can we take Buffett's comments and apply them to achieve returns that far exceed the averages? We may not make 50%, but it's interesting to note that a few of Buffett's friends made 30% consistently managing their own small partnerships that were basically copied from Buffett. One guy worked in Buffett's building in a completely separate business, and noticed Buffett's eyepopping returns, and actually quit his job and started his own partnership. He's mentioned by Buffett in his Superinvestor speech.

So how can we replicate what others, including Buffett, have done in the past and achieve returns that trounce the S&P 500? 

The answer is we have to think differently. I mean differently than most investors-that's a given. But also different than even most "value investors". I read through many client letters and mutual fund letters of managers who call themselves value investors. There are many of them. Their language is usually filled with "Buffettisms" about buying "wonderful businesses at fair prices" and other such well-known Buffett quotes. Now, I have no issue with quotes like that, and in fact, I use plenty of my own Buffettisms on this blog and in my own company literature.

But the problem is this: many value investors buy these "wonderful" companies (and they are wonderful), but they overpay for them. This sets up these investors for mediocre returns going forward. Buying Coca-Cola was especially popular in the late 1990's (10 years after Buffett bought it and after the stock had gone up 10-fold). There were even "value" managers who paid up for Coke, with the logic that Buffett was holding his major position and "time is the friend of the wonderful business".

Well, Coke at 40 times earnings is not that wonderful. And time is the friend of the great business, but in that example, it took over a decade to work off the excess value, leaving Coke shareholders with little to no real returns for a long time. Coke is an extreme example, but many value managers end up hugging the S&P 500 because they aren't thinking opportunistically enough.

Now, I follow Buffett more than anyone else, so it's crucial to understand that I'm just challenging you to think like Buffett in the 1950's, not like Buffett in the 2000's. We can learn a tremendous amount from Buffett in the 2000's, but we should take note of how he achieved those 50% returns (hint... it wasn't by buying and holding great businesses-at least not at first... it was by buying extremely undervalued stocks, selling them as they reached fair value, and repeating the process over and over... a Graham like approach with Buffett like concentration).

To Sum it Up

I'm going through screens this morning looking for undervalued stocks in the sea of the fairly to slightly overvalued overall market. One thing that helps me as I go through my screens is this simple question: How can I make money? I'm not sure if this makes sense, but for me, it helps me to think of stocks as individual investments, rather than worrying about an overall strategy or the overall market environment. Just ask yourself: Which stock can I invest in that will make me a lot of money? 

I think Buffett likely thought of stocks this way when he was making 60% a year in the early 1950's, and 30% a year while running his partnership. He didn't care really what the overall market was doing, as long as he could find stocks that were undervalued that presented him with low risk ways to make a lot of money.

Think like this... bottom up, not top down. Don't worry about markets or the economy, just search for undervalued stocks.

Comments Comments (13 )

  • C.W.R. 2013-04-07 12:23
    Not bad article.  I have some questions for you.

    Concentration: do you know how concentrated Buffett was with his $5000 in the 50's?

    Quality: do you know what minimum quality standards Buffett had for stocks in the 50's?  I mean, today there are plenty of bargains... half of book, quarter of book etc.  A lot of these are steel co.s, gold and silver miners etc.  Some of them are companies with poor balance sheets or other impaired fundamentals that make investing in them very risky.

    BTW, $5000 in 1955 is $42,000 today.
  • John Huber 2013-04-08 09:13
    Thanks for reading CWR. I don't know exactly how concentrated Buffett was, but it's possible to gain a lot of insight by reading Snowball, by Alice Schroeder. She discussed a lot of Buffett's early investments, and he took major positions in the early 50's. I think he put over half of his net worth into Geico at one point. And of course, later on he famously invested 40% of his capital into American Express. I think in the early years, he had much higher turnover, and much greater concentration. He found an idea, invested in it, and then would find another idea, trade out of the old idea to allocate to the new idea, etc... he still was patient, and I assume still held stocks for a long time, but he was a much more active trader than he is today. He filled up his 20 punches on his investment punch card very early in his career...

    Regarding quality, Buffett invested in cigar butts early in his career with little regard for quality. I think he wanted more quality than Graham did, because even at 21 years old when he wrote about Geico, he discussed quality. But he invested in many stocks of poor quality, including Berkshire Hathaway, based purely on the asset values (tangible book values and net current assets).

    I think most investors would benefit by sticking to Graham, and identifying the cheapest portion of the market (including all of the garbage). Then maybe try to filter out the good from the bad. At least then you'll be playing exclusively in the cheap sandbox, which should give you an edge if you make a mistake on judging good from bad.
  • vgm 2013-04-08 09:49
    Fascinating topic. Thanks for the stimulation.

    I too have often wondered about this. I've presumed he had much higher turnover then than later in his career and was not necessarily going for "great companies at good prices". Yet when he gives talks to college students, he advises them to invest as if they only had 20 investment punches on their card - in other words to choose very carefully - and he stresses buying high quality companies that can be held for the long term.

    So, his advice to those just starting out with small amounts of money is to basically follow his current methodology, not the methods he used when he was young(er) and was working with a small(er) amount of cash.

    Any thoughts?
  • John Huber 2013-04-08 10:51
    I've noticed that pattern as well. I think he gives advice to those students (the 20 card punch idea) so that they begin thinking in terms of longer term, as well as thinking of stocks like businesses. Basic Graham philosophy. So I think he actually exaggerates his point using the 20-card punch rule.

    The other thing is that Buffett knows his skill level is greater than most, and so when his turnover was higher, he knew it was adding, and not taking away from returns. In the average investor's case, turnover hurts. Buffett is often talking to these kids who are more proned to be active traders rather than value investors, so I think he's just trying to get them to change their thinking.

    I also think at this point in his career, he follows his own advice on holding stocks forever, but i think it's more due to the size of his capital.

    If he were managing $10 million (or even $100 million), or less, he certainly wouldn't be buying Heinz.

    Just my thoughts...
  • batbeer2 2013-04-08 13:42
    >>Yet when he gives talks to college students, he advises them to invest as if they only had 20 investment punches on their card

    >> So, his advice to those just starting out with small amounts of money is to basically follow his current methodology, not the methods he used when he was young(er) and was working with a small(er) amount of cash.


    Let's just take his words at face value.  In essence, he's saying "raise your standards".

    This is not about growth, value or buy-and-hold. This is about disregarding stocks trading at a 15% or even 50% discount and hunting for stocks that trade at a 95% discount.

    It is the same process, just more work.

    There are many excuses to disregard this piece of advice. What's yours?
    - Why are you not limiting yourself to one stock a year?
    - If you were, what would you not be buying that you now are?
    - What research would you be doing that you now aren't.

    Just some thoughts.
  • John Huber 2013-04-09 08:41
    batbeer2: >>Yet when he gives talks to college students, he advises them to invest as if they only had 20 investment punches on their card

    Thanks for the thoughts batbeer... yes, I think Buffett's main point with the 20-punch card rule is to simply get people to think differently about their investment decisions. I think he probably assumes people would dramatically improve their results if they thought this way. Once you begin to think in terms of Graham and Dodd, then you can build on that foundation and your tactical approach will likely evolve.
  • TheExtraIncome 2015-04-18 00:50
    I think the good question is  not "I wonder who those 6 people are?" BUT "I wonder how he knows these 6 people have the right skills ?"

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