In this article, we will take a look at the second part of Warren Buffett’s 1961 partnership letter.
Our Method of Operation
In this section, Buffett describes his three investment categories. He states that 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.” He goes to say that “The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors.”
Below, in Mr. Buffett's own words, are descriptions of his three investment categories.
The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.
:In the table below, I’ll summarize and comment on these investment categories.
Sometimes these work out very fast; many times they take 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 substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. 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.
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 be down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Down, 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.
Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities 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 work-outs. An important source in recent years has been sell-outs of oil producers to major integrated oil companies.
This category 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. Over the years, work-outs have provided our second largest category. 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. 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.
The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it. These situations, too, have relatively little in common with the behavior of the Dow. 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 enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.
“…generally undervalued securities… where … [the partnership has] nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself.”
· “Over the years, this has been our largest category of investment and more money has been made here than in either of the other categories.”
· “We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.” Thus, 25% to 60% of total assets could be in five or six generals – with the partnership also having smaller positions in another ten or fifteen.
· Sometimes generals work our quickly, other times they take years. Usually, there is no “specific reason why they should appreciate in price.”
· Generals are usually available at “very cheap prices.”
· A group of generals purchased together (i.e., bought in basket-form) should create a “most attractive package of safety and appreciation potential.”
· The Buffett partnership was “usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner” – presumably to then go and buy something much cheaper.
· Generals behave very similar to the Dow market-wise.
· Generals should outperform the Dow over a number of years. During a sharply rising market, generals turn in the best performance of the portfolio. However, they are also the most vulnerable in a declining market.
“…securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities…. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs.”
· These are securities where one can reasonably predict how long it will take to get a certain amount of cash or securities and what might upset the planned event(s).
· This category “will produce stable earnings from year to year, to a large extent irrespective of the course of the Dow.
· Work-outs will generally outperform a declining Dow, but will underperform a strongly advancing Dow.
· “Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these.”
· Buffett believed 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.”
· Buffett’s “self-imposed limit regarding borrowing is 25% of partnership net worth.”
“…situations where we either control the company or take a very large position and attempt to influence policies of the company.”
· Control situations may not return much in any single year – and actually, it is helpful to have a stock stay flat price-wise for a period of time while acquiring it.
· Control situations “have relatively little in common with the behavior of the Dow.”
· Sometimes the partnership buys into a general thinking that it may develop into a control situation. If the price stays low for long enough, that may actually happen. However, if the price increases substantially before the partnership has acquired a large enough stake in the company, Buffett will “sell at higher levels and complete a successful general operation.”
In my opinion, the above descriptions point to the fact that Buffett was aware of market levels and valuations in his investing. He states that “the actual percentage division among the categories is to some degree planned….” This makes sense from a portfolio perspective, because if the level of the Dow is extremely elevated, it might make sense to try and find work-out or control situations where you are at least partially insulated from downward movements of the market. However, one has to be careful to not go overboard planning what percentage of assets will be in generals versus work-outs versus control situations. Doing so might place unnecessary constraints on your investing process and lead you to miss some big bargains. For this reason, Buffett states that while “The actual percentage division among categories is to some degree planned…to a great extent [it is] accidental, based upon availability factors.”
So, as investors, we need to be keenly aware of what’s cheap in the market – and be opportunistic. If Mr. Buffett’s allocation between investment categories was “to a great extent accidental, based upon availability factors,” we should learn to look for bargains even when market levels may appear high. However, I would argue, that we should also be keenly aware of how our existing holdings or new investments may react to a swift downturn in the market and factor that into our expectations.
This section of the 1961 letter also has important implications in terms of catalysts, timing of purchases/sales, portfolio concentration, and leverage. But I’ll leave it up to each reader to decide how Buffett’s method of operation should be applied (if at all) to their own investment process and decision-making.
Thanks for reading along. Next time, we’ll examine Part 3 of the 1961 partnership letter.
Links to other articles in the Buffett Partnership Series:
Previous article: Buffett Partnership Letter Series – 1961 (Part 1)
Introduction: Buffett Partnership Letter Series