In this article, we will a look at the second part of the 1962 Buffett partnership letter. For your reference, my comments on part 1 of the 1962 letter can be found here.
In past letters, Buffett covered his method of operation — and he does so again in the 1962 letter. In this article, I plan to try and focus on some aspects of Buffett’s method of operation that I have not discussed previously.
Below are some passages I have selected from the section entitled “Our Method of Operation.” My commentary is presented below each method of operation described by Buffett.
Our Method of Operation
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 actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors.
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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.
Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any compelling reason why they should appreciate in price…. 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.
Many times generals represent a form of “coattail riding” where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.
The first thing that is noteworthy is that Buffett picked up securities and companies opportunistically. He bought based on “availability factors,” and not based on some portfolio allocation model or grand plan. He says that while the split between his three different investment categories was somewhat planned, to a great degree, it was accidental.
Next, he begins discussing the investment category of generals. He notes that this has been the largest category of investment for the Buffett partnership, and that more money has been made in generals than in either of the other two categories. Finally, he mentions that the partnership usually has “fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another 10 or 15.” Thus, usually, the partnership would have at least 25% to 60% of total assets in five or six positions. Hence, the concentration in the partnership was significantly higher than in your typical mutual fund that tries to hug the market index.
Then, he notes that the timetable for realizing value in generals can be difficult to ascertain at the outset. Interestingly, Buffett also states that he doesn’t buy into a position with the idea that he will extract every last bit of upside. He says that he is comfortable selling out at some “intermediate level between our purchase price and what we regard as fair value to a private owner” — presumably, because he can find something else to buy in the market that’s even cheaper than the existing position.
Finally, Buffett discusses how investing in generals can be a form of coattail riding, and that he is all for riding the coattails of others (and letting them do the work), as long as there is value in the situation and the controlling stockholders know what they’re doing and are trustworthy.
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….
We were fortunate in that we had a good portion of our portfolio in work-outs in 1962. As I have said before, this was not due to any notion on my part as to what the market would do, but rather because I could get more of what I wanted in this category than in the generals. This same concentration in work-outs hurt our performance during the market advance in the second half of the year.
Over the years, work-outs have provided our second largest category…. I 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…. My self-imposed standard limit regarding borrowing is 25% of partnership net worth, although something extraordinary could result in modifying this for a limited period of time.
You will note on our yearend balance sheet (part of the audit you will receive) securities sold short totaling some $340,000. Most of this occurred in conjunction with a work-out entered into late in the year. In this case, we had very little competition for a period of time and were able to create a 10% better profit (gross, not annualized) for a few months tie-up of money. The short sales eliminated the general market risk.
Buffett’s second category of investment is work-outs. These are securities that have a more certain timetable than generals — as value realization depends on corporate events or actions.
Work-outs were the second largest category of investment for the Buffett partnership. Warren Buffett (Trades, Portfolio) believed in using borrowed money to offset a portion of the work-outs in the portfolio, but he established a self-imposed limit on this type of borrowing — presumably to avoid getting into trouble. (Too much debt and an unexpected movement in market or security prices can make for a bad day.)
Buffett then highlights the fact that he sold short certain securities in conjunction with a “work-out entered into late in the year.” Opportunistically, Buffett entered into a work-out situation (when other buyers were scarce) and made some additional profit. However, to truncate his downside, he sold short some securities to eliminate the general market risk. So, here we have an example of Buffett hedging general market risk. Thus, we can legitimately refer to the Buffett partnership as a hedge fund.
The final category is “control” situations, where we either control the company of 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…. 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. Usually, it moves up before we have a substantial percentage of the company’s stock, and we sell at higher levels and complete a successful general operation.
The final investment category that Buffett addresses is control situations. He describes a control situation as one in which the partnership takes a large position in a company and tries to influence management to undertake certain corporate actions. Buffett further notes that this category of investment “should definitely be measured on the basis of several years,” as it can take quite a while to influence corporate policy.
Buffett notes that generals can sometimes become control situations if the price remains low for a long enough period of time. (However, he notes that generals usually move up in price before the partnership can acquire a controlling stake.)
Thus, Buffett had two potential exits for investments in generals: 1) If a controlling stake couldn’t be acquired because the price moved up too quickly, he could sell at the higher price and move on to the next general, or 2) If a controlling stake could be acquired, he could buy up the controlling stake and then encourage management to take proper action on behalf of the shareholders.
Having the option for a general to become a control situation may have allowed Buffett to feel more comfortable taking larger positions in generals than other investment managers (who were unwilling to get involved in corporate affairs). I believe this added to Buffett’s already sizeable edge over his investment management peers.
Next time, we’ll take a look at the third part of the 1962 Buffett partnership letter.
Links to other articles in the Buffett Partnership Series:
Previous article: Buffett Partnership Letter Series – 1962 (Part 1)
Introduction: Buffett Partnership Letter Series