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Warren Buffett's Magic Formula in 1965?

June 27, 2007
Lonnie J Rush

Lonnie J Rush

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I recently read through Buffett's Partnership Letters again. This time I paid particular attention to one of the strategies he used to perform better than the market in down years. Buffett employed three such techniques from 1956-1965:

  1. Generals - Private Owner – Large margin of safety was a cushion when markets fell.
  2. Workouts – Special situations were not correlated to the market.
  3. Controls – Accounting of “controls” typically outperformed the market in down years.

In his January 15, 1965 letter to partners, Buffett introduced a fourth category called:

4. Generals -Relatively Undervalued

"We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sells at 10 times earnings. The risk has always bothered us enormously because of the helplessness position in which we be left compared to the "Generals -Private Owner" or "Workout" types. With this risk diminished, we think this category has a promising future."

The introduction of this new technique followed a period of significant run up in the Dow of 20.6% and 18.7% in 1963 and 1964, respectively. Entering 1965, “Generals - Private Owner” and “Workout” opportunities were dwindling while “Generals - Relatively Undervalued” were becoming a growing percentage of the Buffett Partnership.

I’ve ruled out the possibility of a shorting technique as everything I’ve read suggests that Buffett has never shorted a stock. If true, how then did Buffet reduce the risk of this arbitrage gap closing in the wrong direction? Effectively, he was betting that the 12 times earnings investment would correct upward rather than the more expensive stock, or both, experiencing a downward change in valuation.

Parallel to this analysis, I was studying results from Magic Formula (MF) stocks this past year. Joel Greenblatt in “The Little Book That Beats the Market” argued that by buying MF stocks – businesses with the best combination of high returns on capital invested and high earnings yields - an investor would be purchasing good businesses selling for cheap relative to the market. Basically, the prescribed MF is an index of good businesses selling cheaper than the market, regardless of the market level.

Although most MF stocks were not bargains worthy of “Generals – Private Owner” purchase, many resembled Buffett’s category of “Generals – Relatively Undervalued.” They were undervalued relative to the market, their industry, and similarly situated peers. Without a significant margin of safety to private owner value, each MF stock was also at risk of an overall valuation change and elimination of the arbitrage opportunity. The MF mitigates this overall risk by purchasing a basket of 20-30 non-correlated MF stocks. The MF produced returns as high as 30.8% over the 17 year period.

In his January 20, 1966 letter Buffett commented on the progress of this new category:

“Our results were quite good in the "Relatively Undervalued" group, partly due to implementation of the technique referred to in last year's letter which serves to reduce the risk and potentially augment the gains. It should reduce risk in any year, and it definitely augmented the gains in 1965. It is necessary to point out that results in this category were greatly affected for the better by only two investments. Candor also demands I point out that during 1965 we had our worst single investment experience in the history of BPL on one idea in this group. Overall, we had more than our share of good breaks in 1965.”

Did Buffett purchase a basket of non-correlated MF like stocks considered relatively undervalued to mitigate risk? A basket would reduce the risk of a single position wiping out the gains of the entire group. And if a valuation change occurred for the entire market, the basket as a whole would likely fall by a lesser amount due to the already depressed valuation. Moreover, the basket is likely to include securities with potential for large non-market correlated gains once the uncertainty lifts, like that of PNCL’s 150%+ returns seen below.

Interestingly, Buffett mentioned that just two investments accounted for most of the gains in the relative category while one investment resulted in the worst experience in partnership history. Coincidentally, I found that a small handful of Top 25 MF stocks over the past year accounted for a majority of the gains. For this “back of the envelope” analysis, I chose a sample of 10 Top 25 MF stocks based on their simple business models and competitive advantages. While one MF stock tanked, overall, one would have done quite satisfactory with a basket of MF stocks over the past year. It should be noted that virtually all of the stocks were surrounded by high levels of uncertainty with no apparent relief in sight.

Top 25 MF Picks

Returns

PNCL

150%+

CECO

50%

PPD

50%

CRYP

33%

HNR

25%

INTX

20%

KSWS

20%

RAIL

0%

NOOF

0%

EGY

(40%)

Annualized

30% +

While it is unlikely Buffett performed an elaborate study, my guess is he intuitively knew that holding a basket of MF like stocks relatively undervalued was a better alternative to holding cash and would likely outperform the market in down years. In fact, the MF study results support this claim. MF stocks gained 35% over the worst 3-year period while the market lost -45% over the worst 3-year period; a whopping 80% differential. MF was clearly a better alternative to cash and significantly outperformed the market in down years.

Buffett has consistently stated that small portfolios should be fully invested at all times. As opportunities dried up, he allocated capital to this category and generated “Relatively Undervalued” returns of 23%, 72%, 49%, from 1966-1968 respectively. Although I wasn’t able to find 1964 and 1965 returns, Buffett commented that the group did outperform the market.

I can’t say for sure the exact techniques Buffett used in the “General – Relatively Undervalued” category but he may have employed his own Magic Formula some 40 years prior to Joel Greenblatt’s Magic Formula. As “General – Private Owner” and “Workout” opportunities dried up, did a basket of good businesses at good prices relative to the market work 40 years ago for Buffett as it worked in the MF formula study?

 

About the author:

Lonnie J Rush
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.2/5 (64 votes)

Comments

maxprogram
Maxprogram - 6 years ago
Regarding Buffett's technique to control the risk of his Relatively Undervalued category:

Although I'm not *certain* this technique involved shorting, I do know that Buffett did short during his partnership days for arbitrage and other hedging methods. Graham did this a lot with his partnership, and Buffett did it for Graham while they worked together. I also remember somewhere in the partnership letters Buffett talking about the importance of finding companies that were TRULY comparable, or of lesser quality than the purchase (as quoted above). This leads me to believe there was some sort of shorting/hedging technique involved.

I agree that it may involve buying or selling a basket of relatively undervalued stocks. I don't remember which category Buffett fit American Express in, but he bought Disney in the later 60s, and that seems like it would have been a candidate for "Relatively Undervalued." Somewhere else in the letters he says that stocks in the RU category were also there because they were so large that attempting to value them according to what a private buyer would pay would be useless.
highterm
Highterm - 6 years ago
Where might one view the Buffet Partnership letters, are they freely available?

dasitaly80
Dasitaly80 - 6 years ago
and do u know if it s possible to find pabrai's letter?
DTEARE
DTEARE - 4 years ago
Warren is a master with math and numbers Everyone close to him and himself says all he does is look in the paper to get a quick figure from stocks to see if it is undervalued or not then he does more research what is his quick math method is my question it cant be that hard he taught it to his kids when they were very young so they could spot a deal i think we all over complicate the whole process
sdash
Sdash - 3 years ago
www.investutils.com has a good tool for buffett and Graham intrinsic value formula calculations.
razielmelchor
Razielmelchor - 11 months ago
He talks about it here_[www.buffettfaq.com], find "shorting" . I think he may have either just shorted 25% or less of the paired company, or shorted around 25% the whole market. He talks about how, while working for Graham, he would go to universities and borrow all of their stocks, "Just give me all of them" and how they would look at him strangely for shorting all of the stocks they owned haha.

What would be the drawbacks of buying put options of the overvalued paired company? Since he worried about the paired company coming down in price, this would solve that risk. Additionally, since he was expecting about 25-50% returns on the relatively undervalued company, and say having to pay 2-4% a year for the put option , you can wait for 3-5 years and still make money. That's if everything goes according to plan. If the paired company came down in price, you would then make money on the put option.

Actually, it might make more sense that Warren was buying put options in the paired company.

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