I often like to go back and read the early partnership letters Warren Buffett (Trades, Portfolio) sent out to his investors in the 1960s. I also read the investment letters Charlie Munger (Trades, Portfolio) sent out to his investors and those of Benjamin Graham.
However, Buffett's are the most interesting because he generally went into more detail than other value managers did when they were writing to their investors in the early days.
Buffett's three investment buckets
In one of his very first letters to partners, dated Jan. 18, 1963, the young investor outlined the three types of businesses that he was interested in buying for the portfolio.
These included the so-called "generals," which were cheap undervalued securities that may take many years to work out and the "work-outs," which were situations that depended on corporate action rather than supply and demand factors to realize value. Finally, there were the "control" situations. These were activist positions where Buffett would buy up a significant stake in the business and then try and drive change at the enterprise.
As Buffett explained in his 1962 letter, stocks that fell into the "generals" bucket were not particularly sexy or exciting, but they were cheap and came with a wide margin of safety:
"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. 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 created a comfortable margin of safety in each transaction.
Combining this individual margin of safety with a diversity of commitments creates & most attractive package of safety and appreciation potential. 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."
Buffett was willing to be much more aggressive when it came to his "work-outs." The young investor was happy to borrow up to 25% of the partnerships' net worth to turbocharge partners' profits from these positions:
"Over the years, work-outs have provided our second largest category. At any given time, we may be in five to ten of these; some just beginning and others in the late stage of their development. 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. For instance, you will note when you receive our audit report that we paid $75,000 of interest to banks and brokers during the year. Since our borrowing was at approximately 5%, this means we had an average of $1,500,000 borrowed from such sources. Since 1962 was a down year in the market, you might think that such borrowing would hurt results. However, all of our loans were to offset work-outs, and this category turned in a good profit for the year. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% per annum range. 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."
What can we learn from these statements? Well, for a start, it's clear that Buffett was happy to borrow money to improve returns in the early years. It's also evident in both examples that he was only investing in low risk, high certainty investments. He was never willing to take on more risk to improve returns. That mentality has defined the Oracle of Omaha's investment strategy ever since.
Disclosure: The author owns shares in Berkshire Hathway.
Read more here:
- Why Did Warren Buffett Sell Some of Berkshire's Airline Holdings?
- Warren Buffett on Estimating Discount and Growth Rates
- Seth Klarman on Rational Thinking in Times of Market Stress
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