“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.”
--Â Warren Buffett (Trades, Portfolio)
Berkshire Hathaway track record
Warren Buffett (Trades, Portfolio) has built a fantastic track record at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), achieving a 20.9% return per year in 53 years, or a 2,404.748% total accumulated return. He did this buying great businesses at reasonable prices. He used insurance leverage, he took advantage of fiscal efficiency and he never paid a dividend.
His strategy evolved over time, as assets grew and he listened more to his partner, Charlie Munger (Trades, Portfolio). He focused on buying great businesses at reasonable prices. He did that investing in publicly traded equities but also in taking over businesses and bringing them under the Berkshire umbrella.
The 50% remark
But when Buffett made the “I think I could make you 50% a year” remark, he was not talking about managing a portfolio of many billions of dollars. He was talking about managing a few million dollars and having the “privilege” of investing in small and illiquid companies.
Buffett invested in this arena when he started his career in the 1950s. In 13 years, he did not achieve a record of 50% per a year (that could probably demand extreme portfolio concentration), but he managed to get close to a remarkable 30% a year. But more than just that, he achieved those returns with a portfolio management structure that maximized returns while controlling risks.
Clues to this type of portfolio management can be found in the master’s published Partnership Letters. These contain valuable insights into implementing investment strategies, identifying individual opportunities and actively managing portfolios.
The Partnerships' track record
Between 1957 and 1969, the Buffett Partnerships achieved an annual compound return of 24.5% net of fees (29.5% before fees). The annual return of the Dow over the same time with dividends was 7.4%. The Partnerships charged no management fee, took 25% of any gains beyond a cumulative 6% and agreed to absorb a percentage of any losses.
Generally, fund managers look to properly diversify their portfolios among sectors and geographies. And more often than not, they tend to stick to one process of investment selection. The problem is that over time, certain investment methods tend to be favored and others neglected.
Having a portfolio structure composed of three different investment strategies allowed Buffett to consistently approach the set of market opportunities with different lenses and choose the most convenient for long-term profit maximization and risk-exposure control.
Three investment strategies
Buffett’s system for managing the Partnerships was composed of three strategies, and each investment in the portfolios was cataloged with one strategy label. The strategies he pursued were: generals, workouts and controls.
They all had in common the fact that Buffett was looking for extreme cheapness and that he was looking mostly in the camp of small or micro caps. But each strategy accomplished one objective, and he masterfully managed the weight in each one according to where the opportunities appeared.
The "generals” category referred to undervalued stocks, the "workouts" category were the investments in special situation events and "controls," although rare, were the investments where the Partnership assumed, over time, an activist position, trying to get management to make moves that would maximize the value of the stock.
Over the next few articles, I will dissect each of these strategies and provide an overview of their adaptation to today’s investment scene.
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