The value strategy Warren Buffett (Trades, Portfolio) used for investment selection to the Buffett Partnership, which he ran in the 1950s and 1960s, was known as the “Generals.” As he described in his Jan. 18, 1964 letter to investors:
“'Generals' - A category of generally undervalued stocks, determined primarily by quantitative standards, but with considerable attention also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation on the enterprise substantially below what careful analysis indicates its value to a private owner to be. Again, let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management - we like a decent industry - we like a certain amount of 'ferment' in a previously dormant management or stockholder group. But we demand value."
Deep-value strategy
This was a classic deep-value strategy. Buffett looked in small- and micro-cap buckets. He tried to find the most ignored, non-glamorous and hated companies or industries. He used volatility in his favor and, because he had a long-term horizon, had no problem investing (sometimes heavily) in illiquid stocks. These investments didn’t have a particular catalyst, but, as Benjamin Graham taught him, price eventually caught up with value.
It is harder today to find companies trading with the same discounts as back then, but the small, micro and illiquid camp still offers the same edge opportunity to small investors because it is just a generally hated segment.
Buffett said this group traded in line with the Dow, meaning it registered a negative return in years of declines for the index, but it was also the best-performing group in years of advancing markets. Over the years, Buffett expected this strategy to deliver much better returns that the general index and, in fact, it did.
Usually the Partnership had five or six large positions (5% to 10% of total assets) and about 10 to 15 smaller ones. Sometimes they worked out very fast. Many times, they took years.
This was the best-performing category for the Buffett Partnership, measured by average return, and also had the best percentage of profitable transactions.
Relatively undervalued
Buffett eventually presented a new category under Generals: the “Relatively Undervalued” (introduced Jan. 18, 1965). In this subcategory, he looked more in the camp of mid- to large- cap companies that exhibit similar characteristics to comparable competitors, but are trading with much lower valuations. Of course, the risk of this strategy is the multiples of the competitors are inflated. But in that judgement entered the ability of Buffett to distinguish where, in fact, the opportunity lies. This is a very up-to-date strategy.
Compounders
In the early days, Buffett clearly preferred price over quality. Although there were some examples where he did invest in high-quality businesses, like American Express (AXP, Financial) or Geico, those companies were affected by very specific problems that brought them to a level of cheapness that attracted Buffett.
Today, there is definitely a place for high-quality businesses in a long-term value investing strategy. A group of high-quality stocks bought at reasonable valuations allow for a portfolio to disconnect from the multiple revaluation factor and to focus on pure cash flow generation and compounding returns. Charlie Munger (Trades, Portfolio) would probably agree.
These kinds of businesses are less volatile than the general market, pay more steady dividends and do more frequent buybacks and, therefore, are much less exposed to economic cycles. This allows the investor to have a part of the portfolio that could be safer in times of high valuations and a source of liquidity in times of severe market corrections, when other compelling opportunities emerge.
It is hard to get a edge in quality large-cap investing. The only edge available is time arbitrage or the ability to predict what a business can produce for the next 10, 20 or 30 years. The kind of quality analysis this framework implies is what gives the investor confidence when times are hard.
Being at ease to use different investment strategies at different market moments and evolving those styles over time is of crucial importance for a long-term investor.
In the future, I will write about another very important strategy Buffett used when managing his Partnerships, whose fundamental quality was to produce uncorrelated returns with the markets. We are going to analyze the workouts, or special situations, strategy.
Below is an example from the January 1961 letter, which is a description of the Parternships' investment in Sanborn Map Co. This investment started as a General, but since the stock was trading at a considerable discount and the business had high-quality characteristics, it eventually evolved to represent a 35% position and became a Control investment:
"Sanborn Map Co. is engaged in the publication and continuous revision of extremely detailed maps of all cities of the United States. For example, the volumes mapping Omaha would weigh perhaps fifty pounds and provide minute details on each structure. The map would be revised by the paste-over method showing new construction, changed occupancy, new fire protection facilities, changed structural materials, etc. These revisions would be done approximately annually and a new map would be published every twenty or thirty years when further paste overs became impractical. The cost of keeping the map revised to an Omaha customer would run around $100 per year.
This detailed information showing diameter of water mains underlying streets, location of fire hydrants, composition of roof, etc., was primarily of use to fire insurance companies. Their underwriting departments, located in a central office, could evaluate business by agents nationally. The theory was that a picture was worth a thousand words and such evaluation would decide whether the risk was properly rated, the degree of conflagration exposure in an area, advisable reinsurance procedure, etc. The bulk of Sanborn's business was done with about thirty insurance companies although maps were also sold to customers outside the insurance industry such as public utilities, mortgage companies, and taxing authorities.
For seventy-five years the business operated in a more or less monopolistic manner, with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort. In the earlier years of the business, the insurance industry became fearful that Sanborn's profits would become too great and placed a number of prominent insurance men on Sanborn's board of directors to act in a watch-dog capacity.
In the early 1950’s a competitive method of under-writing known as "carding" made inroads on Sanborn’s business and after-tax profits of the map business fell from an average annual level of over $500,000 in the late 1930's to under $100,000 in 1958 and 1959. Considering the upward bias in the economy during this period, this amounted to an almost complete elimination of what had been sizable, stable earning power.
However, during the early 1930's Sanborn had begun to accumulate an investment portfolio. There were no capital requirements to the business so that any retained earnings could be devoted to this project. Over a period of time, about $2.5 million was invested, roughly half in bonds and half in stocks. Thus, in the last decade particularly, the investment portfolio blossomed while the operating map business wilted.
Let me give you some idea of the extreme divergence of these two factors. In 1938 when the Dow-Jones Industrial Average was in the 100-120 range, Sanborn sold at $110 per share. In 1958 with the Average in the 550 area, Sanborn sold at $45 per share. Yet during that same period the value of the Sanborn investment portfolio increased from about $20 per share to $65 per share. This means, in effect, that the buyer of Sanborn stock in 1938 was placing a positive valuation of $90 per share on the map business ($110 less the $20 value of the investments unrelated to the map business) in a year of depressed business and stock market conditions. In the tremendously more vigorous climate of 1958 the same map business was evaluated at a minus $20 with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing."
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