A Portfolio Allocation Lesson From Buffett's Washington Post Investment

In 1973, Warren Buffett (Trades, Portfolio) made one of the best investments of his career- the Washington Post. Little did he know that in the following year, the stock, which was trading well below his calculated intrinsic value at the time of acquisition, would sink further. In his 1985 letter to shareholders, the Oracle of Omaha penned the following account:

“We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price-value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value - and even thought, itself - were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest - whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?)

Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974 our WPC holding showed a loss of about 25%, with market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

You know the happy outcome. Kay Graham, CEO of WPC, had the brains and courage to repurchase large quantities of stock for the company at those bargain prices, as well as the managerial skills necessary to dramatically increase business values. Meanwhile, investors began to recognize the exceptional economics of the business and the stock price moved closer to underlying value. Thus, we experienced a triple dip: the company’s business value soared upward, per-share business value increased considerably faster because of stock repurchases and, with a narrowing of the discount, the stock price outpaced the gain in per-share business value.”

A 25% paper loss was not the low point – at one point during 1974, the Washington Post investment showed an almost 40% loss.

Of course, we all know the happy ending. Four decades later, Buffett exited the position in a genius tax-free swap with Graham Holdings, for more than $1.1 billion.

Many have lauded the virtues of this fabulous investment:

• Huge margin of safety.
• Capacity to suffer.
• Decades of holding.

I agree with all of the above, but I think there’s one other key lesson that has been rarely discussed – portfolio allocation.

To begin, let’s take a look at the following table:

One aspect that jumps out is that despite a brutal market decline in 1973 and 1974, Berkshire Hathaway’s (BRK.A)(BRK.B) book value actually increased by 4.7% and 5.5%. That’s remarkable. We know Washington Post was down 25%, but Berkshire’s other equity positions suffered big losses that year too. In the company's 1974 annual report, such disclosure was made:

“Realized investment losses in 1974 aggregated $1,908,000 with a tax carryback credit of $568,000, reducing the after-tax realized investment loss to $1,340,000.

Unrealized market value decrease in investments in preferred and common stocks of unaffiliated companies amounted to $4,356,000 in 1974 and $13,741,000 in 1973. ”

Berkshire’s balance sheet that year showed preferred and common stocks of unaffiliated companies were $2.86 million and $50.7 million at cost, and $1.84 million and $34.8 million at market value.

That means, in 1974, Berkshire was in a net loss position in its equity portfolio of almost $16 million, of which Washington Post was $2.6 million.

How does this square with Berkshire’s book value gain?

It definitely has something to do with Buffett’s portfolio allocation. Below are Berkshire’s investable assets at year-end 1974:

• Cash: $4.2 million
• U.S. Treasury bills: $11.1 million
• Bonds: $71.5 million
• Preferred stocks: $2.86 million
• Common stocks of unaffiliated companies: $50.7 million
• Common stocks of Blue Chip Stamps: $17 million
• Investments in unconsolidated bank subsidiary: $23.6 million

In total, Berkshire essentially had a $181 million portfolio, of which equity reported using market value of $50.7 million. Of this, only 28% of the total portfolio was at cost and, at market, the allocation was even lower. Washington Post was about 20% of the total equity portfolio at cost, but only 6% of the total portfolio at cost.

If Berkshire had allocated 75%, instead of 28%, to equities under market value, a rough calculation would show the company's book value suffered a loss that year instead of a gain. Imagine an investor who has 100% of his portfolio in equities and 25% in the Washington Post – a decline of 25% would result in 6.25% paper loss that year for the position. But for Buffett, it was only a 1.5% paper loss.

This is an absolutely key lesson Buffett didn’t discuss in his letter. It’s not just about what you buy, it’s also about how much you buy. Most of the time, how much you buy matters more than what you buy.

We’ll continue to explore this concept in the future.Â

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