Housekeeping
Thanks for signing up to my newsletter! I didn’t write regularly for the past month, but that is about to change. Because of the football (or soccer) European Championship, I spent my evenings with friends. Then I moved to a new apartment across town. In the future, I will post at least once a week. If you find interesting topics, comment or write to me on Twitter @InvestRoiss
Currently, I am reading the “Tao of Seneca” by Tim Ferris based on the writings of Seneca, and I will write a series on how stoic philosophy can give you an edge in the market. Be sure to subscribe so you don’t miss it.
Introduction
Before Warren Buffett became the greatest investor of all time (the Goat), he invested through a partnership and achieved great returns there, beating the Dow Jones Index convincingly. In the first 10 years he achieved 29% annually compared to the 9.7% of the Dow (1028.7% vs 141% cumulative) - a remarkable performance. I read through the 13 years of partnership letters and compiled the most important lessons.
Special Situations and Portfolio Allocation
Already in the first letter, Buffett found the general market level was priced above intrinsic value and lowers the expectations of his partners. However, he also reassures them that even in a full scale bear market, it will not hurt the market value of their work-out portfolio. By work-outs, Buffett means special situation investing, so mergers, liquidations, spin-offs, restructures and rights offerings. Nowadays we know Buffett for investing in “evergreen” companies, so I found it interesting that he invested in work-outs. Joel Greenblatt’s excellent book “You Can Be A Stock Market Genius” describes how to find and profit from these special situations. For his portfolio allocation, Buffett invested in undervalued securities at 5-10% per position (around 5) with around 10-15 smaller undervalued positions. In the beginning he invested into 10-15 special situations at all times, with the big ones being 10-20% and sometimes on margin up to 25%.
This was news to me, as I recall Charlie Munger’s quote: “Smart men go broke three ways - liquor, ladies and leverage. “And Warren with his own words denouncing leverage: “Borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator–and definitely not Charlie nor I–can tell you when chaos will occur.”
25% leverage isn’t the end of the world, but I think his distaste for borrowed money came later, when Rick Guerin, one investor mentioned in the article “The Super-investors of Graham-and-Doddsville”, and a friend of Buffett got margin-called in the 1973/1974 downturn. As a result, he sold his Berkshire shares for under $40. Those shares now trade at $416.244,00 USD. Ouch!
Forecasting and “fashion investing”
Buffett never tries to forecast business results or the market. He recalls one of the essential lessons from “The Intelligent Investor”: In the long run, the market is a weighing machine - in the short run, a voting machine. I have always found it easier to evaluate weights dictated by fundamentals than votes dictated by psychology. He warns of the exuberance he sees at both the amateur and professional level in 1958 and warns of the “New Era” philosophy that many market participants tout. Buffet turned out to be correct. The Recession of 1958 was a sharp worldwide economic downturn.
He mentioned that short-term results aren’t meaningful and offered a great quote:
You will not be right simply because many people momentarily agree with you. You will be right if your hypotheses, your facts and your reasoning are correct.
Buffett invested in often illiquid and small companies, when asked why he doesn’t choose the world’s biggest and greatest companies, he gives the example that investing in the world’s biggest companies (General Motors, Standard Oil of New Jersey, Sears, Dupont, US Steel, Aetna, AT&T and Bank of America) would have lost you 16% in just the first half of 1966. Seeking safety in big companies or “fashion investing” into the hottest stock, is a fallacy. One should not invest based on guesses or emotions, but only if you have a long run edge and the fundamentals are fitting. Without these criteria, one is speculating. Here Buffett quotes his mentor Ben Graham: “Speculation is neither illegal, immoral nor fattening (financially)”.
Quality vs Quantity
There has been an endless debate of quality vs quantity - of growth vs. value. That debate even goes back to Warren Buffett’s Partnership where he debates whether the philosophy “buy the right company and the price will take care of itself” or “buy at the right price and the company/stock will take care of itself” is correct. Being a student of Ben Graham, he leans towards the quantitative side, but his sensational ideas were towards the qualitative side, where he had a high probability insight. These are very infrequent and require hard work. He also ponders how much one should put into the best idea and the ninth best one, but never gives an answer.
There is no insight required on the quantitative side. The figures should hit you over the head with a baseball bat. In bull markets such as the one we are in 2021, those statistical bargains have disappeared, however in other countries like Japan they still exist.
Conclusion
In his letters Buffett underlines it is much easier to achieve higher returns with a small portfolio and hard work. There are special situations and illiquid companies where most of the institutions can’t or won’t invest and if you have an edge, one can outperform the market.
Brilliant article as always. Do you think that both Warren and Charlie refrained from leverage after the Guerin incident? Seems like both loved leverage initially and used unorthodox leverage via float and subsidiary company's cash ever after.
Besides, you inserted a wonderful cliffhanger about cheap Japanese equities! Looking forward to an article of yours about these! And having UK-based BATS as a benchmark for low multiples.