Wit, Wisdom, Warren (Issue #6): Method of Operations

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Last time, I reviewed lessons from Warren Buffett’s 1961 letter to partners of Buffett Partnership, with a special focus on “conservative investing” .

Today, I review another part of the same letter – this time on Buffett’s method of operations i.e., how he categorized his investment in three (and later four) buckets and how this has helped him differentiate from most other investors.

Why we can’t be like Buffett
A lot of fund management companies abroad ape the Warren Buffett portfolio – they buy what he buys and they sell what he sells.

Not only that, there are companies across the world who are trying to sell research services to retail investors that aim to mimic Buffett’s style to earn them huge wealth.

We have some such companies in India as well, who often tell their clients – “We’ll help you build a portfolio like Warren Buffett.” Or they would sell their stock recommendation services promising to reveal – “10 Stocks that Buffett Would Own in India”.

So the world wants to be like Warren Buffett. But what such advisors and investors don’t understand is that Buffett is not just about good stocks at bargain prices, high RoE, zero debt, and honest management.

Of course these are a few rules Buffett has followed to pick up his stocks over the years. But a large part of Buffett’s magnificent returns has also come about from the way he has diversified his portfolio across various types of investments.

In the 1961 letter, Buffett talked about this under the heading “Our Method of Operation”. In this, Buffett described the three categories of investments that formed part of his portfolio.

1. Generals: He called the first category as “generals”. Here is how he described this category…

• Generally undervalued stocks.
• No say in corporate policies.
• No certainty when the undervaluation may correct itself.
• Sometimes these work out very fast; many times they take years.
• Difficult at the time of purchase to know any specific reason why they should appreciate in price.
• Dull, boring businesses and lack of immediate catalysts make these available at very cheap prices.
• Lot of value can be obtained for the price paid (buying price matters!) as substantial excess of value creates a comfortable margin of safety.
• Individual margin of safety, coupled with a diversified portfolio creates safety and appreciation potential.
• Knowing when to buy is easier than knowing when to sell (but generally sold when stocks reach fair value).
• In the short term, such stocks move largely in line with the broader market.
• They can become even cheaper, especially during bad market environment.
• Over a period of years, these outperform the broader market.

Doesn’t this sound like the stocks you are looking to buy and hold in your personal stock portfolio – stocks of good businesses to be bought cheap, and to be benefited from the power of compounding over a number of years?

Well, such stocks have also been the largest category of investment for Buffett, and they have earned him more money than he’s earned in either of the other two categories.

2. Work-outs: Buffett called his second category of investments as “work-outs” (also known as “special situations” in today’s parlance). Mergers, liquidations, reorganizations, spin-offs, buybacks are examples of work-outs. Here are some features of such stocks…

• Returns from such stocks depend on corporate action rather than supply and demand factors in the stock market.
• Timing of return and what might go wrong can be predicted within reasonable error limits.
• Returns are achieved irrespective of the movement of the broader stock market, and thus such a portfolio may do well in a bad year for the market or do badly in an otherwise good year.

In those initial years, work-outs were the second largest category of investments for Buffett. At any given time, he was involved in 10-15 such event-based investments.

What is more, given the relative predictability of return, he was also open to borrowing money to offset a portion of his work-out portfolio as he thought there was a high degree of safety in this category in terms of both eventual return (which he expected in a range of usually 10-20%) and intermediate market behavior.

As he wrote, “My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.”

2. Control: The third category of Buffett’s investments was called “control”. Here is how he defined this category…

• Investments where he either controlled the company or took a very large position and then attempted to influence policies of the company.
• Such operations should be measured on the basis of several years, as returns are generated from solely the way a business behaves and not based on how the stock behaves.
• Like work-outs, these situations have relatively little in common with the behavior of the broader market.

As Buffett also wrote, there were times when he bought into a “general” with the thought in mind that it might develop into a control situation.

If the price remained low enough for a long period, he would take over the control of the company (like he did for Sanborn Map and Dempster Mill Manufacturing Company).

If the stock moved up before he had a substantial percentage of the company’s stock, he sold at higher levels and completed a successful general operation.

How much is this thinking and action different from what most of us practice as investors!

First, most of us will never have the capital to take control of a company.

Secondly, most of us will rarely have the wherewithal to invest more in a company whose stock price has stagnated for a period of time, despite that we may be positive on the company’s business potential.

This is what separates Buffett from rest of us, and this is why we must not target to earn long-term returns like Buffett did, and neither should we fall into the trap that someone else can help us buy stocks like Buffett did.

This is not because Buffett possesses some super-powers that we lack, but simply because we may never have the capital (the float) and wherewithal to invest like he has done over the decades.

Anyways, continuing with Buffett’s categorization of his investments, he added a fourth category in 1965. This he called…

4. Generals-Relatively Undervalued: Here is how Buffett defined this category…

• Consists of stocks selling at prices relatively cheap compared to stocks of the same general quality.
• An investor must demand substantial discrepancies from existing valuation standards.
• Important to compare apples to apples – and not to oranges, and it involves hard work.
• In cases you do not know enough about the industry or company to come to sensible judgments, just pass the opportunity despite its significant undervaluation.

Buffett wrote in the 1965 letter that his investments in this category of stocks had produced very satisfactory results.

On being a control investor
While a part of Buffett’s investment philosophy was that of “control” (the third category above), he often mentioned that his bread-and-butter business was in buying undervalued securities (category 1 & 4) and selling when the undervaluation was corrected, along with investment in special situations (category 2) where the profit was dependent on corporate rather than market action.

Being a control investor was one of the prominent factors in strengthening Buffett’s belief in assessing intrinsic values (instead of focusing on stock prices) and long term investing (short-term results have little meaning when you are running a business, plus intrinsic values closely tracks the long term performance of companies).

So, as Buffett has often claimed, he became a better investor because he became a better businessman.

Can you also become a control investor i.e., buy large stakes in companies and then guide the policies? If you have the capital and enterprise (either of which is lacking is most investors), yes you can do that.

But like Buffett bought his control situations over a period of time when their prices stagnated owing to negligible participation from other investors, you won’t get things “consistently” cheap now owing to rapid information flows within the investment community.

Therefore, getting a control situation at a cheap price isn’t a possibility today. In fact, even companies that have the habit of making acquisitions mostly overpay to satisfy the CEO’s ego that wants nothing less than “taking over” other companies and at “any” prices.

It’s also true for many small investors, who stampede to buy more of a stock just because its price has run up (or is running up). Nobody wants to miss out on the party, and this is what causes a large number of ruined portfolios.

Buffett wrote this so beautifully in his 1964 letter…

Active or passive, in a control situation there should be a built-in profit. The sine qua non of this operation is an attractive purchase price. Once control is achieved, the value of our investment is determined by the value of the enterprise, not the oftentimes irrationalities of the marketplace.

The lesson for you is that, despite the fact that you may not become a control investor owing to the lack of capital and temperament to own a company’s decision making, you must…

• Buy a stock as if you are buying an entire business (or a controlling stake), and thus lay great emphasis on the buying price
• Have a long term perspective, as if you are running a business that will do well only in the next 5-10 or even 20 years. Never get disturbed/elated by short term losses/gains.
• If you have the conviction on a stock/business, buy it over a period of time if the price remains attractive.
• Never buy a stock just because it’s price has risen recently.

This is what Buffett wrote in his 1963 letter while defining the cornerstone of his investment philosophy…

Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.

By buying stocks (controls or generals) at a bargain price, you won’t need to pull any rabbits out of a hat to get extremely good returns.