On Friday, I began reading all of Buffett’s shareholder letters. Well, actually, I did begin reading his letters, but I made a schedule for reading a variety of letters, from Buffett to Terry Smith, Nick Sleep and Francois Rochon. I’ll leave below the schedule and will be sharing through Twitter the main takeaways of all these writings.
Anyway, I began reading Buffett’s Letters, which start in 1957 with the fund being under the name of ‘Limited Partners’, (I’m currently at 1966, writing this article on Monday 23rd). In them, Warren basically states how markets have performed in each year, how the fund has performed, how other investment firms have done and gives room to some meditations he had. Lots of them are on the power of compounding.
While I was going through his letters, I noticed how clearly and thoughtfully Warren explains the strategy he followed and I was kind of shocked I have not read once anyone writing on this. Even though some parts may be inapplicable to individual investing, I believe we can all nurture ourselves from the knowledge he shares and, perhaps, it could trigger new ideas or make us re-think our approach.
This will be an article longer than usual, but it will contain the completeness of Warren Buffett’s strategy in 1957-66 (I hope to cover everything). So, worth.
Strategy
I am interpreting and paraphrasing what I have read, but I’ll try to be as accurate as possible. To make it more digestible, I’ll break down the strategy into the most important categories. Just for context, these are the results the strategy brought him in the 60s.
Buying
Warren Buffett is very much known for getting the concept of MOAT to a mature state, but this word is not even mentioned from 1957/66. The actual first time in which the word is mentioned is in 1986 and the first time the concept of a ‘sustainable competitive advantage’ is discussed is in 1984. His strategy early on does include a qualitative aspect and could, unconsciously, include the concept as well, but it is not mentioned.
In this 10 year timeframe, I read several times, perhaps every year’s letter include it, the importance of the price he pays for companies. Warren highlights how crucial it is to pay as cheaply as one can.
“Never count on making a good sale. Have the purchase price to be so attractive that even a mediocre sale gives good results.” Jan, 1963
“This is of particular satisfaction to me since I consider the buying end to be about 90% of this business.” July, 1964
Before moving forward, I wanted to say he almost literally states how subjective these things are. By no means are these rules of thumbs nor must-follow tips.
Diversification
Warren consistently mentions what’s the weight of the biggest position the portfolio has. During that decade, the top position oscillates between 10-35%, which could be considered as heavy concentration for what I hear to be the standards today.
“We are obviously only going to go to 40% in very rare situations - this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity.” Jan, 1966
“In selecting the limit to which I will go in anyone investment, I attempt to reduce to a tiny figure the probability that the single investment (or group, if there is intercorrelation) can produce a result for our total portfolio that would be more than ten percentage points poorer than the Dow” (…) “We presently have two situations in the over 25% category.” Jan, 1966
“The addition of 100 stocks simply can’t reduce the potential variance in a portfolio performance sufficiently to compensate the negative effects.” Jan, 1966
The importance of thinking for oneself
Warren Buffett is a thorough reader and a widely known intellectual. Among his writings, he often calls out the weight that thinking has in his decisions. Perhaps I’m incorrect with the following, but he seems to believe that the only way to get rid of index-like performance is to think and evaluate upon thoughts, measures, hypothesis and facts. It is key though to be a consistent thinker because, if not, the tendency towards index-like performance is inevitable.
“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you.” Jan, 1962
“A public opinion poll is no substitute for thinking.” Jan, 1965
“We diversify substantially less than most investment companies.” Jan, 1966
Measurement of performance
Planning investments is not enough. Measuring performance is of extreme relevance since it’s what allowed him to compound on the errors he made. As mentioned, he evaluated his decision performance upon hypothesis and facts. Of a more pragmatic substance, he used the Dow Jones as the benchmark. Lastly, to evaluate the conservatism (which he believed he maximized) of his portfolio, he thought the ultimate measure was to compare the decline his portfolio suffered in tough market conditions.
“We feel it is essential that investors and investment managements establish standards of performance (apriori) and, regularly and objectively, study their own results just as carefully as they study their investments.” July, 1964
I think this way of establishing upfront how will the measurement be made doesn’t give room to potential biases that could occur in hindsight.
“Our target is an approximately 1/2% decline for each 1% decline in the Dow and if achieved, means we have a considerably more conservative vehicle for investment in stocks than practically any alternative.” July, 1962
Patience
Generally, the price paid for companies was as undervalued as they could find. Knowing the market, it is usually the case where such scenarios could take a very long time to flip. Therefore, patience is required for investments to work out (or not).
At the same time, waiting for a particular stock to be in an actual undervalued (by Warren) spot is also essential. It determines the price you pay for such company, which, in Buffett’s words, is around 90% of the job.
In 1957, the fund had a position in a company at around 10/15%, but Warren wanted for it to be at 20%. What did he say? That he wouldn’t buy at the current prices because the expected return from them did not seem satisfactory.
As Graham’s pupil, Warren was also very conscious of market behavior dynamics. He quoted his mentor several times, one of them referring to Benjamin’s idea of the market being a voting machine in the short run and a weighting machine in the long term.
“I feel 3-5 years is an absolute minimum to judge performance” Jan, 1963
“Our business is one requiring patience. It has little in common with a portfolio of high-flying stocks.” Nov, 1963
No Predictions
Even though he ‘makes’ and reiterates a particular prediction of at which rate could the Dow compound from the 60s levels, Warren consistently states he does not make nor is in the business of making predictions. In accordance to the idea but in parallel, he continues with one of Graham’s thoughts.
“The success of past methods and ideas does not transfer forward to future ones” Jan, 1966
“We will not sell our interests in businesses (stocks) when they are attractively priced just because some astrologer thinks the quotations may go lower even though such forecasts are obviously going to be right some of the time. Similarly, we will not buy fully priced securities because "experts" think prices are going higher” July, 1966
The way he addresses uncertainty is by thinking statistically (a very recurrent theme of this Newsletter haha). He assigns probabilities of success and failure to each company and future scenarios playing out. Logically, he then establishes theoretical position sizes accordingly.
“Just why any particular one should do is hard to say at the time of purchase, but the group expectancy is favorable” Nov, 1963
Avenues for investments
All following extracts are from January 1965.
Generals – Private Owner Basis: “a category of generally undervalued stocks, determined 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”
Generals – Relatively Undervalued: “this category consists of securities selling at prices relatively cheap compared to securities of the same general quality” (…) “It is important in this category, of course, that apples be compared to apples - and not to oranges, and we work hard at achieving that end.”
Workouts: “They arise from corporate activity - sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or "inside information" pertaining to such developments, but to publicly announced activities of this sort.”
Controls: “These are rarities” (…) “They result from situations where a cheap security does nothing pricewise for such an extended period of time that we are able to buy a significant percentage of the company's stock.”
On portfolio allocation:
“The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors.” Jan, 1962
Objective
When making the buying decisions, Warren kept two things in mind
“We are hopeful that they will each, over a ten or fifteen year period, produce something like the ten percentage point margin over the Dow that is our goal.” Jan, 1964
Minimize risk as much as it could possibly be. He pursued and measured this goal with the following course of action (besides the margin of safety taken when buying):
“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning” Jan, 1965
“In any event, evaluation of the conservatism of any investment program or management (including self-management) should be based upon rational objective standards, and I suggest performance in declining markets to be at least one meaningful test.”
Selling
Yes, he sold companies. As stated in one of the quotes above, he made sure the buying price was as low as possible so that the selling price could be as ‘badly timed’ as possible. Warren comfortably sold when a wide gap between current price and intrinsic value was closed (or great part of this gap).
“That would suit us fine, but it also suits us if they advance in the market to a price more in line with intrinsic value enabling us to sell them, thereby completing a successful generals - private owner operation.” Jan, 1965
Personal Commentary
This article was like 3x normal longitude, but I didn’t have a choice. I tried to be as comprehensive and concise as possible, hope you found it useful.
I’m currently working on a research article, this time on Visa. If you would like to keep up with the Sunday Newsletter and with Research/ERs articles, feel free to subscribe below!!
Great work! Definitely not the ultra high quality businesses Buffet we know today.
Regards,
Dani
Excelente artículo amigo 👌