“The highest rates of return I’ve ever
achieved were in the 1950’s. I killed the Dow. You ought to see the numbers. But I was investing peanuts back then. It’s a huge structural advantage
not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” Perhaps you’ve heard this line before. It’s from the sage of securities himself, and I guess he doesn´t need any further
introduction on this channel? It’s Warren Buffett. As some of you know, before operating through
the entity of Berkshire Hathaway, Warren Buffett ran an investment partnership. He did this between 1956 and 1969. It was during this time that he produced
his first “real” fortune, so to speak. He absolutely crushed the Dow, all while staying true
to his rather conservative investment approach. On various occasions Buffett has said that
he could achieve similar returns again, if he was “only” working with a capital of a few millions
and not the billions of capital that he has today. This is because today, companies must be valued
in the billions to be able to move the needle at Berkshire Hathaway, and therefore
it excludes a lot of opportunities. So how did a young Warren Buffett invest
back then, and what can we learn from that? To help us answer these questions we shall
take a good look at his extensive writings during these early years,
more specifically; we shall have a look at the letters
that he wrote to his fellow partners in Buffett Partnership Ltd. I hope this video can help you perform
more like a young Buffett, so that you too can run into the problem of
“having too much capital”. Sit tight! We’re about to explore the brain of
a young Warren Buffett! This is a top 5 takeaways summary of
Warren Buffett’s Partnership Letters. And this is the Swedish investor, giving you the
best tips and tool for reaching financial freedom through stock market investing. Takeaway number 1 – Measuring Up Imagine being a duck sitting on a lake. When the water level rises, up goes the duck, and
when the water level goes down, so does the duck. It is easy to fool yourself into believing that
you are moving up in the world, you know, that you are some duck, when actually,
all that is happening is that it is raining heavily. In fact, the duck can only take credit when it is his
own flapping of his wings that makes him take off. During the 12 full partnership years, Buffett
never had a down one, or even a year when he performed worse than the market overall
– although he prepared his fellow investors to expect both. He repeatedly tried to teach his
partners that being down 10% a year when the market declines 35%,
is a splendid year. And a year when the market is up 20%, and the
partnership only advances 15% is not nearly as good. Therefore, the result in 1957 is better
than the one in, for instance, 1959. This way of thinking was clearly a bit disruptive
to the partners, as it was a recurring subject in his letters at the time. If you don’t really like ducks, here’s
a metaphor from golf for you: “the important thing is to be beating par; a four on a par three hole is not
as good as a five on a par five hole and it is unrealistic to assume we are not going to
have our share of both par three’s and par five’s.” Relative performance is way more
important that absolute performance when it comes to measuring your
stock market accomplishments. Always use a benchmark, such as the S&P 500 or
the Dow Jones Industrials to see how you compare. Don’t fool yourself into believing that
you are a genius when all that is happening is that we’re in a bull market. Moreover, don’t bash yourself for losing
money in a year when the market is crashing. Takeaway number 2 – Buffett’s Early Toolbox During the Buffett Partnership Ltd era
Buffett saw opportunities everywhere and most of the time he had more
ideas than he had money to invest. The opportunities were comprised within three
main categories - Generals, Workouts and Controls. The Generals were investments in
undervalued common stocks, and usually made up the biggest part of Buffett
Partnership Ltd’s, or BPL’s investments. Buffett’s main-dish here was tiny, obscure,
and off-the-radar companies, which often traded below
liquidation value. Many of the generals were
“cigar-butt” like investments. The analogy is that a cigar-butt found on the street
oftentimes has one more good puff left in it, and that the average pedestrian doesn’t
notice that, mistaking it for trash. This can be true for businesses too; even
though they may be in a tough situation, they can be even cheaper than that. To be fair – Buffett was still looking for businesses
with competitive advantages in good industries, with good management running them,
but above all, he wanted to buy at a low price. As always, price is what you pay,
value is what you get. Within this category there were two sub-categories
– “private owner basis” and “relatively undervalued”. The distinction was simply made because of
the market caps of the companies he bought into. Companies within the “private owner basis”
category were so small that, eventually, BPL could seize control over the whole business
if management didn’t do its job well. In the “relatively undervalued” category,
the companies were too big for Buffett to be able to have this backup of sorts. An important investment from the first category
was Dempster Mill Manufacturing. From the second category, the most
famous example is probably the financial service company
American Express. Next up is what Buffett calls the Workouts. These are special arbitrage
resembling situations. Corporate events such as mergers, liquidations,
reorganizations, spin - offs, etc. lead to these workout situations. Within this area, Buffett also consistently
used leverage, up to a maximum of 25%. However, beware, this is an area where mistakes
oftentimes are punished quite hard. Buffett tended to focus more on Workouts as
the market was rising, as the expected return on the Generals at the same time was shrinking. This gave his portfolio a cushion in bad years, sort of
like a hedge, but it also had a dampening effect on his results during really good years – this is because the Workouts have little
or no correlation with the general market. A bank called Commonwealth Trust Co.
had some workout potential, and we’ll go through this investment
more in detail in takeaway 4. “Give a man a fish and
you feed him for a day. Teach a man to arbitrage and
you feed him forever.” The third and last of the categories
was the so-called Controls. This is where Buffett bought a controlling
stake of a company, and where he saw no choice but to take on an active role himself. Typically, Buffett only did this if the management
continued to stubbornly reinvest cash in a business with dismal prospects. Rather, he wanted that money to be put to use
elsewhere, perhaps in entirely different industries. This is how he built Berkshire Hathaway from
a textile manufacturer into the gigantic conglomerate that it is today. Berkshire was the ultimate Control situation. So, these were the three different types of
investments Buffett juggled with, in order to create those stellar results. The Workouts are something I know that at least
I can be better at in including in my own toolbox. How about you? Takeaway number 3 – (Over?)-Diversification When it comes to portfolio sizing, it is
generally seen as a conservative thing to have a lot of different stocks,
and only a few percentages in each one of them. Buffett, on the other hand, is convinced
that when the right conditions are met, it is stupid to not load up
heavily on your best plays. Although he would have loved to have 50 different
stocks in which he saw the same level of opportunity, the stock market just doesn´t work that way. There aren’t 50 great opportunities present
in the stock market at all times, and more importantly, there’s no way
that neither you, me, nor even Buffett himself, would be able to identify all 50 of
them even if they were out there. The keyword here is opportunity cost and you
should always remember that spending time, effort and money on your 18th most attractive
idea subtracts time, effort and money from your top 5 ones. Consider this: - In 1958, 20% of the partnerships’ money was invested in that bank which we shall talk
about later – the Commonwealth Trust - In 1960, no less than 35% of the assets were
invested in the mapping business of Sanborn Map - In 1966, a whopping 40% was
invested in American Express This is what a somewhat older Buffett
has to say about diversification: You know, we think diversification is — as practiced generally — makes very little
sense for anyone that knows what they’re doing. Diversification is a protection against ignorance. Sure, having some diversification does make
sense as it is impossible to foresee every potential risk of an investment,
even if you spend tons of time with it. However, if you can find, say, 6 – 8 diverse
companies, you can neutralize the bulk of these unforeseen and
unknown consequences. This advice is perhaps not ideal for beginners,
as a more concentrated portfolio will lead to higher volatility and therefore a higher
degree of psychological stress. I´m going to use the same quote to end this
takeaway that Buffett used in 1966 to wrap up his writings about
over-diversification: “If you´ve got a harem of seventy girls; you don´t get to know
any of them very well.” Takeaway number 4 – Commonwealth Trust Co. In Buffett´s 1959 letter to partners, Buffett
writes about a situation from 1958, in order to teach his partners how he thinks
about a typical investment. If Buffett thought his partners could learn
something from the example, I´m sure we can too! The example is regarding his investment in
Commonwealth Trust Co. of Union City. I will highlight specific parts from the case
and sometimes add my own comments in between. Last year I referred to our largest holding
which comprised 10% to 20% of the assets of the
various partnerships. I pointed out that it was to our interest to have
this stock decline or remain relatively steady so that we could acquire an even larger
position and that for this reason such a security would probably hold back our comparative
performance in a bull market. This stock was the Commonwealth Trust Co.
of Union City, New Jersey. Let´s pause there. So, in Commonwealth Trust Co., Buffett invested
a big chunk of his partnerships’ money. He was clearly not afraid of a concentrated
portfolio, which we’ve discussed earlier. What also strikes me is how he wanted the
stock to remain steady, or even decline somewhat, so he could build up
the position even more. This demonstrates his long-term perspective. Back to Buffett. At the time we started to purchase the stock,
it had an intrinsic value of $125 per share computed on a conservative basis. However, for good reasons, it paid no cash dividend
at all despite earnings of about $10 per share, which was largely responsible for
a depressed price of about $50 per share. Stop, stop! Notice that margin of safety. He thought it was worth $125 right now
but it was selling for just $50. He had also identified what he thought was
the main issue for the depressed share-price. Commonwealth was 26% owned by a larger bank,
which had desired a merger for many years. Such a merger was prevented for personal reasons,
but there was evidence that this situation would not continue indefinitely. The risk of losing money on the
investment looked minimal. Buffett wanted a buyout, that would unlock
the value of the investment quick, but he was fine with waiting many years too as he
saw that value would most likely build up in that case too. After all, the investment was still earnings
money at a fast rate at a P/E of 5. So, heads, he wins big,
and tails, he doesn´t lose. Let´s continue. Over a period of a year or so, we were successful
in obtaining about 12% of the bank at a price averaging about $51 per share. Obviously, it was definitely to our advantage
to have the stock remain dormant in price. Our block of stock increased in value as its
size grew, particularly after we became the second largest shareholder with sufficient
voting power to warrant consultation on any merger proposal. Late in the year we were successful in finding
a special situation where we could become the largest holder at an attractive price, so we sold our block of Commonwealth
obtaining $80 per share although the quoted market was
about 20% lower at the time. Pause! Ok, so even though Buffett still very much
liked the investment, he decided to sell out because an even more attractive situation showed up
(which I think was Sanborn Map by the way). In order to maximize the expected performance
of our portfolios, we too must be ready to leave a company which we know the ins-and-outs
of, like Buffett in Commonwealth, in order to redeploy the capital where we see
a better risk adjusted return. Let´s hear his final remarks on the case. Pay extra attention to the
implicit margin of safety. I might mention that the buyer of the stock at
$80 can expect to do quite well over the years. However, the relative undervaluation at $80
with an intrinsic value of $135 is quite different from a price of $50 with an intrinsic value
of $125, and it seemed to me that our capital could better be employed in
the situation which replaced it. Wow, wasn´t that a gem? Takeaway number 5 – The Go-Go Years Simultaneously with Buffett’s success in
value investing in the 1950s and 1960s, another, quite opposite investing
approach was gaining in popularity. This era was dubbed the Go-Go years and
a quote from a money manager at Wall Street at the time will have you understand what
this new investing approach was all about. “The complexities of national and international
economics make money management a full-time job. A good money manager cannot maintain a study
of securities on a week-by-week or even a day-by-day basis. Securities must be studied
in a minute-by-minute program.” Buffett said that this type of thinking made
him feel guilty for going out for a Pepsi (he hadn’t started drinking Coke yet). During the 1960´s, speculation remerged after
having almost completely vanished ever since the Great Depression some decades earlier. Growth funds became a big thing, and besides
measuring performance on a day-to-day basis, sometimes “just spending a couple of nights
together” with their stocks, Wall Street had found another love,
or perhaps I should say, one-night stand. The conglomerates. During this Go-Go era, conglomerates practiced
something that was called the “P/E trick”, nowadays referred to as “multiple arbitrage”. When a company trading at P/E 20 buys an equally
sized company trading at P/E 10, you could argue that the combination
should be trading at P/E 15. But during the Go-Go years there was
an overconfidence in synergies, people thought that 2+2=5
in every single merger, and the newly formed company usually
traded at the acquirer’s initial multiple. Therefore, companies could “create value”
by buying lower valued companies. A certain Swedish casino/betting company that I owned
between 2013-2017 incorporated this P/E trick too, so I don’t know, perhaps
it’s getting fashionable again. The P/E trick was a way to make trees grow
to the sky, and the market loved it. But this only worked until it didn´t … The Go-Go years came to an end when
one of its most famous followers, the money manager Gerald Tsai and
his Manhattan Fund delivered a return of -6.9% for the year 1968,
as the Dow returned 7.7% (and yea, Buffett returned 58.8%). The Manhattan Fund would lose more than 90% of
its assets under management during the ensuing years. After a decade of warnings from Buffett,
the Go-Go funds became the No-Go funds. Buffett, and value investing,
prevailed once again. So: - Relative performance is more
important that absolute performance - You need multiple tools in
your investment toolbox. If you can’t find any undervalued
companies currently, perhaps it is time to look for
some arbitrage opportunities? - Diversification is a protection
against ignorance - Okay, I admit it! The Commonwealth Trust case was just a sneaky
way of pushing more than 5 takeaways into the 5 takeaways format. - Calculate, don´t speculate. Fads come and go. If you just can’t get enough of Warren Buffett,
here’s a video based on his letters to Berkshire Hathaway shareholders. In other words, it’s a video with
takeaways from his later career much like this was a video with
takeaways from his early one. Cheers guys!
