Investment Partnerships

In How does Warren Buffett invest? – Part 1 you read the advice which Warren Buffett has given to investors over the years.

Warren Buffett ran his own investment partnerships between 1957 and 1969, which returned an annual average of 30.4%.

The investment partnership rules were simple:

1. Warren Buffett was free to invest their money in any security.
2. His yearly fee was 25% of the profits that were earned over the first 6% (hedge funds call this the hurdle rate).

The investors in these partnerships received audited results from Peat, Marwick, Mitchell & Company, who in 1987 merged with Klynveld Main Goerdeler (KMG) and became KPMG.

Investment Strategies

Whilst managing his investment partnerships he used 3 different categories of investments:

Generals – This was Warren Buffett’s largest category of investments and consisted of undervalued securities. That is companies which are trading at discount to their intrinsic value. The investment partnerships held fairly large positions thus a concentrated portfolio, usually about 5% to 10% of total assets in about five or six positions and smaller positions in another ten or fifteen. “This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential”. The idea behind this is that the gap between the quoted price and the intrinsic value eventually close, sometimes in months or sometimes in years but they always close. Warren wrote in one letter to his partners ‘Over the years, this has been our largest category of investment and more money has been made here than in either of the other categories’.

Work Outs (special situations) – These are publically announced merger & acquisition arbitrage situations. Whilst this investment category provided stable earnings, the reason Warren Buffett stated why he did not allocate more money to these is because in rising markets he would not be able to outperform the market. Like the returns, the risk was also little and the partnerships sometimes, but not often used leverage for these type of investments and never more that 25% of the total amount of assets under management. A really good book which covers these special situations is Joel Greenblat’s You Can Be A Stock Market Genius.

Control Situations – Buying large stakes to control a company and influence the policies and unlock shareholder value. These situations were also purchased when they were undervalued, but by purchasing a larger and controlling stake Warren Buffett believed that this has a ’substantial advantage’ many times in determining the length of time required to correct the undervaluation. The faster it takes for the share price and valuation to converge, the higher the returns.

Joys of Compounding

In Warren Buffett’s letter to partners dated 18th January 1963, he wrote about the ‘joys of compounding’ which was expressed using two examples.

The first example of compounding was relating to the $30,000 that the Spanish Royalty purportedly invested in Christopher Columbus. That investment of $30,000 invested at a 4% annual rate of return would of grown to about $2 trillion by 1963 wrote Warren Buffett.

In the second example, he illustrated to his partners how a $100,000 investment would grow at 5%, 10%, 15% over 10, 15 and 20 year time periods.

Conservative

During this period we could see that he was very conservative. One particular comment that he made was “I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a ‘New Era’ philosophy where trees really do grow to the sky”.

Psychology

Warren Buffett’s investment objective was to achieve a ‘long term performance record superior to that of the Industrial Average’.

“I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities”. Even today Warren Buffett’s comments echo’s this way of thinking and so does the quote “I believe that a program of investing in such undervalued well protected securities offers the surest means of long term profits in securities”.

Importantly “Our bread-and-butter business is buying undervalued securities and selling when the undervaluation is corrected, along with investment in ‘special situations’ where the profit is dependent on corporate rather than market action” describes his strategy perfectly.

“My own thinking is much more geared to five year performance” is probably the least understood psychology of Warren Buffett, even today look at the amount of times that people are judging his short term performance and questioning his abilities.

In How does Warren Buffett invest? – Part 3, we will talk about his role after the investment partnerships at Berkshire Hathaway.