This article on the Buffett Partnership strategy was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by Free-Photos, edited by Broken Leg Investing.
The concept of value investing dates back more than 80 years, when Benjamin Graham and David Dodd wrote the original edition of Security Analysis. Since then, some of the earliest disciples of the church of Graham and Doddsville have held on tightly to many of the core principles of their teachings, while allowing other such teachings to become somewhat less significant in their own belief system. Nobody provides a better example of this dynamic than a man named Warren Buffett.
After achieving an A+ in Benjamin Graham’s class at Columbia in 1951, Buffett went on to produce what is still one of the best investment performance records by any investor over a prolonged period in history. This success was achieved by his Partnership during the 1950s and ’60s and was predicated on the idea of value investing. Specifically – and directly in line with what Graham would have taught him during his days at Columbia – the Buffett partnership strategy used a method that was made up of stocks that he coined his “generals.”
But, what exactly are generals? How did Buffett put them to use? And most important for us, are they still relevant to us today? Let’s take a look.
What Is A General And How Did It Fit Into The Buffett Partnership Strategy?
Buffett defined his generals in an extract from his 1964 partnership letter:
“‘Generals’ – A category of generally undervalued stocks, determined primarily 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; that is, an overall valuation on the enterprise substantially below what careful analysis indicates its value to a private owner to be. Again let me emphasize that while the quantitative comes first and is essential, the qualitative is important. We like good management – we like a decent industry – we like a certain amount of ‘ferment’ in a previously dormant management or stockholder group. But we demand value....”
The so-called generals made up a significant portion of the Buffett partnership strategy, and were therefore the key driver in the performance of his portfolio during those decades. As Buffett states above, he chose his generals primarily using quantitative data. While the key focus on quantitative data manifested in different ways, there was an overwhelming importance placed upon the concept of value, i.e., only purchase a security if you do so at a price that is below an appropriate measure of value.
Throughout the partnership years, this measure of value tended to be represented by either liquidation value or a derivative of it. A company’s liquidation value is the price that you would receive for it if the company were to be sold in a hurry. Therefore, rather than just deducting total liabilities from total assets, it becomes necessary to give a haircut to the assets. Benjamin Graham taught us in his book The Intelligent Investor to adopt the “net net” strategy. This is an ultra-conservative strategy that assumes that all fixed assets, in the case of a fire sale, will be valued at zero. Once this is complete, the investor subtracts total liabilities from current assets and only purchases the stock if this residual value is greater than the company’s market value. The rationale behind this approach is that, by buying something so cheap, the upside potential is far greater than the downside risk. As a result, the investor’s margin of safety is large. This margin of safety is exactly what was sought in the Buffett partnership strategy, and this is why his generals tended to be largely constituted of net nets.
Of course, before a hypothesis becomes a principle, it must first prove itself scientifically. We will now examine whether this Buffett partnership strategy has indeed enjoyed success.
Did The Deep Value Generals Category Really Contribute Much To The Success Of The Buffett Partnership Strategy?
We know at this stage that Buffett has always been a successful investor, right? But how much did the generals actually help out the partnership’s performance numbers?
“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. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen. Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favourable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments, creates a most attractive package of safety and appreciation potential.”
Due to the success of the Buffett partnership strategy, the generals represented Buffett’s largest investment category. By the time he had written the above piece, Buffett’s partnership was already in its sixth year of existence. By this time, and in Buffett’s own opinion, there was now a sufficiently long yardstick with which to measure his investment performance. With this in mind, and recognising that the total compounded return after the first five years of the fund was over 350%, Benjamin Graham himself might have agreed that such a performance was “quite satisfactory.”
Based on Buffett’s own calculations above, and the amount of time he spent discussing the generals strategy in his letters, it is highly probable that the majority of the partnership’s capital at any one time was invested in these deep value opportunities. Due to the success of the Buffett partnership strategy, Buffett was justified in spending his days trawling through pages and pages of Moody’s manuals (the prehistoric version of today’s stock screeners, where you actually had to read from a book to obtain data on securities!) in order to discover his next big idea. With so few others doing what he was doing, there was an absolute ocean of undervalued public companies out there, just waiting to be discovered. By finding them first, Buffett could buy and hold them until the rest of the market caught up with him and returned the stock to its fair value.
Though many people forget this, Buffett’s most successful years as a professional investor came during the partnership years. Of course, one of the reasons that his annual performance dipped over the years was because he began to manage more and more money – making it difficult to invest in many of the companies he would have before, due to size constraints. However, many will argue that the strategy is no longer viable because the market, due to advances in technology, has become more efficient and thus has eliminated deep value opportunities forever. We will investigate this idea next.
Are The Deep Value Generals Used In The Buffett Partnership Strategy Still Viable?
First and foremost, let us quickly quash the suggestion that deep value strategies no longer work in today’s financial markets. There are far too many modern investors who focus almost entirely on value strategies and who have also found success in their campaigns. Seth Klarman, Tobias Carlisle, and Joel Greenblatt (not to mention Net Net Hunter and Broken Leg Investing founder Evan Bleker!) are just a few high-profile names who are all-in on such strategies.
The main reason that value investing strategies still work is that while technology has changed, people have not. We are still subject to the same human biases and cognitive dissonance that we always have been. In addition, there is an entirely separate argument that the advancement of technology makes the landscape even better for value investors. While there are still relatively few of us, we are more capable than ever before of locating these pricing mismatches!
How To Apply The Buffett Partnership Strategy In Today’s Investing World
Now that we know that the generals of old worked and are still a useful strategy today, how can you actually go about putting them in action?
“This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments, creates a most attractive package of safety and appreciation potential.”
The significance of what Buffett is saying here is that, whether it is 1918 or 2018, the reason that value investing has been, and always will be, successful is that the presence of a margin of safety attained with a strategy – such as Benjamin Graham’s net net strategy or the Buffett partnership strategy – is constant. Securities with a high margin of safety, by their very nature, have significantly more upside than downside. This ultimately translates as superior investment performance.
“Many times generals represent a form of ‘coattail riding’ where we feel the dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.”
This quote provides further confirmation of the applicability of value investing strategies today. A further perk of value investing – particularly when it comes to Carlisle’s Acquirer’s Multiple strategy – is that such low-priced companies often become acquisition targets of larger competitors or private equity firms. This can often represent an excellent catalyst for the realisation of value with such stocks.
While aspects of value investing have changed over the years and new strategies have emerged, the fundamental basis of the overall concept has not – buy cheap and realise gains. Whether discussing the embryonic days of value investing or the modern era, the fact that we can use stock screeners now instead of manuals, or the awareness investors have of the success of value-oriented strategies now versus during decades gone by, the principles of the Buffett partnership strategy remain true today. It is a scientific fact that deep value investing has worked in the past, still works in the present, and will continue to work into the future.
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