Th 1961 annual letter is quite a gem. The letter gives us a glimpse of several
aspects of Buffett’s philosophy on investing, including the more practical
aspects like portfolio construction, etc.
As always, in the annual letter for 1961, Buffett starts out with a report on the
performance of the Dow Jones Industrial Average. It is hard for me to imagine a
world when this was the sort of information you’d need to get from your
investment manager, once a year!
Anyway, the funds handily beat the index. He also takes great pains to document how the performance of the funds has been over the five years they were in operation. After fees, the funds compounded at 23% per annum. In comparison, the index returned 11.75% per annum. Quite a lead.
Establishing a benchmark
But having reported these numbers, Buffett spends a lot of time explaining why the
Dow Jones Industrial Average is even a decent benchmark to compete against.
It appears that back in the day, enough people figured that it should be easy to
beat an unmanaged index of thirty stocks. He cites statistics for 38 mutual
funds (selected without bias). 32 of those did worse than the index over the 15
year period for which he had the statistics.
Those that did beat the index, did so only by a few percentage points. Sound familiar?
He goes on to say that their portfolio is quite different from the Dow, and their
method of operation differs substantially from other mutual funds.
However, he chooses the Dow as the benchmark because it represents the alternative opportunity that his investors have. This is a great way to think about it. Buffett has always framed his investment decisions as competing against his opportunity cost. Even the cost of capital he uses for valuation represents the opportunity cost of his funds (more on
this at another time).
Process and portfolio construction
Having established why he chose the Dow as his benchmark, he goes on to speak about
his investment process. Buffett breaks down his investment opportunities into
three broad categories – generals, workouts, and control situations.
Generals are the most common type of investment – at the time, even for Buffett himself. This is like buying stocks of good companies at decent prices. There are no special situations involved and no clear time-table for when a fair valuation would be received.
The portfolio construction here is instructive. In five or six of these, he would put in between five and ten percent each. Other than this, there could be ten to fifteen smaller investments as well. So a total of fifteen to twenty positions, with five or six bigger bets. There are no immediate catalysts visible in these positions and so the holding period is not known at initiation. These positions are also fairly correlated with the index
Finally, the intention is to sell off when he can get a decent price for the business – not necessarily waiting for the absolute fair price. Notice, that this is a very different Buffett from the one we now know.
Workouts are what we today call special situations. These are usually on a time-table, i.e., a set of events is in motion that will unlock the value of the investment.
The value of these investments are also expected to be somewhat uncorrelated with the broader market. At any point, he could have ten to fifteen investments in this category.
Interestingly, he is not averse to using leverage for these investments, because they are supposed to be safer investments. As much as 25% of the partnership funds. At this point, he does not consider this excessive.
The final category is control situations. Here, he takes a large position in the company and attempts to actually influence the company’s policies. We know this better today as activist investing. Naturally, the ability to invest in such opportunities requires a decently large fund size.
Sometimes, he can invest in a general with the expectation that it can become a control situation. If the price remains low enough for long enough to build a controlling stake, he’d do that. If not, and the price moves up quickly, he’d book a profit and move on.
The value of workouts and control situations in the portfolio stems from their
ability to hedge against an overvalued market.
On conservative Investing
He says that what people think of as conservative investing changes over time. At
one point, people thought that investing in long-term municipal bonds was a conservative thing to do.
That turned out to hurt badly as inflation caused these investments to lose value. Then, overly conscious of inflation, people felt that buying blue-chip securities was conservative, no matter the price they paid for them. This is likely to hurt in the future. He says, and I quote:
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.
In many quarters the simultaneous occurrence of the two above factors is enough
to make a course of action meet the test of conservatism.
You will be right, over the course of many transactions, if your hypotheses are
correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.
On expected performance
Through his letters so far, Buffett has repeatedly stressed that he expects to outperform the index in the years when the index is flat or down.
In the years when the index is up, he expects to just about keep up. However, he does not profess to know when the markets will be up and when they will be down. He does say that over a long period, he’d expect to beat the index by about ten percent.
That’s quite a high bar to set for oneself, so early in the game!
They’re beginning to get longer. Read the original here.