Buffett never makes a bet with sucker odds

This is Berkshire Hathaway weekend in Omaha, Nebraska. Woodstock for capitalists. So I thought a column about Warren Buffett would be appropriate.

Every couple of years I pull out Buffett’s old partnership letters, written to his investors between 1957 and 1970, and re-read them. In my opinion, these letters are the greatest “book” ever written on how to manage an investment partnership.

The Buffett Partnership Limited was formed in 1956 with $100,000 in capital. Buffett did not charge an annual management fee but he took 25 per cent of the profits above a 6 per cent “hurdle” rate. The partnership compounded money at 31 per cent annually between 1957 and 1969, when Buffett disbanded the partnership and sent the money back to investors, versus 9.1 per cent annually for the Dow. During this period the fund outperformed the Dow every year and never lost money, in spite of four losing years for the Dow (see table below). Buffett liquidated the partnership in 1969 and 1970 and sent his investors their money back. (I can’t help noting the irony that Buffett got rich from hedge-fund-like fees, yet now rails against the high fees charged by hedge funds.)

Back then, Buffett classified his investments into three categories: generals, workouts and controls.

Generals were defined as out-of-favour stocks with good management teams and a low valuation relative to their intrinsic value. This is the type of investment Buffett is best known for today, and it comprised the largest portion of his portfolio back then.

Workouts were defined as “securities with a finite timetable” – essentially turnround plays or arbitrage situations with a defined catalyst. This was Buffett’s second most common type of investment, although today he shuns turnrounds and ignores arbitrage situations.

Controls were stocks that did nothing for such a long time after Buffett began buying that he was able to accumulate a significant percentage of the stock, thereby garnering some control over the company’s direction. Berkshire Hathaway, which he began buying in 1962, was one of these. Sometimes these would turn into activist situations.In the case of Dempster Mill Manufacturing, Buffett acquired control, hired his own chairman and instructed him to liquidate the company. I don’t think Buffett ever engages in activism today, but he made a lot of money doing it then.

There are other notable differences between Buffett’s strategy then and what he does now.

Most of the stocks held by BPL were obscure micro-caps such as Sandborn Map, Dempster Mill Manufacturing and Texas National Petroleum. Today, because of the size of his investment pool, Buffett can consider only investments in large companies. This hinders his performance (although he still does amazingly well, given the size of his portfolio).

Although Buffett has always been known for taking large positions, not many people are aware that in 1959 and 1960 he had about 35 per cent of his fund’s portfolio in one stock, Sandborn Map. It turned out to be a very profitable investment for the partnership.

There may have been others of this magnitude; Buffett told his investors in one letter that he would invest up to 40 per cent of the partnership’s capital on a single idea if the risk/reward ratio was highly favourable.

Buffett is well-known as an avid devotee of Coca-Cola, but in the 1950s and 1960s the offices were “well stocked with Pepsi”, according to one of his letters. I am not sure when he switched his allegiance; perhaps after he bought Coke stock in the 1980s.

In one of his letters during the late 1960s, Buffett mentions that he regularly employed 110 per cent to 1,000 per cent of the fund’s capital, implying huge leverage. Undoubtedly this leverage was related to the many arbitrage situations he got involved in, where he would go long the acquiree and short the acquirer and profit from the diminishing “spread” between the offer price and the acquiree’s stock price as the merger date approached. Buffett does not do this any more because his portfolio is too large and the arbitrage market is too efficient to make much money these days. He used to make a fortune doing it, though.

But some things never change. In 1961 Buffett wrote to his investors that the most common question he was asked was: “What happens if you die?” People have been asking him this question for almost 50 years.

And even early on he realised that buying a stock is the same as buying into a partnership with the management team, so you had better be careful who you get into bed with. This philosophy has not changed in 50 years.

Most important, Buffett has never wavered on one overriding principle: he has never made a bet unless he was sure the odds were strongly in his favour. Whenever he is not sure what the odds are, he does not bet. Rule One, do not lose money. Rule Two, see Rule One. And this is Buffett’s biggest “secret”. If you never make a bet with sucker odds, you can’t help but do well over the long term. You won’t win every single time, but over time you will do very well.

Thanks for that lesson, Warren.

The writer is a former equities strategist at Morningstar who manages a hedge fund, Sellers Capital, in Chicago. msellers@sellerscapital.com