Most of us know Warren Buffett today as the head of Berkshire Hathaway. Widely considered the greatest investor of all time, he’s built a business empire following the principles of Ben Graham and his other largest influencer and business partner, Charlie Munger.
Before the days of Berkshire, Buffett managed an investment partnership starting with funds raised from his closest family and friends. Essentially this was a form of “hedge fund” before the term was coined. Between 1957-1968 the partnership made an annual compounded return of 31.6%.
Today Berkshire Hathaway’s annual letter to shareholders is considered the gold standard of shareholder communication. In his partnership days, he laid out the “Ground Rules” under which the fund will operate. Additionally, he wrote letters to the partners revealing his investing philosophy. This post will dive into a lesser known side of Buffett, from the “golden years” of his investment partnership.
The Ground Rules
Buffett wrote a total of 7 “Ground Rules” on which the partnership will operate. These all relate to timeframe, proper benchmarking, and having skin in the game. Here are the most relevant for the intelligent investor.
- “Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year. Instead, we will measure against the Dow Jones Industrial Average and leading investment companies. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.“
- While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
- I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership.
- I cannot promise results to partners. What I can and do promise is that:
a. Our investments will be chosen on the basis of value, not popularity;
b. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and
c. my wife, children and I will have virtually our entire net worth invested in the partnership.
Real World Translation of the Ground Rules
Proper performance benchmarking is not measured by a plus year or negative year. It is against the wider market index. Back in the days there was no S&P 500 equivalent, so the target benchmark was the Dow. Buffett states that over long periods, preferably between 3-5 years, the partnership should outperform the benchmark. Otherwise, why invest with him in the first place?
Trying to predict where the market is heading is useless. Buffett clearly understood this, and holds on to it to this day. Human beings are naturally drawn to forecasts and “expert” opinions. We require certainty in an uncertain world. There may be merit to this line of thinking in other disciplines, but not in the stock market.
People behave differently with “other peoples money”. Buffett removes the principal-agent problem by having his entire net worth invested in the partnership. The principal-agent problem is one of the main reasons why most “professional” fund managers underperform. Having skin in the game incentivizes better behavior and creates trust. Food for thought: If you live in an developed nation, do you believe your current pension managers have skin in the game with your retirement? Why is it so easy for politicians to promise “free” money? Understanding incentives and human behavior is the key in making better investment decisions.
Wisdom From the Partnership Letters
Great investment advice can be absorbed from the Buffett Partnership letters. The letters are probably available for free on the web, but I highly recommend Jeremy Miller’s 2017 book “Warren Buffett’s Ground Rules”. In addition to the letters, the book dissects the advice deeper, and gives background to where and how Warren learned his philosophy. I’ll be paraphrasing some key takeaways from the book.
On Predictions
As investors, we understand that the right answer to questions about what stocks, bonds, interest rates, commodities, etc., are going to do over the next day, month, quarter, year, or even several years is: “I don’t have the first clue”. We don’t want to fall victim to the siren songs of “expert” opinions. Predictions often tell you more about the forecaster than they do about the future.
Free yourself from wasting valuable time and effort and allow yourself to focus on thinking from the vantage point of the owner or prospective owner of an entire business you might understand and come to find as attractive. Who would sell a farm because they thought there was at least a 65% chance the Fed was going to raise rates next year?
Mental Model: Focus on What Will Happen, Dismiss the Timeframe
Buffett determines business value the following way: The value of a business will be determined by one of two methods:
- What the assets are worth if sold, or
- The level of profits in relation to the value of assets required in producing them.
This is true for each and every business and they are interrelated. Operationally, a business can be improved in only three ways:
- Increase the level of sales
- Reduce costs as a percentage of sales
- Reduce assets as a percentage of sales
The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value. These are the only ways a business can make itself more valuable.
“The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.“ – Warren Buffett, Partnership Letter, July 12, 1966.
Investing is part-art, part-science. The “art” is to evaluate the “character” of the assets properly, thinking it through and making the appropriate conclusion as to their future value and earning power. You really can’t outsource your thinking – you have to do it yourself. Your paid advisors, whether they do it willingly or not, will likely only steer you in the direction of doing what’s good for them. It’s only human nature.
-IGTSKasimir
Further Reading
Sir John Templeton – Wisdom From Global Value Investing Legend
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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