“Buffett leaves us a road map that is invaluable for students and investors alike. It’s as if he’s laid down a challenge to all of us. It’s as if he has written the letters, made them public, and said, ‘Here’s how to invest, here’s how I did it; this is the road I took. Now, let’s see if you can follow me down the path.”
—Jeremy Miller, author of Warren Buffett’s Ground Rules
A Road Map for a Road Less Traveled
Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor is written by Jeremy Miller and was released in 2016. The book consists of three parts, all of them discussing and summarizing the most important things from Warren Buffett’s Partnership Letters, letters written by Warren during the Partnership era in 1959-1970.
Here’s what I like the most about this book.
- The Ground Rules. “These ground rules are the philosophy. If you are in tune with me, then let’s go. If you aren’t, I understand.” (p. xii)
- Structure and the fee setup of the Buffett Partnership. “The interest provision was set at 6% for everyone, beyond which Buffett would take 25% of the gains. Since he figures the market was going up 5-7% a year on average, the interest provision was set at a level so he earned nothing unless he was beating the market. He had a “high-water mark”—any cumulative deficiency below a 6% annual gain would have to be recouped before he would resume taking fees.” (p. 59)
- Alignment of manager incentives and investors. “If you want your investment manager to behave with your best interests in mind, you have to ensure that your interests are aligned. Buffett was masterfully aligned with his investors.”
- Investment categories. From the beginning Warren utilized three categories to describe the investment operations to his partners: Generals-Private Owner, Workouts, and Controls. In January 1965 he added another one—Generals-Generally Undervalued—to reflect his “…further consideration of essential differences that have always existed to a small extent with our ‘Generals’ group.”
Inside the Book: An “Investment” Treasure
The book is divided into three parts, each containing a few chapters. Each chapter ends with a few excerpts from the Partnership letters that have been discussed by the author earlier in the chapter.
- Part I lays out the investment principles and ground rules employed by Warren between 1956-1970. It also describes the Partnership structure and the fees that all partners paid to Warren based on the investment returns realized each year.
- Part II explains the different investment categories. In the beginning there were three; Generals-Private Owner, Workouts, and Controls. A fourth category was added later on: Generals-Relatively Undervalued.
- Part III contains a few different topics, all related to investing; “Conservative Versus Conventional,” “Taxes,” “Size Versus Performance,” “Go-Go or No-Go,” “Parting Wisdom,” and “Toward a Higher Form.” Each one of the chapters touch upon important questions to consider for an investor, and at the same time shows what Warren’s thoughts looked like in these areas.
The Ground Rules
At a dinner at the Omaha Club where the Partnership’s first members gathered, Buffett focused on the thing that he thought to be of most importance; the Ground Rules—this to make sure that all of the partners understood and accepted the rules that Warren was going to follow when carrying out the investment operations for the Partnership.
Click image below to read an excerpt of “The Ground Rules.” These rules were first published in writing by Warren in his Partnership Letter from January 18, 1963. To read this letter, click here.
Structure and fee setup of Buffett Partnership
The fee structure set by Warren for the Partnership was; 1) no management fee, 2) no fees paid by partners for any annual investment returns up to 6%, and 3) above 6% Buffett would take 25% of the gains.
The fee structure of the Partnership is a bit different compared to many of today’s hedge funds and mutual, something that is discussed by the author himself in the book.
The fee structure can be compared to “Today’s hedge funds and mutual funds that typically charge a management fee, compounded as a fixed percentage of the investor’s assets under management. These can range from .25% to 2% or more, per year, and the fee is taken irrespective of performance.” Also, “Because the as asset management business is highly scalable—an increase in assets usually requires few additional costs—the more funds under management, the more profitable the asset manager will be. While performance is certainly a key component of a fund’s ability to grow, a great marketing effort can bring in new investors and has the ability to drive asset growth even faster. Most asset managers—particularly mutual fund companies—earn fees, and therefore are incentivized to maximize the size of their total assets. Fees based on a fixed percent of assets under management make it hard for asset managers to say no to the incremental dollar of investor capital, even when it’s clearly going to have a dampening effect on performance. When an investor’s primarily interest (annual percentage gains) is out of step with the primary interest of the manager (more assets, more fees), a potential conflict exists. Buffett charges no management fee. He got paid only for performance. His system was better because it removed a source of potential conflict between his interest and the interest of the LPs [Limited Partners]. (pp. 59-60)
Buffett’s Four Investment Categories
Buffett employed three principal types, or categories, of stock picking that he referred to as; Generals, Workouts, and Controls. These three categories define Warren’s investment style during the Partnership era.
Talking about portfolio composition, “Buffett typically committed 5-10% if his total assets in five or six Generals with smaller positions in another 10-15%. Concentrating on his best ideas was another key component of his success.” The maximum size on any single investment was revised upwards in 1965 when the rules was amended to allow as much as 40% of the portfolio in a single General (hint… American Express). The amount of assets used for Workouts “…in most years […] made up 30-40%.”
Here are the categories used by Warren during the Partnership era to explain and describe the investment operations conducted by him to his partners.
- Generals-Private Owner. “‘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.” (BPL, January 18, 1964)
- Generals-Relatively Undervalued. “…this category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept.” (BPL, January 18, 1965)
- Workouts. “These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs.” (BPL, January 24, 1962)
- Controls. “The final category is ‘control’ situations where we either control the company or take a very large position and attempt to influence policies of the company.” (BPL, January 24, 1962)
Each of the sub-chapters about the different investment methods also includes examples of investments that Warren made. For Generals, only one was ever named explicitly; Commonwealth Trust Company, and this only in order to illustrate the type of stocks Warren was buying in this category. In 1964, the same year as Warren introduced the new category—Generals-Relatively Undervalued—he also made his now famous investment in American Express. Another example of Generals was Walt Disney. The most important characteristic of the investments in the Generals-Relatively Undervalued category was that they produced magnificent profits year in and year out, and that Warren potentially could hold them for a very long time, compared to most Generals-Private Owner investments with their one free puff.
Warren outlined four critical questions needed to evaluate these kinds of investments, i.e, Workouts: “(1) what chance does the deal have of going through, (2) how long will it take to close, (3) how likely is it that someone else will make an even better offer, and (4) what happens if the deal busts?” One example of a Workout was the investment in Texas National Petroleum. The Workouts were expected to do as well as the Generals (10 points better than the market, or 15-17% per year on average). They not only produced solid, fairly stable returns, but their success was largely independent of the DOW and so insured BPL’s overall performance in down markets.
Warren also invested in companies like the Sanborn Map Company, Dempster Mill Manufacturing Company, and Berkshire Hathaway, all examples of businesses in the Controls category.
I enjoyed this book, and I would say it’s a great one. I like the way the partnership letters have been reorganized into topics, so that you get everything from the letters regarding a certain topic in one chapter. This is pretty much the same setup as in The Essays of Warren Buffett, with the only difference being that the essays focus on the Letters to Shareholders written by Warren during the Berkshire Hathaway era that started in 1970 when the Partnership years ended.