Book review: Warren Buffett's Ground Rules: Words of Wisdom from the Partnership Letters of the World's Greatest Investor by Jeremy Miller

Finished reading: 9 Jan 2017

https://www.amazon.com/Warren-Buffetts-Ground-Rules-Partnership/dp/0062415565

The book provides a good summary of the key principles that came from the Buffett Partnership letters.

How to think about the market

As has been written many times before the letters emphasises Buffett approach to investing in businesses and not stocks. There is a common theme that stocks should be held for the long term and that the long-term performance from stocks will be determined by the underlying fundamentals that the business generates.

The fact that businesses have a quotation should be used to the investors’ advantage and at all other times they should be free to disregard the current price quotation. Buffett believes the investor would be better off if there was no stock market quotation at all for he would then be spared the mental anguish caused to him by other persons mistakes of judgement.

Think of stocks (1) as fractional claims on entire businesses, (2) that swing somewhat erratically in the short term but (3) behave more in line with their gains in intrinsic business value over the longer term, which, when (4) viewed through the lens of a long-term compounding program (5) tend to produce pretty good results, which, with (6) an index product, can be captured efficiently in a low-cost, easy-to-implement way. From here we’re going to turn to Buffett as an active investor, starting with his ideas on what exactly he’s setting out to achieve and how he intends to measure it.

Redemptions / withdrawals

Interesting insights that I learnt was that Buffett operated a system whereby partners could only withdrawal once per year and if they wanted to withdraw before that time they could do so however at a cost of 6% interest. Partners could also pre-fund year end additions where the partners would receive 6% therefore compensating those who wish to add to the existing investment.

Buffett’s investments were divided into three categories being generals, workouts and controls.

Generals

Many of the generals were acquired at steep discounts to their appraised intrinsic value. These companies tended to be much smaller companies where if the stock remain dormant and price for long enough Buffett would come to gain a large in stake to have a say over how it was being run.

Buying Generals represented a two strings to a situation where Buffett would either benefit from an appreciation in the securities price as a minority shareholder or force events to occur by gaining control of the company and acting as a corporate Raider.

Buffett believed his return from investing in Generals over the 12 year history of the Buffett partnerships was probably 50 times or more is total losses.

Buffett also implemented a long-short strategy. Buffett mitigated some of that risk by hedging them, meaning when he bought one he would sell short1 the more expensive peer company. For example, by buying a stock trading at 10 times earnings and simultaneously shorting a similar company trading at 20 times earnings, Buffett reduced the risk of overpaying for the company he liked because if it declined to, say, 8 times, one would expect the stock of the company he sold short (at 20 times) to decline further.

Quality compounder method
However, as they years passed and opportunities to put money to work in the small capitalisation Generals diminished Buffett became more focused on the qualitative aspects of business. Instead of jumping from undervalued stock to another undervalued stock Buffett realised that this was the wrong foundation on which to build a large and enduring enterprise.

“So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

Here is a checklist for evaluating a potential investment in a General: (1) Orient: What tools or special knowledge is required to understand the situation? Do I have them? (2) Analyze: What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows? (3) Invert: What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose? (4) What is the current intrinsic value of the business? How fast is it growing or shrinking? And finally, (5) Compare: does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favorably to all the other options available to me?

Buffett also emphasised being very selective about your investments.

I will only swing at pitches that I really like. If you do it 10 times in your life, you’ll be rich. You should approach investing like you have a punch card with 20 punch-outs, one for each trade in your life.

Work-outs

Everyone can benefit from the diversification workouts offer, but workouts aren’t something everyone is going to be comfortable doing. For the latter group, other outlets exist for investing that can produce high returns and are also not tightly correlated to the overall market direction from day to day.

Buffett often did use leverage when investing in special situations, or “workouts” as he called them.

Controls

“Everything else being equal, I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.”

Some of the best situations arise when you find a General where you can make a significant investment of your own but some other investor is doing the work to improve management’s decision making. Today activists are still agitating managements to improve their operations. In fact, it’s become a very popular strategy that has gained a lot of attention; the funds dedicated to this activity have attracted a lot of assets.

The later partnership letters Buffett was commenting on how he was revising down his goal of outperformance over the Dow as a function of having much more money under management and also the general level of the market. Buffett was also disparaging of momentum and growth funds that performed well when the market was strong but suffered significant impairments when the market turned. Buffett believed such funds where an attempt to anticipate market action over business valuations.

Buffett decided to shut down his partnership in 1969 as he thought an all-out effort to continually beat the Dow was not what he wanted to pursue going forward. He would rather pursue other ideas in the investment field that do not promise the greatest economic reward such as buying a great business and owning the forever.

Feedback

The book was a good summary of the Buffett Partnership letters. I think it would be valuable to go through the letters themselves in chronological order as sometimes I felt that the book jumped around in time periods as it attempted to collate comments from the letters under particular topics. I think you would also gain more from the examples provided by reading the letters themselves.

Conclusion

Overall I would recommend the book. It is easy to read and provide a good summary of how Buffett was so successful investing in the Partnerships.