I just spent all afternoon reading through all of Warren Buffett’s original partnership letters. These are the letters that he wrote to his investors when he was managing his private partnership from 1956-1969 prior to taking control of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B). I’ve read through these letters numerous times, and I recommend them to anyone who is serious about truly understanding the methods of Buffett. A while back I printed them and bound them so I have them collected in one place like a book.
Today, I had a specific purpose for reading through them. Over the past few days I’ve been spending a lot of time thinking about portfolio management, specifically how I should allocate cash during periods where the market is getting overvalued and bargain stocks are hard to find. I currently think the market is moderately overvalued, but not extremely so. There are still good valuations out there, but they are getting harder to find. So I’ve been brainstorming for how I want to allocate capital as stocks in the portfolio reach fair value and get sold. Do I buy other stocks that look cheap (even though they are not as cheap as they were a year ago), or do I look for special situations such as share tenders or risk arbitrage (what Buffett called “workouts”)? These types of strategies can provide steady returns and act like a substitute for holding cash.
For the readers who aren’t familiar with this topic, risk arbitrage (workouts) is a term that usually refers to a situation where an investor buys stock in a company that is getting acquired by another company. Usually when a merger is announced, the stock of the company getting acquired will jump (sometimes significantly) to a level that is close to the buyout price. But there is always a small spread between the current price and the buyout price. For example, let’s say Company A is trading at $30 per share. Company B thinks Company A is undervalued, and decides to buy the whole company for $45 per share. The stock in Company A will immediately jump to a level close to that $45… let’s say in this example $43. The difference has to do with many variables including the likelihood of the deal closing, terms of the deal, interest rates, and many other variables. But that $2 spread eventually closes if the deal works, and that is how arbitrageurs profit.
Buffett used arbitrage, and so did his mentor Ben Graham. In fact, Buffett once did a study of his own arbitrage activities along with Graham’s, and found that over a 63 year period, they averaged 20% per year using that strategy. So it’s something to consider. I thought I would read through Buffett’s original letters to read his thoughts on the topic.
Here are my basic thoughts after reading through all of his letters:
In his letters, Buffett divides his strategy into 3 main categories: Generals (undervalued stocks-basic value investing), Workouts (risk arbitrage investments), and Controls (businesses that he acquired a controlling stake in). The interesting thing I discovered is that although he had fantastic results in all of these categories (overall he averaged 31% per year during the 13 year period!), his basic value investing category-generals-dramatically outperformed the other two categories. In his later letters he begins to show us his performance in each of the 3 categories. Here are a few results to take note of:
- In 1966, Buffett had an overall return of 20%, but his general stock investments were up 26% (the Dow was down 15%!)
- In 1967, Buffett had an overall return of 36%, but his general stock investments were up 72% (Dow was up 19%)
- In 1968, Buffett had an overall return of 59%, but his generals were up an incredible 104% (Dow only up 7%!)
Now, many people talk about the bull market of the late 1960?s, but look at the Dow from 66-68 (-15%, 19%, 7%). Not exactly 1999. But it was a bull market, and Buffett certainly had the wind at his back.
Also, it’s worth pointing out that in an earlier letter (I think in the early 1960?s), I recall him mentioning that workouts performed better than generals over a 2 year period during a bear market. So basically, his general stock investments performed much better than workouts (and the market) in bull markets, and workouts perform better in bear markets.
But it’s worth noting that overall, his general stock investments outperformed the market by a much wider margin than his workout investments. We unfortunately don’t have exact numbers as Buffett starting reporting results by category only in the later years, but he does specifically say that his general stock investments were by far his best category in both percentage returns and gross profits.
My final thoughts on arbitrage:
I think arbitrage is a technique that is extremely valuable for any value investor to study, but I think that overall, especially in today’s environments where spreads are very small, it’s much more beneficial to focus your energy on studying individual stocks and looking to assemble a portfolio of undervalued companies. Both Buffett and Graham both had better results from their general stock investments than they did from their arbitrage investments. (I went through Graham’s letters that he wrote while managing his firm and confirmed this: read his letters here)
Arbitrage strategies can lower volatility, and can smooth out returns. They can also provide a cushion in down markets. But overall, if you’re concerned about the highest absolute returns, I think your chances are higher by investing in cheap stocks. After all, when you can achieve this type of outperformance by simply owning a diversified basket of the cheapest stocks… why complicate things?
For more info check out the full piece on Quantitative Value. Of course, this chart shows results from backtesting and past performance doesn’t guarantee future results, but it does lead me to believe that owning a basket of undervalued securities stacks the deck in my favor. For now, that is my foundation to build on as I improve my valuation skills and learn more about special situation tactics.
Over the next few weeks I’ll be starting a model portfolio here at Base Hit Investing and will be discussing more specific ideas relating to stock investments.
Enjoy the rest of your weekend!