Written by Alex Hughes, International Equities Analyst, StocksInValue
Original article first published in StocksInValue
Warren Buffett is one of the world’s greatest and most celebrated investor for good reason, his record of consistently high returns over such a long period is unmatched the world over. Many can generate 20% in a single year, but virtually no one has been able to do it year in year out for 50 years. When reflecting on this, many people conclude that in order to replicate Buffett’s success they should mimic the kind of investments the world’s best investor is currently making.
The 85 year old Buffett of today manages a balance sheet with a book value of $250 billion, the result of 50 years of retained earnings and impressive rates of compounding. With $32B of operating cash flow, Buffett has to find a sensible home for $615m each week. While Berkshire owns some fantastic stocks and subsidiaries, boding well for ongoing returns, his potential universe for reinvestment is limited to only the largest of listed companies, a remarkably small universe of the most widely researched and most well-known businesses. The challenges of rising scale is increasingly evident in Berkshire’s returns. As we can see below, each decade has produced a meaningfully lower return than the last.
Based on this information, perhaps replicating what Buffett is currently doing is not the optimal strategy, given he is investing as he does out of necessity. In doing so, small investors are essentially giving up the advantage small scale gives them. If your goal in investing is to maximise your returns, instead of drawing inspiration from the Buffett of today, perhaps it is more rational to focus on Buffett when he was at his best. So when was Buffett at his best, and how was he investing then?
In his own words: “The highest rates of return I’ve ever achieved were in the 1950’s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1million. No, I know I could. I guarantee that.”
Buffett made this remarkably bold statement in 1999 reflecting on over 5 decades of investment returns. Interestingly, his best returns came not when the market was the strongest (80’s and 90’s) but when his capital was the smallest. So for the enterprising investors who are looking to meaningfully outperform, perhaps its makes sense to invest like Buffett did in the 50’s.
So how would Buffett go about generating 50% returns? Luckily for us, Buffett has been asked numerous times in the public forum (watch here) how he would do so:
“If I were working with small sums I certainly would be much more inclined to look among what you might call classic Graham stocks, very low PE’s and maybe below working capital and all that. And incidentally I would do far better percentage wise if I were working with small sums. There are just way more opportunities. If you are working with a small sum, you have thousands and thousands of potential opportunities, and when we work with large sums we have relatively few possibilities in the investment world that can make a real difference in our net worth. So you have a huge advantage over me if you are working with very little money, but there are compensations to that on the other side of the equation.
The Korean stocks you mentioned that I looked at 6 or 7 years ago were companies where you could only put a small amount of money in, and I was sort of reliving my youth. Somebody sent me a handbook of Korean stocks and told me that the market was interesting, so one Sunday afternoon I did leaf through a couple thousand pages of Korean stocks………..I bought a number of stocks in small amounts from companies whose names I couldn’t pronounce. But the stocks as a group were so cheap that you had to make money out of them, they were Graham type of stocks. That’s what I would be doing, I would be combing that kind of a list.
This investment style is a stark contrast to the wonderful-company-at-a-fair-price strategy which Buffett champions today. To provide further detail, let’s review Buffett’s investment in Sanborn Map, which he first purchased in 1958.
Sanborn’s core business was involved in the sale of detailed maps of cities that property insurance companies used to assist with their underwriting. The business had a monopoly like position for decades as Sanborn map was the sole provider of the must have information, however as underwriting departments gradually adopted different techniques, Sanborn’s earnings fell from $500k p.a. to $100k p.a., an 80% erosion in earnings capacity despite the strong economic growth of the time. Due to continued retention of earnings since the 30’s, Sanborn Map had built a sizeable investment portfolio of stocks and bonds.
Due to the depressed price at which Sanborn traded, Buffett was able to pay $45 per share for Sanborn, a 30% discount to the $65 per share investment portfolio. This implies that Buffett was gifted the profitable, albeit challenged map business for free.
Buffett was certainly well aware that the map business was not a wonderful company by any stretch of the imagination. However, the bargain basement price gave Buffett a large margin of safety and rendered the future of Sanborn unimportant. If Sanborn’s map business evaporated, it would not hurt Buffett as the investment portfolio provided immense downside protection. If it continued to generate profitable returns, Buffett’s upside was potentially significant. As it turned out, Sanborn separated the investment portfolio from the map business, generating a 50% return on the investment for the Buffett Partnership with very low downside risk.
This is clearly far from the wonderful-company-at-a-fair-price process that Buffett champions today. The business was obviously challenged with its profit falling 80%, however Buffett still purchased based on the large discount to tangible assets on offer. This is the type of situation which is typically only available in smaller securities that are two small for institutions to buy.
Investing in obscure stocks certainly isn’t for everyone. It requires a deep understanding of accounting principles, business dynamics and people, and the willingness to spend considerable time looking where others won’t. Most people do not have the time or temperament to look among the cracks of the market to find the opportunities that will give outstanding returns. For these people, investing in low cost index funds or entrusting your capital to a fund manager is likely to be the only sensible option. However, for those who seek to meaningfully outperform, investing like Buffett at thirty five, not eighty five, could add another alpha generating dimension to your investment strategy.