http://www.ft.com/cms/s/2/105e4dc8-f9bd-11db-9b6b-000b5df10621.html - Buffett never makes a bet with sucker odds

By Mark Sellers

Published: May 4 2007 17:08

Every couple of years I pull out Buffett’s old partnership letters, written to his investors between 1957 and 1970, and re-read them. In my opinion, these letters are the greatest “book” ever written on how to manage an investment partnership.

The Buffett Partnership Limited was formed in 1956 with $100,000 in capital. Buffett did not charge an annual management fee but he took 25 per cent of the profits above a 6 per cent “hurdle” rate. The partnership compounded money at 31 per cent annually between 1957 and 1969, when Buffett disbanded the partnership and sent the money back to investors, versus 9.1 per cent annually for the Dow. During this period the fund outperformed the Dow every year and never lost money, in spite of four losing years for the Dow. Buffett liquidated the partnership in 1969 and 1970 and sent his investors their money back. 

Back then, Buffett classified his investments into three categories: generals, workouts and controls.

Generals were defined as out-of-favour stocks with good management teams and a low valuation relative to their intrinsic value. This is the type of investment Buffett is best known for today, and it comprised the largest portion of his portfolio back then.

Workouts were defined as “securities with a finite timetable” – essentially turnround plays or arbitrage situations with a defined catalyst. This was Buffett’s second most common type of investment, although today he shuns turnrounds and ignores arbitrage situations.

Controls were stocks that did nothing for such a long time after Buffett began buying that he was able to accumulate a significant percentage of the stock, thereby garnering some control over the company’s direction. Berkshire Hathaway, which he began buying in 1962, was one of these. I don’t think Buffett ever engages in activism today, but he made a lot of money doing it then.

There are other notable differences between Buffett’s strategy then and what he does now.

Most of the stocks held by BPL were obscure micro-caps such as Sandborn Map, Dempster Mill Manufacturing and Texas National Petroleum. Today, because of the size of his investment pool, Buffett can consider only investments in large companies. This hinders his performance (although he still does amazingly well, given the size of his portfolio).

Although Buffett has always been known for taking large positions, not many people are aware that in 1959 and 1960 he had about 35 per cent of his fund’s portfolio in one stock, Sandborn Map. It turned out to be a very profitable investment for the partnership.

There may have been others of this magnitude; Buffett told his investors in one letter that he would invest up to 40 per cent of the partnership’s capital on a single idea if the risk/reward ratio was highly favourable.

And even early on he realised that buying a stock is the same as buying into a partnership with the management team, so you had better be careful who you get into bed with. This philosophy has not changed in 50 years.

Most important, Buffett has never wavered on one overriding principle: he has never made a bet unless he was sure the odds were strongly in his favour.