Warren Buffett's Ground Rules: Words of Wisdom from the Partnership Letters of the World's Greatest Investor

by Jeremy C. Miller

2. Ground Rule #5: “While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year

year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.”4

Buffett also teaches investors that there is one important caveat to the multiyear test: Underperformance in the late stages of a speculative bull market is highly likely. It’s a caveat that he repeats to this day.

We should only care about trailing 3-year figures (at a minimum) because that is the threshold where markets can be expected to become efficient. Five years is better. A full market cycle is the best period over which to evaluate an active manager (market low to market low, or market high to market high).

When the water (the market) rises, the duck rises; when it falls, back goes the duck. SPCA or no SPCA, I think the duck can only take the credit (or blame) for his own activities. The rise and fall of the lake is hardly something for him to quack about.

Speculative bull markets aside, Buffett thought he could beat the market by a wide margin. He teaches us to establish clear, consistent measurements so that performance can be monitored and judged fairly and accurately. He spells out ahead of time exactly what we are setting out to do, and he encourages us to regularly test ourselves against that yardstick.

Incentive dictates behavior. Whether we’re talking about investment managers, business leaders, or politicians, more often than not, people will behave according to what they’re being rewarded for.

He was consistently fair and accommodating to the needs and risk tolerance of the different partners.

Buffett was now not just the general partner collecting fees; he and his family also had more at stake financially than any other limited partner.

In order to appease both groups, the 6% would be distributed, ½% each month, to those who wanted it. Those who wished to keep their funds fully invested could choose to forgo these payments, which would be reinvested back into the Partnership at year-end.

Buffett charged no management fee. He got paid only on performance. His system was better because it removed a source of potential conflict between his interest and the interest of the LPs.

In addition to not charging a management fee, Buffett thought he should get paid only for performance in excess of what a “do-nothing” investor would otherwise get; he only took a fee beyond a 6% return threshold, which was the midpoint of his 5–7% average return expectation for the market. In this way, he was further aligned with his partners’ interests.

observing the world through the lens of incentives is a valuable tool whenever you’re trying to predict any outcome where people are involved. Incentives make the world go round. It’s helpful to think it through backward and look for ways that others will do well when you won’t, an obvious red flag.

When we know what motivates people, we pretty much know how they will behave.

Do you like to hunt for the cheapest of the cheap, irrespective of the underlying business’s quality or current fundamentals, with the view that you’ll be protected by an attractive purchase price that harnesses the power of mean reversion in your favor? This was one of Graham’s principal approaches and continues to define how many great investors operate today.

There is absolutely no need to classify yourself into a particular style bucket. You will, however, need to figure out what is and isn’t going to work for you.

own mother was devastated by the crash before it. There is little surprise Graham focused on tangible net asset and liquidation values in order to ensure that a significant backstop of value existed to limit the risk of a permanent loss in an investment.

Because his primary focus was not to lose money, Graham liked to “look down before he looked up.” He relished acquiring companies that could (if necessary) be shuttered, where all the assets could be sold off and all the debts and obligations extinguished, and yet still, once all this activity was complete, a residual amount would be remaining as a profit above the market price.

It’s not that the companies were actually liquidated all that often, although sometimes they were—the point was that there was value in the equity even in liquidation.

Grahamite “Super Investors” were all originally taught to jump from cheap stock to cheap stock. The results were typically fabulous and the chance of loss was small. Again, most of these are not good businesses, but they are often mouthwateringly cheap, and good returns for buyers of a portfolio of these securities are almost a lock given the prices paid.

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.

Quantifiable opportunities are often available, particularly at market cycle lows, and while the extreme cases of ultra-cheap net-nets have become more infrequent from cycle to cycle, value investors of the more quantitative bent, with marginally lower standards of what defines cheap, still manage to do very well with the bargains they find.

Cigar-butt investing was scalable only to a point. With large sums, it would never work well.

though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating.

The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”

having started out as Grahamites—which, by the way, worked fine—we gradually got what I would call better insights. And we realized that some company that was selling at two or three times book value could still be a hell of a bargain because of the momentum implicit in its position, sometimes combined with an unusual managerial skill plainly present in some individual or other, or some system or other.

Buffett introduced this new category to partners in 1964, the same year he bought the large stake in American Express. There was a scandal at one of its subsidiaries that created a potentially large liability and was perceived to threaten the reputation and value of the brand—the stock had gotten pummeled. Once Buffett realized the issues were recoverable, and that America Express could survive the scandal with its brand, reputation, and business fundamentals still intact, Buffett loaded up.

In keeping with his earlier dictate not to reveal the names of individual firms in which the Partnership had invested, Buffett never told his partners that they were such substantial owners of either company.

Below-average returns in an industry tend to cause competitors to flee. Managements motivated to restore at least an adequate return on their time and money often change strategy, improve their process, or stop doing the business that is losing money. Buying stocks that are cheap when the companies are struggling gives the investor a chance to be rewarded twice: once through improved business results and then again through an improved market valuation in accordance with the better business results.

Tom emphasizes that you have to get only a very small number of these right for this type of strategy to really pay off. The companies you get right will harness the power of compounding and grow to dwarf the mistakes.

Tom’s strategy is almost the opposite of Tobias’s but he understands it and it works for him. Neither one is “right” or “wrong”; each has developed a value system that works for him. What’s right in investing is what works for the individual.

I have three mailboxes in my office—IN, OUT, and TOO HARD. I was joking with the MIT students that I should have a TOO HARD bin and they made me one, so now I have it and I use it. 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.

I think people would be better off if they only had 10 opportunities to buy stocks throughout their lifetime. You know what would happen? They

would make sure that each buy was a good one. They would do lots and lots of research before they made the buy. You don’t have to have many 4X growth opportunities to get rich. You don’t need to do too much, but the environment makes you feel like you need to do something all the time.

If you find yourself unable to make it all the way through the checklist, then write down in a single paragraph the merits of the investment. If you get caught up along the way, either do more work or simply forget the idea as “too hard” and move on to something else.

While Buffett has made many investments over his long career, only a small handful have accounted for the vast majority of the wealth he’s been able to create. Recognizing this, Buffett encourages investors to make a punch card, then only use it when you find yourself inside your own circle of competence.

Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.”

As a boy, Buffett paid 25 cents for six-packs of Coke at his grandfather’s store, then sold the individual cans for a nickel each, making 20% on every six-pack “arbitraged.” Buffett had performed a financial trick called arbitrage—a practice that follows a straightforward formula: Something is bought at X, value is added or risk assumed, and then a sale is made at X plus a profit.

Workouts and other forms of arbitrage can be a highly attractive area for profits in their own right and have the added benefit of diversifying the sources of annual gains in a way that protects overall results in down markets. They provided Buffett with an outlet for his energies when the overall market was high—doing nothing when there is “nothing to do” can be a challenge for vigorous investors.

Buffett teaches investors to think of stocks as a conduit through which they can own their share of the assets that make up a business. The value of that business will be determined by one of two methods: (1) what the assets are worth if sold, or (2) the level of profits in relation to the value of assets required in producing them.

Following the crowd can be a remarkably effective strategy in most situations. When you’re at an unfamiliar school to watch the big game, following the mob before kickoff is usually a good way to find the stadium. Similarly, if you see people running panicked out of a movie theater, it’s a pretty good sign you shouldn’t go in. The next time you see a gathering of people all looking intently in the same direction, see if you can keep yourself from looking, too. I’ll bet you can’t. This instinct, which is programmed into our human condition, is called social proof, and it tends to be very helpful in most situations.

Social proof also happens to be the muse of the investing underworld. It lures you in with the

comfort that comes with being part of the crowd and then kills your chances for outperformance because, by definition, being part of the herd means your investment views will lack sufficient variance. It i...

In investing, the herd typically gets it wrong. The best time to be a buyer of securities is when the mob is most fearful.

When even the taxi drivers are talking about their stock portfolios, it’s prudent to be cautious.

There is an old saying on Wall Street, “What is a good idea in the beginning is ofte...

The Partnership lessons teach investors that there is only one set of circumstances where you or anyone else should make an investment—when the important facts in a situation are fully understood and when the course of action is as plain as day. Otherwise, pass.

If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea.

The fact that Buffett never had a down year during the Partnership era is truly remarkable. Stanley Druckenmiller, who had previously made billions with George Soros, never had a down year at his hedge fund, Duquesne, where he managed money for twenty years. Joel Greenblatt, another famous investor who averaged 50% returns per year at Gotham, never had a down year in the ten years from 1985 to 1994. The ability to perform well in down markets is a hallmark shared by all three of these great investors.

The letters teach investors to always assess the value of their holdings as if they’ve already been liquidated. He would tell you your “net worth” is the market value of your holdings less the tax payable upon sale.2 That’s the proper way to think about it.