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

by Jeremy C. Miller

We attempt to obtain all facts possible, continue to keep abreast of developments and evaluate all of this in terms of our experience. We certainly don’t go into all the deals that come along—there is considerable variation in their attractiveness. When a workout falls through, the resulting market value shrink is substantial. Therefore, you cannot afford many errors, although we fully realize we are going to have them occasionally.

Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs.

Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development. I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior.

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.

Our bread-and-butter business is buying undervalued securities and selling when the undervaluation is corrected along with investment in special situations where the profit is dependent on corporate rather than market action.

After Sanborn, Buffett continued executing Control transactions throughout the rest of the Partnership era and discussed two others, Dempster Mill and Berkshire Hathaway, in detail.

Graham was first to say it and Buffett often repeats it—Investment is most intelligent when it is most businesslike and business is most intelligent when it’s most investment-like.

Interacting with a board not focused on shareholder value made Buffett’s blood boil.

Sanborn, Dempster, and Berkshire were all asset plays. The value of their assets, less all liabilities, far exceeded the market price of the stocks. These were not good businesses, didn’t earn adequate or better returns on the assets they employed, and were not readily valued on current earnings.

For the liquidation plays, Graham advised, as a general rule of thumb, ascribing 100 cents on the dollar to cash, 80 cents on the dollar to receivables, 67 cents on the dollar for inventory (with a wide range depending on the business), and 15 cents on the dollar for fixed assets.

Sanborn had a “hidden asset” in its portfolio of securities that was worth far more than the balance sheet suggested (convention at the time was to carry securities at cost, not market price, so the value had to be “marked up”).

Dempster Mill’s assets, net of all liabilities, were carried on the balance sheet at values that were significantly higher than the total value of the stock in the market. The accounting values were plain as day. The question Buffett encountered was what were the assets really worth?

With Berkshire, the question was how could the capital in the business be re...

The initial question is always the same: Are you capable of estimating what these assets are worth? Or, as Buffett would put it, are you within your circle of competence? If the answer is no, forget it and move on to valuing something else. There is nothing wrong with that; in fact, you should take pride in knowing what you are and are not capable of valuing. This self-knowledge is what distinguishes the great investors and avoiding mistakes is just as important as doing a good job picking winners. Buffett puts the majority of potential investments into the “too hard to value” pile and simply moves on.

With Dempster Mill, Buffett encountered just such a situation. In 1961, its book equity was $76, making the stock look ridiculously cheap at $28, at least on paper. Watching Buffett skillfully mark down Dempster’s assets is a good chance to watch him in action as he conservatively assesses true market values line by line. Here, even after his markdowns, Buffett found the stock was still exceedingly cheap.

This is what Buffett saw at Sanborn Map, who had acquired a portfolio of securities that were being carried on the books at their cost (not at their market value).

However, when you are a minority holder, you’re at the mercy of the existing management and the board of directors. While it’s their job to act in the best interest of shareholders, they don’t always live up to their responsibilities. This is the potential agency cost you bear when you don’t have control and the reason why an evaluation of management can be a very important part of your investment decision.

With control comes the added ability to take charge, which is a real advantage when change is needed. By turning Generals into Controls, Buffett was able to change the behavior of companies. He stopped the value-destructive activities at Dempster and Berkshire; he fixed the lopsided capital structure of Sanborn Map. Through the Controls, we not only get to see how Buffett came to recognize undervalued securities but also how he made businesses more valuable by improving the returns on the capital (assets) they employed. In an optimally run business, the value of control to a financial buyer is zero. The right to force change is valuable only when something needs fixing. All three Controls offered significant opportunities for improvement.

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. Carl Icahn, Nelson Peltz, Dan Loeb, and Bill Ackman, among others, have garnered quasi-rock-star status as investors. However, not all activists are worth following, and Buffett spoke disparagingly about the activists of today at the 2015 Berkshire meeting, saying that most of what he sees nowadays is “really reaching,” meaning he sees their demands as not necessarily in the interest of the long-term shareholders.

When I am dealing with people I like, in businesses I find stimulating (what business isn’t?), and achieving worthwhile overall returns on capital employed (say, 10–12%), it seems foolish to rush from situation to situation to earn a few more percentage points. It also does not seem sensible to me to trade known pleasant personal relationships with high grade people, at a decent rate of return, for possible irritation, aggravation or worse at potentially higher returns.

Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.

I may be wrong in this expectation—a great deal depends, of course, on the future behavior of the market on which your guess is as good as mine (I have none).

Our purchases of Berkshire started at a price of $7.60 per share in 1962. This price partially reflected large losses incurred by the prior management in closing some of the mills made obsolete by changing conditions within the textile business (which the old management had been quite slow to recognize). In the postwar period the company had slid downhill a considerable distance, having hit a peak in 1948 when about $29.5 million was earned before tax and about 11,000 workers were employed. This reflected output from 11 mills.

At the time we acquired control in spring of 1965, Berkshire was down to two mills and about 2,300 employees. It was a very pleasant surprise to find that the remaining units had excellent management personnel, and we have not had to bring a single man from the outside into the operation. In relation to our beginning acquisition cost of $7.60 per share (the average cost, however, was $14.86 per share, reflecting very heavy purchases in early 1965), the company on December 31, 1965, had net working capital alone (before placing any value on the plants and equipment) of about $19 per share.

While a Berkshire is hardly going to be as profitable as a Xerox, Fairchild Camera or National Video in a hypertensed market, it is a very comfortable sort of thing to own. As my West Coast philosopher says, “It is well to have a diet consisting of oatmeal as well as cream puffs.”

I attempt to apply a conservative valuation based upon my knowledge of assets, earning power, industry conditions, competitive position, etc.

Particularly outstanding performances were turned in by Associated Cotton Shops, a subsidiary of DRC run by Ben Rosner, and National Indemnity Company, a subsidiary of B-H run by Jack Ringwalt. Both of these companies earned about 20% on capital employed in their businesses. Among Fortune’s “500” (the largest manufacturing entities in the country, starting with General Motors), only 37 companies achieved this figure in 1967, and our boys outshone such mildly better-known (but not better appreciated) companies as IBM, General Electric, General Motors, Procter & Gamble, DuPont, Control Data, Hewlett-Packard, etc.

I still sometimes get comments from partners like: “Say, Berkshire is up four points—that’s great!” or “What’s happening to us, Berkshire was down three last week?” Market price is irrelevant to us in the valuation of our controlling interests. We valued B-H at 25 at yearend 1967 when the market was about 20 and 31 at yearend 1968 when the market was about 37. We would have done the same thing if the markets had been 15 and 50 respectively. (“Price is what you pay. Value is what you get).” We will prosper or suffer in controlled investments in relation to the operating performances of our businesses—we will not attempt to profit by playing various games in the securities markets.

Dempster was Buffett’s first experience jumping into the management of a Control with both feet, and Bottle gave him a firsthand view of the difference a high-quality, trustworthy CEO could make. Harry Bottle was showered with praise in the letters. Here we see the origins of what later became Buffett’s signature style, borrowed from Dale Carnegie: Praise by name, criticize by category.

One final facet of the story demonstrates Buffett’s acumen for maximizing after-tax profits. Because all the manufacturing assets were gone, only securities remained. Buffett was able to avoid Dempster’s corporate capital gains tax bill in a move that effectively doubled BPL’s return, allowing BPL to realize a $45 per share gain.

Today, plenty of free Internet tools exist to screen for stocks trading below their accounting book value or their net working capital. Buying an equal-weighted basket of these types of properly selected stocks and holding them for a year or two (one of Tobias Carlisle’s strategies) has proven to be very effective historically. But, if you want to make more concentrated bets like Buffett did, you’re going to have to do some analysis, and that starts with understanding the actual economic value (realizable liquidation value) of a company’s assets.

Operationally, a business can be improved in only three ways: (1) increase the level of sales; (2) reduce costs as a percent of sales; (3) reduce assets as a percentage of sales. The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value. These are the only ways a business can make itself more valuable.

Buffett “pulled all the levers” at Dempster. Raising prices on replacement parts and reducing operating costs pulled lever #1 and #2. Lever #3 was pulled as inventories (assets) were reduced. Lever #4 was pulled when Buffett borrowed money to buy more stocks. Lever #5 was pulled when he avoided a big tax bill by selling all the operating assets of the company.

A good friend, whose inclination is not toward enthusiastic descriptions, highly recommended Harry Bottle for our type of problem.

For tax reasons, we will probably not put workouts in Dempster.

Successful investing requires you to do your own thinking and train yourself to be comfortable going against the crowd. You could say that good results come primarily from a properly calibrated balance of hubris and humility—hubris enough to think you can have insights that are superior to the collective wisdom of the market, humility enough to know the limits of your abilities and to be willing to change course when errors are recognized.

You’ll have to evaluate facts and circumstances, apply logic and reason to form a hypothesis, and then act when the facts line up, irrespective of whether the crowd agrees or disagrees with your conclusions. Investing well goes against the grain of social proof; it goes against the instincts that have been genetically programmed into our human nature. That’s part of what makes it so hard.

To Buffett, if it’s rational, it’s conservative. Period. Sometimes this approach ends up being conventional and sometimes it doesn’t. As he said, “you will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.” 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.

You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is enough to make a course of action meet the test of conservatism. You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct. True conservatism is only possible through knowledge and reason.

It is unquestionably true that the investment companies have their money more conventionally invested than we do. To many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative.

We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case—whether conventional or unconventional—whether others agree or disagree—we feel we are progressing in a conservative manner.

In any event, evaluation of the conservatism of any investment program or management (including self-management) should be based upon rational objective standards, and I suggest performance in declining markets to be at least one meaningful test.

I am willing to give up quite a bit in terms of leveling of year-to-year results (remember when I talk of “results,” I am talking of performance relative to the Dow) in order to achieve better overall long-term performance.

I could have operated in such a manner as to reduce our amplitude, but I would also have reduced our overall performance somewhat

Personally, within the limits expressed in last year’s letter on diversification, I am willing to trade the pains (forget about the pleasures) of substantial short term variance in exchange for maximization of long term performance. However, I am not willing to incur risk of substantial permanent capital loss in seeking to better long term performance. To be perfectly clear—under our policy of concentration of holdings, partners should be completely prepared for periods of substantial underperformance (far more likely in sharply rising markets) to offset the occasional over performance such as we have experienced in 1965 and 1966, and as a price we pay for hoped-for good long term performance.

Consider two stocks, each compounding annually at 15% for 30 years (we’ll assume everyone’s capital gains rate is 35% to make our calculations easier). The investor who jumps back and forth between the two stocks each year will also have their gains taxed each year; the 15% pretax rate will slip down to 9.75% after-tax: [15% x (1 −tax rate) = 9.75%]; $10,000 invested today will be worth $150,000 in 30 years at this rate. Not bad. However, if the investor instead holds just one stock for all 30 years and gets taxed just once at the end, they get the same pretax rate of 15% but the after-tax rate improves to 13.3%. The same $10,000 will compound at an extra 3.55% and will ultimately produce 2.5 times as many after-tax dollars after 30 years. The deferral of taxes provides a form of financial leverage that allows the second investor to control more assets for longer. When each year’s gains are taxed annually, there is no deferral, and thus no benefit from leverage. That’s what makes DTLs so attractive.

The bottom line is that if you can improve your portfolio, you should, even if it involves paying taxes.

Pyrrhic victory.

It is extremely improbable that 20 stocks selected from, say, 3,000 choices are going to prove to be the optimum portfolio both now and a year from now at the entirely different prices (both for the selections and the alternatives) prevailing at that later date. If our objective is to produce the maximum after-tax compound rate, we simply have to own the most attractive securities obtainable at current prices. And, with 3,000 rather rapidly shifting variables, this must mean change (hopefully “tax-generating” change). It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now. It is obvious that an inability to “get even” in a security that has declined is of no importance. It is obvious that the inner warm glow that results from having held a winner last year is of no importance in making a decision as to whether it belongs in an optimum portfolio this year.

I have never been able to understand why the tax comes as such a body blow to many people since the rate on long-term capital gain is lower than on most lines of endeavor (tax policy indicates digging ditches is regarded as socially less desirable than shuffling stock certificates).