I have often told people that the Buffett Partnership Letters is my favorite investment book. As a young investor (26 years old when he started in 1956), Buffett was nimble, opportunistic, and far more candid in his discussion of ideas and portfolio management techniques. The Partnership Letters and the early Berkshire letters are a treasure trove of information, revealing the staggering genius behind the simple folksy manner he employs for mass media. Summaries and excerpts related to portfolio management will be posted in series form over the next few months. I hope our Readers will enjoy them. I will certainly enjoy going back through and articulating my thoughts in written form.
It may surprise some Readers that Warren Buffett was not always a “buy and hold” investor. Wait until you read the letter in which he talks about drinking – I hope you’re sitting down – Pepsi!
Special Situations, Volatility
“My view of the general market level is that it is priced above intrinsic value…Even a full-scale bear market, however, should not hurt the market value of our work-outs substantially."
“A work-out is an investment which is dependent upon a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline in general.”
Buffett’s “work-out” names muted (improved) the volatility profile of the return stream while providing upside potential – offering upside capture with little or no downside capture – in essence the “holy grail” security of every portfolio manager’s dream.
Fast forward 55 years, our industry now uses the term “special situations” and “event driven” to describe Buffett’s “work-outs.”
I suspect the arbitrage and special situations space back in 1957 was a lot less competitive, and investors could extract decent returns with minimal downside exposure to overall markets.
Today, many investors hold work-out / special situations / event driven securities in their portfolios. As a result of the competitive nature of the investment management industry, these types of securities either (1) no longer shield portfolios from market volatility as effectively as in 1957 or (2) do not provide the upside return potential as they once did.
With all that said, I still believe that Buffett’s technique is valuable today because his general rationale for holding uncorrelated “work-outs” in a portfolio still holds true. Investors just need to think more creatively and seek “work-outs” disguised in different forms – beyond the special situation securities in which event driven investors usually traffic.