Warren Buffett’s Ground Rules | Jeremy Miller


Published in 2016

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In this book, financial analyst Jeremy Miller summarizes Warren Buffett’s letters to his partners in Buffett Partnership Ltd. (BPL). The letters were written during the 1950s and 1960s and were before the Berkshire Hathaway era. It was the time in Buffett’s career when he managed the least amount of capital and was able to use all the tools he learned from Benjamin Graham.

CRUSHED THE MARKET DURING 13 YEARS. Buffett started BPL in 1956 with $105k from family and friends. He was then 25 years old and the company was managed from a room in the house on Farnam Street in Omaha. The portfolio consisted of three types of investments; Generals (mainly “cigar butts” – cheap companies that often-had problems with profitability), Work-outs (arbitrage) and Control situations (activist positions in “cigar butts”). For 13 years, BPL’s annual return was 25% after fees, compared to the Dow’s (index) 9%. When Buffett shut down BPL in 1969, assets under management amounted to $100m and Buffett had a net worth of $26m.

IF YOU ARE SMALL, STAY FULLY INVESTED. Large funds cannot invest in micro-companies no matter how attractive the valuations are – there are simply not enough stocks to buy. Managers with little capital can invest in almost any company, regardless of size, and should take advantage of it. When Buffett invested in Dempster Mill and Sanborn Maps, they had market capitalization of $13m and $38m, respectively, in 2014 money value – small enough to be classified as microcaps today.

”If I was running $1m, or $10m for that matter, I’d be fully invested. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts back then. It’s a huge structural advantage not to have a lot of money.”

CAPITAL MANAGEMENT IS A RELATIVE GAME. Buffett saw Dow as his opponent and his main task was to deliver a higher return to his partners. Absolute return was irrelevant to him. If the index was up 30% and the partnership up 25%, he was dissatisfied. If the index was down 20% and the partnership down 10%, he was satisfied.

 “The Dow as an investment competitor is no pushover and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.”

AT LEAST THREE BUT PREFERABLE FIVE YEARS. If you want to overperform over time, you must be prepared to underperform in the short term. But if you have underperformed for five years or more, you should consider whether it might be time to change strategy or simply invest in an index fund. However, the later stages of a “bull market” are an exception, then value investors should expect to underperform the market.

FOCUS ON WHAT CAN HAPPEN, NOT WHEN. The market will inevitably crash from time to time and when it does, it will take all the shares with it in the case – growth shares as value shares. Buffett never had a view on whether the market was overvalued or undervalued. He invested in individual companies and focused on their values, future and potential. The accuracy of the analysis determined whether he was right. The market’s longer ups and downs cycles decided when he got it right.

EVERYONE IS A CAPITAL ALLOCATOR. There is no difference between a fund manager and a CEO – both are capital allocators. The manager controls the fund’s capital and the CEO the business’s assets. When Buffett took control of “Generals”, he often converted capital previously used in a low-yielding business (inventories and receivables) into capital that could be used in a high-yielding business (securities). A CEO should see all investment capital as variable and place it where the return potential is greatest.

FIVE WAYS TO INCREASE THE VALUE OF A COMPANY. Operationally, a company’s value can be increased by (1) increasing sales, (2) reducing costs as a share of sales and (3) reducing the asset base as a share of sales. In addition, (4) increased borrowing and / or (5) lower taxation may increase a company’s value.

NEVER COUNT ON A GOOD SALE. By buying assets at a discounted price, we do not have to rely on a strong stock market to get a good return. The cornerstone of value investing is to make the purchase price so attractive that even a mediocre sale gives a good result.

READY TO BUY THE LAST SHARE. “Generals” often became “Control situations” if the low valuation remained for a long time. If the price was attractive, Buffett continued to buy as long as there were sellers. Since he was then one of the major shareholders, he took an active role in the company. Through this, the partnership could get a revaluation either by the market buying the share or by Buffett being given the opportunity to buy a large enough position to be a “catalyst” and realize the values.

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