The 3 Sources of Returns for Warren Buffett's Original Partnership

I was recently reading through Buffett's Partnership Letters (which can be found here) and stumbled upon something that he mentioned numerous times that I've never seen mentioned anywhere else before. Buffett classified his investments into three categories that he believed would have various correlations with the market. He believed that by splitting his capital up into general issues, work-outs, and control situations, he could better protect his downside in order to out-perform the Dow Jones long term.

Buffett defines these categories as follows:

General Issues

"[General Issues are undervalued securities] where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen." - 1961 Partnership Letter

He emphases later that this section of his portfolio is the most correlated with the market and most likely to decline in a bear market. However, in a bull market, these are the primary source of returns.

Work-outs

"A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of [general issues]. 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 generally." - 1957 Partnership Letter

Buffett further comments in his letters that work-outs are the primary source of returns during a down market. General issues may decline, perhaps significantly, but the steady returns from the work-outs will help the partnership out-perform in the long run by shielding the partnership from large declines.

Control Situations

"[Control situations are] where we either control the company or take a very large position and

attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it." - 1961 Partnership Letter

Like the work-outs, these situations produce returns with very little correlation to the market. The control situations have the added benefit of forcing price of the stock towards its fair value rather than waiting for another catalyst.

My Thoughts

At the beginning of the partnership in 1956, Buffett worked with a relatively small base of capital, so his focus was on general issues and work-outs rather than control situations. He had a split of 70/30 between general issues and work-outs respectively. By the following year, he had a split of 85/15 but wished to allocate more to the work-out category in order to protect against a downturn (as he believed equities to be relatively expensive in 1957).

I find it interesting that most money managers focus on general issues rather than attempting to find work-outs, especially when these work-outs provide downside protection against a bear market. I suspect the reason for this phenomenon is a combination of difficulty in finding work-outs as well as short term thinking. Although work-outs provide downside protection, they also temporarily limit upside, which may scare away limited partners who prefer liquidity and short term results to long term out-performance.

Control situations are a bit harder for average investors to participate in as it requires a larger capital base. One of the reasons why reading Buffett's partnership letters is so interesting is because he is using a sum of money that is not unreasonably large compared to what a semi-wealthy investor or money manager may have. Buffett intentionally focuses on smaller companies rather than "blue chip" large cap stocks in order to influence the management in a way that would unlock value. The major lesson here is that investors with smaller amounts of capital should focus on smaller companies. The control situations were a major reason that the Buffett Partnerships were so successful, especially with his investments in Sanborn Map and Dempster Mill (which I may write about in a future post).

Investors would also be wise to look for work-outs, especially as the current bull market nears 10 years of age and valuations seem stretched. Buffett's partnership letters are an excellent read for all investors, and I highly recommend everyone to check them out. I also plan on writing a bit more about other lessons learned from Buffett's letters, which will hopefully provide a bit of knowledge to everyone reading this blog.