Thursday, June 7, 2007

Warren Buffett -- 50% Returns

Much attention has surrounded reports that Warren Buffett said he could generate 50% returms on small sums of money. Typically, three immediate questions arise:

Did he really say that? Did he really mean it? And, how would he (or me or my favorite money manager) do it?

Looking at the record of his comments, it's pretty clear that he said it (and repeated it) and he really means it.

Buffett seems to have got the set this ball rolling in 1999. At that year's BRK shareholder meeting, he was aked:

Shareholder: Recently, at Wharton, Mr. Buffett, you talked about the problems of compounding large sums of money. You were quoted in the local paper as saying that you're confident that if you were working with a small sum closer to $1 million, you could compounded at a 50% rate. For those of us not saddled with a $100 million problem, could you talk about what types of investments you'd be looking at and where in today's market, you think significant inefficiencies exist?

Buffett: I may have been very slightly misquoted, but I certainly said something to that effect. I talked about how I polled this group of 60 or so people I get together with every couple of years as to what rate they think they can compound money at if they were investing small sums: $100,000, $1million, $100 million, $1 billion, etc. And I pointed out how the return expectations of the members of this group go very rapidly down the slope.

But it's true. I could name half a dozen people that I think can compound $1 million at 50% per year -- at least they'd have that return expectation -- if they needed it. They'd have to give that $1 million their full attention. But they couldn't compound $100 million or $1 billion at anything remotely like that rate.

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there is an opportunity to earn very high returns.

But that advantage disappears very rapidly as the money compounds. As the money goes from $1 million to $10 million, I'd say it would fall off dramatically in terms of the expected return -- because you find very, very small things you're almost certain to make high returns on. But you don't find very big things in that category today.

Later, similar comments by Buffett were reported in the June 25, 1999 Business Week:

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. 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 then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

He has repeated similar statements in recent meetings with college students, and at the 2007 annual meeting, he hit the topic again:

If I were working with a very small sum – you should hope this doesn't happen – I'd be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you're investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can't do it, but if you know what you're doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $ 5 billion in a stock. It won't work – it's not even close. If Charlie and I had $500,000 or $2 million to invest, we'd find little things we could do, not all of it in stocks.

This most interesting part of the statement is the emphasis on how different his activies and opportunities would be with smaller sums of capital and therefore more opportunities: "I'd be doing almost entirely different things than I do." Not sitting on Coke, the Washington Post, AXP. Not committing new money in the past few years to BUD, WMT and JNJ.

What then would he do? Well, he's hit this theme a few times also. At the 1998 shareholder meeting he said:

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there is an opportunity to earn very high returns.

What was the Adam Smith interview? It aired in October 1993, and it went like this:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

As he explained at the 2001 shareholder meeting:

When I started, I went through the manuals page by page. I went through 20,000 pages in the Moody’s industrial, transportation, banks and finance manuals -- twice. I actually looked at every business -- although I didn’t look very hard at some.

He told Columbia business students in 2006:

Reading has made him rich over time. He told the story of going through Moody’s annuals in 1951. “It was absolutely a question of turning pages”. On page 1433, he found Western Insurance Securities. Its earnings per share were as follows: 1949 -$21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. He went to a broker and read the Best’s Insurance manuals, and talked to agents – it was a perfectly fine company with nothing wrong. Ten pages later, on page 1443, he found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. Buffett found it fascinating that this company was located several blocks from the broker where he worked. His fellow brokers were bright, rational people whose job it was to buy cheap securities, and they refused to buy NAFI, instead investing in “blue chips”.

He then took out a copy of the 2005 Korean Stock Market guide. It was more of an almanac than a brokerage report. It was sent to him for free by a broker. “If it had been $10, I wouldn’t have paid for it.” Based on the recommendation of a friend who thought South Korean stocks were cheap, Buffett spent 5-6 hours leafing through the pages and put together a $100m portfolio of 20 or so companies. Daehan Flour sold 25% of the flour in South Korea, which had a large and stable economy. It’s earnings over the last few years: 12,870 won, 18,000 won, 22,830 won. It had over 100,000 won in securities. The stock price was 38,000 won. “You have to make money buying stocks like this at 2x earnings. Brokers aren’t going to tell you about Daehan Flour.”


All this corresponds nicely with Charlie Munger's recent comments to the graduating class of USC law school:

Another thing you have to do, of course, is to have a lot of assiduity. I like that word because it means: sit down on your ass until you do it.


10 comments:

Shai Dardashti said...

Very interesting post; I've got some 1950s Moody's Manual PDF's you might find interesting... shoot over a note:

ShaiDardashti@gmail.com

Enjoy,
Shai

Anonymous said...

Returns of 50% compounded or more are very, very possible. I managed a Private Equity Portfolio in the early 1990's that returned, audited, in excess of 64% compounded during the time I managed it. Several successful Private Equity Investments you may have heard of were: Nextel(NXTL), PetsMart(PETM), and others.

David E. Westphal, CFA

Bruce said...

"I actually looked at every business -- although I didn’t look very hard at some."

Yeah. Turn over a lot of rocks and you'll find good investments every now and then. I also found it to be an outstanding learning experience.

When I went through the pink sheets the first time, I hired people to filter out the total garbage and then I skimmed over the rest very quickly to pick out the few that were worth looking at carefully.

Bruce from pink sheets

valuevista said...

Bruce --

As you can see by the link, I like your blog. If I have enough energy, I hope Valuevista will develop into something like PinkSheets.

While I enjoy writing, so far I have found writing to add more time to the process than I desire. Though the writing process does impose an added level of welcome discipline.

When I went through the pink sheets the first time, I hired people to filter out the total garbage and then I skimmed over the rest very quickly to pick out the few that were worth looking at carefully.

What rules did you give your screener to filter?

What did you do to skim the others? Read 10-Ks and 10-Qs, or some other more accelerated process? I am interested in speeding the process on my end.

Regards,
Valuevista

Bruce said...

"What rules did you give your screener to filter?"

I had two people doing the work, neither one had any sort of financial background. The screening rules were fairly simple and weren't very important. If you look at 50 random pink sheets stocks, you'll get a good idea for what rules you want. Mine were structured first on assets vs liabilities, then looking for any income, and a cash flow check thrown in as well.

The quick skimming wasn't easy in the sense that I had no rules. You can see the process fairly well in the middle of December 2005. It was all based on recent SEC documents, typically the 10-K.

Wesley said...

fascinating blog, considering i mostly only look at australian stocks an important reminder that great value can lie outside my relatively small market. thanks, wez

Nas said...

Great post.

Jay said...

what does "Start with the A's" mean?

1. company name start with A?
2. best quality companies?

Could someone clarify it?

valuevista said...

"Start with A's" refers to the alphabet. Just start reading, going through the available companies, one by one.

The Value Investor said...

It seems like that "assiduity" can be replaced with a simple screen. If Warren had a screen in his younger days, he wouldn't have had to go through all 20,000 companies. He could have found that insurance company by only screening those with P/Es of 2 of less. The same can be said for the South Korean stocks...That won't help you gain that bank of knowledge though:)