Warren Buffett’s Ground Rules


no title has been provided for this book
Category: Investing
Publisher: Harper Business
Published: 4/26/2016
Using the letters Warren Buffett wrote to his partners between 1956 and 1970, a veteran financial advisor presents the renowned guru’s “ground rules” for investing—guidelines that remain startlingly relevant today.

Book Summary - Warren Buffet’s Ground Rules by Jeremy Miller

Key Insights

Warren Buffet, before his world-famous tenure at Berkshire Hathaway, ran his own investment partnership in the 1950s and 1960s. He built his investment philosophies on the theories of his teacher Benjamin Graham, and stuck to them for the rest of his life. Through letters, he shared his evolving thoughts with a growing team of partners and followers. The letters shed light on a period of enormous investing success and offer his commonsense guidance for investors of all kinds.

Key Points

Buffet based his own principles on those of Benjamin Graham, his mentor. Graham believed that in the long run, the market will reward valuable companies.

In 1956, Warren Buffet worked in New York with his mentor, the legendary investor Benjamin Graham. Buffet had been a fan of Graham, the author of his favorite book The Intelligent Investor, even before business school. When he found out that Graham worked at Columbia, he immediately applied, and soon enough was sitting front row during Graham’s lectures. After graduating, he desperately wanted to work for his professor’s company, but was turned down twice. After returning back to New York from Nebraska a few years later, Buffet eventually landed the job in 1954.

Graham was Buffet’s ultimate hero, given his convictions as an investor and pioneer of a new, more conservative style of investing. Graham had a reason for his methods— he had survived many failures early in his career, going totally broke in the 1929 stock market crash. Going forward, he vowed to build his investment strategy from scratch, coming up with a way to avoid as much risk as possible.

This approach involved looking for companies with liquidation values that were higher than the market valuation. This meant that even if the company folded, he would still avoid total losses. In a way, there was no way to lose, but the process was not for the lazy or impatient.

In the long term, Graham said, the market will get the valuation right, even if they undervalued the companies in the long-run. He called this theory “deep-value investing”, focusing on the hidden value of each purchase over everything. This approach was different from the often popular short-term investing, which speculates about the ups and downs of trends in the market. Graham believed these fluctuations to be wholly unpredictable and not worth an investor’s consideration.

Buffet built many of his own principles on this foundation of patience and careful analysis of individual companies. He would go on to become a stock-picker obsessed with companies that were inherently valuable and priced too low.

Unfortunately, Buffet didn’t get a chance to work for Graham for very long. After a year, Graham decided to retire and Buffet had to return to his home state of Nebraska. Back in Omaha, at the age of 25, Buffet decided to start his own investing partnership, against the advice of his parents and Graham himself. Still, he modeled his company after Graham’s philosophies and quickly proved everyone wrong.

Buffet started his investment firm with his friends and family as partners.

After launching the fund, Buffet recruited his friends and relatives to be partners with his firm. His aunt, father-in-law, and college roommate all pitched in.

Soon enough, everyone experienced rewards. Starting with 105,000, the fund grew to 7 million in just a few years. Over the next fourteen years, Buffet Associated would regularly outperform the market and produce 24% compounded annual returns.

Buffet reflected on his start by saying that he found it easier to outperform the market when he was working with less money, calling it a “structural advantage”. This was because, with less money, he could better understand how to focus on the small differences in compound interest rates, which over time, would produce gains if successfully performing above the market by even a fraction.

Buffet always judged his performance relative to the DOW. If he could outperform the DOW’s rate of return by even a little bit he considered it a victory.

For the entirety of his career, Buffet believed he could get over the anxiety of wondering about his performance by choosing a way to measure his performance and sticking with it. He settled on comparing his performance to the Dow Industrial Average, and always aimed to relatively outperform it. If the DOW rose, and he only outperformed it by a fraction of a percent, he considered that a victory. If it fell and his investments fell less, he celebrated. Buffet knew that by sticking to this metric, he would experience longterm gains, in the long run, thanks to compound interest.

But the DOW is no easy competitor for the average Joe. In 1962, he wrote to his partners that it was close to impossible for individual investors to yield high-profits (most commonly through pension funds). He recommended that people put their passive investments in index funds to ride the upward trend of the market rather than trying to beat it through individual stock-picking.

Buffet was serious about his commitment to relative performances. He told his partners that if the investment fund made less than 6% in a year, compared to the DOW, he wouldn’t charge his partners anything. Only when he outperformed his number did he collect 25% of the profits. He was determined to work hard, and only pay himself when this work paid off.

When investing, look at the companies rather than market trends. Do this best by working in your area of expertise.

Buffet knew from the wisdom of his mentors that the market was too volatile and to “play” the market was too risky. Instead, he looked to invest in companies that really spoke to him.“I will only swing at pitches I really like,” he said.

Buffet believed that by focusing on quality companies, you can feel confident holding the shares in the long-run, knowing that the market will eventually value them too. He was known for his pickiness with companies. He believed that if people were given only 10 opportunities to invest in their lifetimes, their investments would likely pay off since they would only have to strongly consider the longterm value of each business.

In investing, this betting on a company’s future value is called “arbitrage”. To get this right, Buffet believed that it’s best to only make these bests in industries you’re specialized in. If you work on computers, think about which computer companies will likely rise in value or get bought out by larger companies. Otherwise, Buffet writes, it can be too tricky to make these sorts of guesses. In general, you should only put your money on the line in the rare instance you understand the entire picture and the best course of action.

In the beginning of his career, Buffet chose underdog companies with ugly business models but hidden value. Buffet called these “Generals” and they produced the majority of the Partnership’s overall gains.

A majority of his investment returns came from Buffet’s “General” companies, or companies that were fair businesses at low prices. He regularly read a pamphlet called Moody’s Manuals, which contained brief reports on various businesses, looking for bargains.

He wanted companies that he thought other people would have a hard time stomaching— things like farm equipment and map-making companies. These companies were certainly not glamorous— he and his partners called them “soggy cigarette butts”— but Buffet was sure they’d pay off even if they were liquidated.

Buffet took large stakes at these small or privately owned operations. In the mid-1950s he bought a massive amount of shares in the Sanborn Map Company which produced maps of buildings in each city across the United States. He picked the company because he saw that the company owned its own investment portfolio that other investors were overlooking. When Buffet got to split up the company, he made a massive profit.

Buffet got involved in “controls”, which meant he had a say in how the company was run. This worked to increase the value of his investments.

Buffet was often secretive in his letters about the particulars of his investments, but in 1961 he let his partners in on his process of selecting a company called Dempster Mill, an agriculture equipment manufacturer whose stock had lost almost all of his value in a year. Buffet saw this as an opportunity to polish a diamond in the rough.

He bought a majority of the stake in Dempster Mill and took control of the company. He saw that internally, the company was mismanaging its inventory and hired a man named Henry Bottle to reduce the surplus. Bottle came up with a strategy where he drew a line on the warehouse floor and informed the team that if the boxes extended passed the line, he would fire the entire staff. Slowly, Bottle moved the line closer and closer to shelves until the inventory excess fell a fourth.

The first was able to boost their prices and increase their prices. Soon enough, the company value shot back up. Buffet came to call this success “Dempster diving”.

Ultimately, Buffet got some blowback for engaging in “controls” like this or buying a large enough piece of the company that you can have a say in how it's run. It oftentimes leads to tension between the owners of the company and the board members, but Buffet believed this was a way to save shrinking companies by dealing with obvious inefficiencies.

As Buffet’s firm grew, he moved away from investing in small obscure companies.

As the fund grew, Buffet was growing tired of the potentially messy business of “controls” which often involved uncomfortable layoffs. The profits he was seeing, like the $9 million revenue of Dempster Mill, were impressive but not enough to sustain a growing fund. He started investing in “blue-chip” companies instead, or companies like American Express and the Walt Disney Company whenever a scandal would lower their prices. He used his philosophy to look for undervalued but large companies, going from buying “fair companies at wonderful prices” to “wonderful companies at fair prices”.

Stay courageous and convicted in your values, even when everyone around you is doing something more glamorous. Learn to think for yourself.

Buffet valued the longterm in all senses and didn’t care for short-term improvements. He told his investors to at a minimum, judge his performance at a minimum over 3 years and in general, over five years.

Because Buffet didn’t believe in short-term investing, he also didn’t believe in changing his own philosophies to fit more in line with industry trends. In 1956, when the stock market seemed ludicrously high, the world watched it continue to move upwards. This was known as a “go-go period”. Buffet knew that a correction was coming and stuck to his guns, remaining conservative with his investments.

Meanwhile, other investors were getting massive pay-days. On Wall Street, an investor named Jerry Tsai took the opposite approach to Buffet, buying and selling constantly with each turn of the market. For some time, this made him big money. He bought swanky new offices and properties. Buffet still felt skeptical. While they eat bon-bons we continue to eat oatmeal, he famously said.

In 1966, Buffet doubled down on his conservatism. He said he wasn’t accepting new partners and shrunk his performance goal in half. Somehow, his fund continued to grow, and they even had their best performance year in 1969 with a 58.8% return.

Suddenly, everyone saw the end of the bubble coming. Tsai sold his fund in 1968 and in the early 1970s, the DOW crashed harder than it had since the Great Depression. Buffet had dodged this crash by taking all his money off the market. Tsai dodged it too, but his investors lost almost 90% of their assets.

In 1969, Buffet closed his partnership too, seeing little opportunities for a value investor in the new economy. By this time, he was worth $26 million. He would go on to work with Berkshire Hathaway and achieve even greater successes. Today, he continues to write letters to his partners and his philosophies remain consistent to this day.

The Main Take-away

Warren Buffet based his investment strategy on Benjamin Graham’s concept of “deep-value investing”, or only investing in companies that he knew to be intrinsically valuable. In the long-run, this strategy paid off, as he consistently worked to choose companies that would beat the DOW and grow in value over time. Even if these companies failed, he wouldn’t lose money since they were just as valuable at liquidation. He started taking large stakes in companies and helping them move past inefficiencies. In the end, he stuck by his values and didn’t start speculating when it became popular, ending his run at the investment firm with millions to his name.

About the Author

Jeremy Miller is a brand strategist and bestselling author. He and his team Sticky Branding have profiled hundreds of companies to find out how they grow “sticky brands”. That is, brands that are memorable, recognizable, and sustainable. He is a popular keynote speaker and his books Sticky Branding, Brand New Name, and Warren Buffet’s Ground Rules were all best sellers.

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