Warren Buffett's Ground Rules
Warren Buffett's Ground Rules

Warren Buffett's Ground Rules

The market can and will at times be completely deranged and irrational in the short term, but over the long term it will price securities in line with their underlying intrinsic values. (Location 407)

profession. Buffett was consumed by Graham’s ideas from the moment he encountered them—so much so that he even named his son, who is in line to become the next nonexecutive chairman of Berkshire Hathaway, Howard Graham Buffett. (Location 421)

Several weeks later (he applied in August) he was enrolled at Columbia and not too long after that he was sitting in Graham’s classroom as the star pupil. (Location 429)

He stresses this as an inevitable part of owning securities and that if a 50% decline in the value of your securities portfolio is going to cause you hardship, you need to reduce your exposure to the market. (Location 508)

end. Since the general trend is up, as long as a severe 25–40% drop isn’t going to somehow cause you to sell out at the low prices, you’re apt to do pretty well in stocks over the long run. You can allow the market pops and drops to come and go, as they inevitably will. (Location 513)

While most investors were selling when the market outlook became worrisome or even cloudy, those who ignored market sell-offs (or forgot they were invested at all) did vastly better. (Location 518)

Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. (Location 524)

If you think I can do this, or think it is essential to an investment program, you should not be in the partnership. (Location 535)

If a 20% or 30% drop in the market value of your equity holdings (such as BPL) is going to produce emotional or financial distress, you should simply avoid common stock type investments. In the words of the poet—Harry Truman—“If you can’t stand the heat, stay out of the kitchen.” (Location 577)

The two determining factors of the ultimate result are (1) the annual average rate of gain and (2) time. (Location 606)

Unfortunately, many are shortsighted or impatient and fail to take full advantage of what they offer. (Location 610)

Compounding is exponential, it builds momentum as it goes; after 20 years, the advantage widens to 125%. (Location 615)

Viewed through Buffett’s compound interest lens, it’s not hard to see why he has lived such a frugal life. His haircuts really are expensive! (Location 621)

Consider the case of Ronald Read, a gas station attendant from Vermont who amassed an $8 million net worth by consistently investing a small portion of his salary into high-quality dividend-paying stocks over a lifetime. (Location 630)

If you can combine the two factors, the results are eye-popping: $100,000 compounded at 16% will be worth more than $8.5 million in 30 years! (Location 642)

If that same $20,000 were to somehow have compounded instead at 6% annually, it would have grown to $1 quadrillion by 1964, nearly 3,000 times the national debt at the time. (Location 657)

There is no question that a long time period and a high rate of growth combine to produce nonsensical projections when allowed to go too far. (Location 660)

From here we’re going to turn to Buffett as an active investor, starting with his ideas on what exactly he’s setting out to achieve and how he intends to measure it. (Location 955)

Because the general trend is up, if you can manage to be down a little less in down markets and up a little more in up markets, your performance will likely be stellar. (Location 987)

everyone had to be in tune with his relative-versus-the-market yardstick and his 3-year test before the first dollar was put to work. (Location 993)

After first establishing what he was trying to avoid (3–5 year rolling relative underperformance), he laid out his aim to beat the Dow by an average margin of 10 points per year. (Location 1005)

The additional 10% advantage meant he was aiming for 15–17% average annual returns. (Location 1011)

If the market is down and you are down less, you’ve had a good year, and vice versa. As long as your performance is even slightly better than the market average, whether the outperformance comes in up or in down markets, the results will likely be excellent. (Location 1021)

Buffett warned he could very well lag the market by as much as 10% in the bad years and thought he could be up as much as 25% when “everything clicks.” (Location 1029)

he felt it essential that investors should measure their results over a multiyear period and thought three years was the absolute minimum; he much preferred five. (Location 1031)

While the Dow is not perfect (nor is anything else) as a measure of performance, it has the advantage of being widely known, has a long period of continuity, and reflects with reasonable accuracy the experience of investors generally with the market. (Location 1071)

managers. But I certainly do believe anyone engaged in the management of money should have a standard of measurement, and that both he and the party whose money is managed should have a clear understanding why it is the appropriate standard, what time period should be utilized, etc. (Location 1086)

job. Finally, setting up the relevant yardsticks ahead of time insures that we will all get out of this business if the results become mediocre (or worse). It means that past successes cannot cloud judgment of current results. (Location 1103)

No matter how others in the market were changing their yardsticks—no matter whether they were measuring too infrequently or too often—Buffett teaches us never to change ours. It (Location 1146)

He spells out ahead of time exactly what we are setting out to do, and he encourages us to regularly test ourselves against that yardstick. (Location 1150)

Investors who decide to go the active route simply need to think it through ahead of time and commit to sticking to a measurement plan. (Location 1153)

monitor the 3- and 5-year trailing results and when there is chronic underperformance, in the absence of speculative bull market runs, strongly consider making a change. (Location 1155)

“The new partnership will represent my entire investment operation in marketable securities, so that my results will have to be directly proportional to yours, subject to the advantage I obtain if we do better than 6%.” (Location 1164)

you can compare their expected behavior with your own best interest. (Location 1169)

As Charlie Munger has said, “I think I’ve been in the top 5% of my age cohort almost my entire adult life in understanding the power of incentives, and yet I’ve always underestimated that power. (Location 1171)

It had a general partner, the GP (Buffett), who was responsible for the management and took a percentage of the profits. The limited partners, the LPs (like Aunt Alice), contributed capital but had no say in how funds were deployed. (Location 1186)

“You used to sell stocks, and we want you to tell us what to do with our money.” I replied, “I’m not going to do that again, but I’ll form a partnership like Ben and Jerry had, and if you want to join me, you can.” (Location 1192)

get; he only took a fee beyond a 6% return threshold, which was the midpoint of his 5–7% average return expectation for the market. In this way, he was further aligned with his partners’ interests. (Location 1245)

he was aligned with all partners’ interests in maximizing performance. He had to focus on risk, to protect his own capital, and reward, both to grow the capital he had in the Partnership and to generate fees. Buffett (Location 1260)

Buffett set it up so that additions and redemptions could be made only once a year, which forced investors to look at their performance from a long-term perspective. (Location 1265)

For this privilege, Buffett charged or paid 6% interest respectively, giving LPs access to funds in the event that they really needed them and more than fairly compensating those who wished to add to their existing investment. (Location 1267)

If you’re considering investing with an active manager today, you can be sure that most salespeople aren’t going to highlight these for you—you’re going to have to figure them out on your own. (Location 1283)

Let me, however, emphasize two points. First, one year is far too short a period to form any kind of an opinion as to investment performance, and measurements based upon six months become even more unreliable. (Location 1298)

Our holdings, which I always believe to be on the conservative side compared to general portfolios, tend to grow more conservative as the general market level rises. (Location 1304)

We have also begun open market acquisition of a potentially major commitment which I, of course, hope does nothing marketwise for at least a year. (Location 1308)

B. A division of profits between the limited partners and general partner, with the first 6% per year to partners based upon beginning capital at market, and any excess divided one-fourth to the general partner and three-fourths to all partners proportional to their capital. Any deficiencies in earnings below the 6% would be carried forward against future earnings, but would not be carried back. Presently, there are three profit arrangements which have been optional to incoming partners: (Location 1316)

The minimum investment for new partners is currently $25,000, but, of course, this does not apply to present partners. (Location 1347)

For Buffett, the Generals were a highly secretive, highly concentrated portfolio of undervalued common stocks that produced the majority of the Partnership’s overall gains. (Location 1391)

Throughout the Partnership years, Buffett typically committed 5–10% of his total assets in five or six Generals with smaller positions in another 10–15%. (Location 1403)

You cannot expect fruit every year from each species of tree. Each will ripen according to its own, typically unknowable schedule. (Location 1413)

Many of the Generals were acquired at steep discounts to their appraised intrinsic value using the private owner method—what a well-informed private buyer would pay for the entire company. (Location 1424)

He was, in effect, willing to become the “well-informed private buyer” himself. (Location 1426)

This made the private owner method a less risky investment method because the stocks would either appreciate on their own, or Buffett (or some other third party) would acquire enough stock to at least influence and sometimes take full control of the companies. (Location 1430)

The essential methods involved in investing in Generals come down to doing good valuation work and doing it consistently. Intrinsic value can be estimated a number of different ways. (Location 1450)

In some situations, Buffett was buying companies that were not very profitable but owned valuable assets. (Location 1457)

He got excited when he came upon the ultra-cheap companies that had liquid current assets (here we’re talking about cash in the bank, unsold inventories, or receivables) that in aggregate, even after subtracting all the liabilities of the business, were worth more than the market value of the company. (Location 1459)

In other cases where companies had earnings that were healthy, we see Buffett using an earnings-based valuation. (Location 1463)

He was constantly appraising the value of as many stocks as he could find, looking for the ones where he felt he had a reasonable ability to understand the business and come up with an estimate for its worth. (Location 1471)

Buffett was a highly disciplined buyer, especially in the early years. In many cases, a stock that he was involved in appreciated before he could buy the full amount he wanted. (Location 1476)

. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value. (Location 1498)

way. Usually when a new idea or rules-based trading system is introduced and shown to be effective, market participants copy it, and by doing so, the excess return from the new idea gets “arbitraged away.” (Location 1501)

price. These companies were literally worth more dead (in liquidation) than they were alive (as going concerns). (Location 1522)

Buffett was also purchasing these kinds of stocks for the Partnership, called “net-nets” for short. In these situations, he often found some combination of a large pile of cash, securities in the bank, trade receivables due, or salable inventory. (Location 1525)

Whether they chose to wind up the business at a profit or allowed it to recover on its own, they were usually buying below the liquidation value, getting the value of the underlying business for free or even at a negative value. (Location 1530)

Of course, if the business operates at a loss that is expected to continue indefinitely, it will eventually erode away any surpluses that may be present. In such cases, something has to be done to preserve the value, either through the action of a motivated management or through actions taken by the shareholders. (Location 1536)

As Buffett describes it, Generals that also offered the potential for a majority stake represented a “‘two strings to our bow’ situation where we should either achieve appreciation of market prices from (Location 1540)

external factors or from the acquisition of a controlling position in a business at a bargain price. (Location 1541)

In other words, Buffett was willing to take the action needed to realize the value in his net-nets if necessary. In the 1980s, this approach was called “corporate raiding,” but is now more politely referred to as activism. (Location 1544)

Better yet was when he spotted others doing the work on behalf of all shareholders, and he could go along for the ride. (Location 1546)

Today Graham-inspired ultra-cheap Generals tend to emerge in smaller, obscure securities. (Location 1550)

Buffett and his contemporaries had to hunt for them—and they loved the hunt. (Location 1553)

One warning: It’s very unlikely that anyone is going to bring these investment opportunities to you; you have to find them yourself. (Location 1557)

To this day he describes these often marginally profitable companies as mostly gross and disgusting from a business standpoint, but for a time he did very well investing in them because they offered a “free puff” (profit) with little risk of permanent loss. (Location 1578)

As you read his comments, remember that while the net-nets and ultra-cheap stocks had largely vanished by 1967, and while he felt that when it came to his quantitative approach to investing, he “may be the only one left in class,” (Location 1601)

First, as the bull market was maturing, it was getting harder and harder to find cheap stocks—a phenomenon that is typical of every cycle. (Location 1617)

Buffett’s growing appreciation for the qualities that make a business “good” as opposed to just cheap. (Location 1618)

he was talking about the huge position he had taken in American Express, a high-quality franchise business that was not statistically cheap in the Graham sense but had a tremendous amount of future earnings power. (Location 1620)

Cigar-butt investing was scalable only to a point. With large sums, it would never work well. (Location 1628)

“It took Charlie Munger to break my cigar-butt habits and set the course for building a business that could combine huge size with satisfactory profits. . (Location 1637)

Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.” (Location 1638)

After he and Munger dissected the business while touring the park on a family vacation, Buffett bought 5% of the company for $4 million in 1965.14 (Location 1657)

these were great businesses at a great price. (Location 1661)

Buffett never told his partners that they were such substantial owners of either company. (Location 1662)

Assuming you are an investor operating with modest sums, should you follow an approach more like Graham and early Buffett, which emphasize statistical value, or should you emphasize quality, in line with how Buffett was investing toward the end of the Partnership? (Location 1665)

His research shows that the worse a cheap company’s fundamentals, the better the stock is likely to do. (Location 1671)

He seems to have found something that he understands and that works well for him. Note that he literally shuns quality in his approach to finding value. (Location 1674)

While he’s smart to have found something that works for him, he’s even smarter to avoid what doesn’t. Of course he’d prefer to buy a great business over a poor business if he could be sure that it could maintain its high returns well into the future. (Location 1679)

He looks for high-return, established businesses with strong track records of success through past business cycles, run by managers demonstrating equal measures of talent and integrity. (Location 1689)

I have three mailboxes in my office—IN, OUT, and TOO HARD. I was joking with the MIT students that I should have a TOO HARD bin and they made me one, so now I have it and I use it. (Location 1715)

(1) Orient: What tools or special knowledge is required to understand the situation? Do I have them? (2) Analyze: What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows? (3) Invert: What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose? (4) What is the current intrinsic value of the business? How fast is it growing or shrinking? And finally, (5) Compare: does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favorably to all the other options available to me? (Location 1725)

(1) what chance does the deal have of going through, (2) how long will it take to close, (3) how likely is it that someone else will make an even better offer, and (4) what happens if the deal busts? (Location 1963)

it—Investment is most intelligent when it is most businesslike and business is most intelligent when it’s most investment-like. (Location 2215)

Oftentimes, as we’ve discussed, Controls required Buffett to roll up his sleeves and become confrontational, similar in some ways to what we see activist investors doing today. (Location 2226)

“Everything else being equal, I would much rather let others do the work. However, when an active role is necessary to optimize the employment of capital, you can be sure we will not be standing in the wings.” (Location 2235)

With a market as thin as it was in these two stocks, even a minor amount of buying or selling could have dramatic impact on the quoted price. (Location 2246)

The value had to be estimated in all three. (Location 2248)

Remember that partners could only add or withdraw their capital once a year, so this valuation, particularly when it accounted for a third or more of Partnership assets, was a big deal. (Location 2258)

While there is no doubt that Buffett came to prefer owning a whole business as opposed to slices of them (who wouldn’t?), his writing suggests he gave up the cigar-butt controls more because he didn’t like doing it than because he found some higher return for his investing dollars. (Location 2379)