Sunday, March 1, 2009

How Might A Small-Cap Warren Buffet Act?

Warren Buffett got an early start in the investment world having a paper route business. With this business he was able to save $2000. He took $1200 of his small fortune and bought a 40 acre farm in which he hired a tenant farmer to run it. Later he and a buddy bought several pinball machines and set them up throughout town. Another early business venture was buying a old limo and renting it out which provided another stream of income. Buffett's first stock purchase came at the age of 11 years old when he bought 6 shares of Cities services preferred stock for $38.25 per share, in which 3 shares were for him and 3 for his sister. The stock initially traded down to $27 per share, when it recovered to $40 per share the young Buffett sold only to watch it soar to $202 per share.

Today many people follow The Oracle of Omaha... professional value investors, stock holders of Berkshire Hathaway, the media such as Fox Business News, Bloomberg, CNBC even has a Buffett Watch, and on many of these financial blogs. While most of these sources do a very good job at tracking Buffett's every move, announcing all the buys and sells that his Berkshire Holding company makes, many do not cover what Buffett might be buying if he had much less capital. This is a subject that should entice any investor especially the small investor. The stocks that Buffet buys now a days for Berkshire are very large companies often in the billions of dollars. Why does he concentrate on the large companies? Well the underlying reason is that Berkshire is so large even after the stock indices major sell off that buying smaller companies is not enough to move the needle. It takes larger companies to move Berkshires performance.

With in the last few years many aspiring Buffeteer's have asked the question: What would Buffett be buying if he had a much smaller equity base to work with. Well he does not give out stock tips but he has given out small hints over the years. We also can do a little detective work to find out what he would be buying with a smaller equity base than what he manages today. In order to do this we must look back in time. Back when Buffett was working for Ben Graham at The Graham Newman Partnership. This was circa 1954-56 and Graham who had managed money through The Great Depression was using a little different technique to investing than what Buffett uses today. Graham was Buffett's teacher, mentor and employer. Back in this era and through the 1960's Buffett used the techniques of Graham, which were controlled investing, arbitrage, and cigar-butt aka NCAV style investing.

There are investors today that apply the early style and methods that Buffett and Graham used . One money manager is Mohnish Pabrai who has gotten much media attention and has even written a book titled The Dhandho Investor. A lessor known, but a up and comer is Sardar Biglari who manages the Lion Fund and whose holdings include the Western Sizzlin $WEST and Steak n' Shake $SNS in which Biglari & Co. is practicing the art of "Controlled Investing". Eddie Lampert is another example that is practicing some of Buffett's earlier investing strategies. For example, Lampert has huge stakes in Sears $SHLD and AutoZone $AZO making up a huge percentage of his portfolio.

So what would Warren Buffett buy today with a smaller equity base, say a few hundred thousand to a few million. Well the investors universe certainly gets much larger. I suspect he would be buying into some of these net net working capital also known as special situations. I also think he would be buying into companies that have had a track record of 10 plus years trading near or below book value with cash on hand and management having a significant stake.
Below are some excerpts taken from the 1962 Buffett Partnership letter:

I have consistently told partners that it is my expectation and hope (it's always hard to tell which is which) that we will do relatively well compared to the general market in down or static markets, but that we may not look so good in advancing markets. In strongly advancing markets I expect to have real difficulty keeping up with the general market.

Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to so degree planned, but to a great extent, accidental, based upon availability facts.

The first section consists of generally undervalued securities (herein after " generals") 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 portions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.

Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.

The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in the declining market.

Our second category consists of "work-outs" (or Arbitrage). These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. (Some current examples have been Constellation Energy $CEG or the Rohm-Haas $ROH/Dow Chemical $DOW deal) In other words, they are securities with a timetable where we can predict within reasonable error limits, when we will ger how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorangizations, spin-offs, eventually lead to work-outs. An important source in recent years had been sell-outs in oil producers to major integrated oil companies.

The category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in work-outs, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have produced our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both every results and intermediate market behavior. Results, excluding the benefits arrived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth often times we owe no money and when we do borrow it is only as an offset against work-outs.

The final category is "control" situations where we either control the company or take a very large position and attempt to influence policies of the company. (Today we see investors such as Biglari buying into Steak n' Shake and Western Sizzlin or Lampert buying into Sears). Such operations should definitely be measured on the basis of several years or a given year, they may produce nothing as it is usually to our advantage that the stock be stagnant market-wise for a long period while we are acquiring. These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company's stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.

Their are plenty companies out their today that offer upside potential with little downside risk or should I say a margin of safety. Can these companies decrease further before reversing, absolutely. However, we are in a market completely opposite of 1999. During that time period we kept going higher and higher pushing stocks with no earnings or fledgling operations to extreme prices, where their was NO real value. Today the markets push the stock prices below the intrinsic value of these companies.

Warren Buffet stated a few months ago that he was buying American stocks for his Personal account and moving out of treasuries. I would bet he is implementing methods that he used 45 to 50 years ago, for we are seeing stocks valued like this today!

Relevant Articles: