Share Quotes: Warren Buffett’s Magic Formula In 1965?

Warren Buffett’s Magic Formula In 1965?

I recently read through Buffett’s Partnership Letters again. This time I paid particular attention to one of the strategies he used to perform better than the market in down years. Buffett employed three such techniques from 1956-1965:

Generals – Private Owner – Large margin of safety was a cushion when markets fell.

Workouts – Special situations were not correlated to the market.
Controls – Accounting of “controls” typically outperformed the market in down years.
In his January 15, 1965 letter to partners, Buffett introduced a fourth category called:

4. Generals -Relatively Undervalued

“We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sells at 10 times earnings. The risk has always bothered us enormously because of the helplessness position in which we be left compared to the “Generals -Private Owner” or “Workout” types. With this risk diminished, we think this category has a promising future.”

The introduction of this new technique followed a period of significant run up in the Dow of 20.6% and 18.7% in 1963 and 1964, respectively. Entering 1965, “Generals – Private Owner” and “Workout” opportunities were dwindling while “Generals – Relatively Undervalued” were becoming a growing percentage of the Buffett Partnership.

I’ve ruled out the possibility of a shorting technique as everything I’ve read suggests that Buffett has never shorted a stock. If true, how then did Buffet reduce the risk of this arbitrage gap closing in the wrong direction? Effectively, he was betting that the 12 times earnings investment would correct upward rather than the more expensive stock, or both, experiencing a downward change in valuation.

Parallel to this analysis, I was studying results from Magic Formula (MF) stocks this past year. Joel Greenblatt in “The Little Book That Beats the Market” argued that by buying MF stocks – businesses with the best combination of high returns on capital invested and high earnings yields – an investor would be purchasing good businesses selling for cheap relative to the market. Basically, the prescribed MF is an index of good businesses selling cheaper than the market, regardless of the market level.

Although most MF stocks were not bargains worthy of “Generals – Private Owner” purchase, many resembled Buffett’s category of “Generals – Relatively Undervalued.” They were undervalued relative to the market, their industry, and similarly situated peers. Without a significant margin of safety to private owner value, each MF stock was also at risk of an overall valuation change and elimination of the arbitrage opportunity. The MF mitigates this overall risk by purchasing a basket of 20-30 non-correlated MF stocks. The MF produced returns as high as 30.8% over the 17 year period.

In his January 20, 1966 letter Buffett commented on the progress of this new category:

“Our results were quite good in the “Relatively Undervalued” group, partly due to implementation of the technique referred to in last year’s letter which serves to reduce the risk and potentially augment the gains. It should reduce risk in any year, and it definitely augmented the gains in 1965. It is necessary to point out that results in this category were greatly affected for the better by only two investments. Candor also demands I point out that during 1965 we had our worst single investment experience in the history of BPL on one idea in this group. Overall, we had more than our share of good breaks in 1965.”

Did Buffett purchase a basket of non-correlated MF like stocks considered relatively undervalued to mitigate risk? A basket would reduce the risk of a single position wiping out the gains of the entire group. And if a valuation change occurred for the entire market, the basket as a whole would likely fall by a lesser amount due to the already depressed valuation. Moreover, the basket is likely to include securities with potential for large non-market correlated gains once the uncertainty lifts, like that of PNCL’s 150%+ returns seen below.

Interestingly, Buffett mentioned that just two investments accounted for most of the gains in the relative category while one investment resulted in the worst experience in partnership history. Coincidentally, I found that a small handful of Top 25 MF stocks over the past year accounted for a majority of the gains. For this “back of the envelope” analysis, I chose a sample of 10 Top 25 MF stocks based on their simple business models and competitive advantages. While one MF stock tanked, overall, one would have done quite satisfactory with a basket of MF stocks over the past year. It should be noted that virtually all of the stocks were surrounded by high levels of uncertainty with no apparent relief in sight.

Top 25 MF Picks

Returns
PNCL    150%+
CECO    50%
PPD    50%
CRYP    33%
HNR    25%
INTX    20%
KSWS    20%
RAIL    0%
NOOF    0%
EGY    (40%)
Annualized 30% +

 

While it is unlikely Buffett performed an elaborate study, my guess is he intuitively knew that holding a basket of MF like stocks relatively undervalued was a better alternative to holding cash and would likely outperform the market in down years. In fact, the MF study results support this claim. MF stocks gained 35% over the worst 3-year period while the market lost -45% over the worst 3-year period; a whopping 80% differential. MF was clearly a better alternative to cash and significantly outperformed the market in down years.

Buffett has consistently stated that small portfolios should be fully invested at all times. As opportunities dried up, he allocated capital to this category and generated “Relatively Undervalued” returns of 23%, 72%, 49%, from 1966-1968 respectively. Although I wasn’t able to find 1964 and 1965 returns, Buffett commented that the group did outperform the market.

I can’t say for sure the exact techniques Buffett used in the “General – Relatively Undervalued” category but he may have employed his own Magic Formula some 40 years prior to Joel Greenblatt’s Magic Formula. As “General – Private Owner” and “Workout” opportunities dried up, did a basket of good businesses at good prices relative to the market work 40 years ago for Buffett as it worked in the MF formula study?

Lonnie J. Rush is an ardent follower and practitioner of value investing. He holds an MBA with a concentration in Finance and Accounting from the University of California, Davis and a B.A. in Economics. He plans to launch Rush Investment Partnership on January 1st, 2008 and operate out of Folsom, CA. He can be reached at rushmoney@yahoo.com

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