Micro Caps and Buffett's >50% returns

[finetrader]

I remember Buffett said that he could achieve 50% return and said look at a stock  52 week high and low, and you will notice that the high is very often double from the low.

[BG2008]

No one has really mentioned event driven investing so far.  Keep in mind, Buffet had 1/3 of his portfolio in market neutral event driven investing.  I believe someone had mentioned that he would put his money into some sort of arb plays that produce smaller absolute returns, but very high IRRs. 

 

My overall observation about the market is that the pure net-nets are hard to come by.  Micropac (MPAD) is a cashflow positive net-net for those who cares.  They make military grade components that has no chance of being outsourced.  But, there are no catalyst to re-rate the stock.  Other interesting ideas include Hudson technologies where there is a re-rating of the earnings power.  The company went from earning about $2mm a year to earning double digit millions because of an EPA ruling.  Stock from a low of about $1 to around $4 in early 2012.  Events that includes spin-offs likely generate great IRRs.  Trades involving the IPO of nitrogen fertilizer plants have been great for the parentco, same goes for refineries.  I guess anytime you have a hidden gem that all a sudden has a dividend yield slap on it gets quickly re-rated.  I believe that to do 50% in a year, it's hard to do so with a simple buy and hold from day 1.  Perhaps, you need a 10% position to double and then you have 110% and you benefit from the effect of compounding within the same 12 months period.  People should pay attention to Joel Greenblatt's strategy.  He did earn 40% over 10+ years.  I think that the Graham stuff is tough to do 50+% in today environment when most companies are earnings based rather than asset based. 

 

There are other smaller iliquid strategies that I'm involved that will generated 50>% a year when done right. 

[ItsAValueTrap]

Buffet had 1/3 of his portfolio in market neutral event driven investing

 

In hindsight, a lot of market neutral strategies weren't market neutral in 08/09.  But I think that Warren Buffett has always been saying that he would be 100% long, and that 130%/30% short (which he did in his partnership days) is statistically about the same as 100% long.  I don't think that the would make Ben Graham's mistake of going more than 100% long.

[meiroy]

 

 

Greenblatt has done 40% over 20 years. I'm sure Buffett can do his 50%.

 

 

[BG2008]

Yes, a lot of market neutral really aren't market neutral in 08/09.  I want to make some distinctions. 

 

Spinoffs are not 100% market neutral, the sum of the parts will still depend on the market.  Merger arb spreads will blow open in 08/09.  Some deals will fall apart.  The ones that do close are market neutral, if they close.  I don't consider merger arbs to be truly market neutral. Pure liquidations are truly market neutral.  However, the price on a future liquidation distribution will likely fluctuate all over the place prior to distribution.  But, if the distributions are within a 6 to 12 months period, then it is truly market neutral.  I would imagine that share class arbs, long share A and short share B to arb out large discrepancies will likely work out well as all share prices fall and the A/B discrepancies gets narrower with a lower stock price in general.  Trades involving litigation, regulatory decisions, and other "event types" may work in your favor, but the 08/09 crisis will still price your securities much lower than 07.  Would love to hear feedback from people on what's truly market neutral and what isn't.  This is an important component of my portfolio allocation. 

 

Buffet partnership never really did 130/30.  His portfolio was more 65/35.  65% was general undervalued (Low P/BV, low P/S, low P/E) and 35% was event driven (merger arbs, liquidations etc). 

 

Meiroy - It's contradictory for you to say that Buffet can do his 50% for 20 years.  I agree that Buffet will do 50% in one calendar year if he has less than $1mm or $10mm.  But, he did manage money for 20 years and he clearly did not achieved 50% returns.  I thinks that's exactly why his statement is puzzling to a lot of us.  He says he can do 50% in 1 year given a small amount of capital.  But, his track record was closer to 30% on average during his partnership days.  Why would today's environment be any more beneficial. 

 

 

[mcliu]

Buffett also knew a lot more today about investing than when he started, so if he did 30% then..

 

Maybe he's saying based on what he knew today, that if he only had $1 million, he could achieve those returns.

[racemize]

I thinks that's exactly why his statement is puzzling to a lot of us.  He says he can do 50% in 1 year given a small amount of capital.  But, his track record was closer to 30% on average during his partnership days.  Why would today's environment be any more beneficial.

 

I always interpreted this statement as Buffett could get 50% returns on a small amount of money now due to his increased ability/skill versus when he had the partnership (he has learned a lot since then!).  I would think the 50's were better for investing than now, for him to get those returns, but he was saying "now" for the benefit of the audience.  i.e., if he said he could do >50% in the 50's, the statement would not have much meaning for the audience listening to him.

 

I'd never considered the alternative you just mentioned--perhaps he did mean that.  Maybe because there are more opportunities/stocks to look at?

 

 

Edit: mcliu pretty much just said the same thing...  I'll leave mine since I typed it out.

[meiroy]

Meiroy - It's contradictory for you to say that Buffet can do his 50% for 20 years.  I agree that Buffet will do 50% in one calendar year if he has less than $1mm or $10mm.  But, he did manage money for 20 years and he clearly did not achieved 50% returns.  I thinks that's exactly why his statement is puzzling to a lot of us.  He says he can do 50% in 1 year given a small amount of capital.  But, his track record was closer to 30% on average during his partnership days.  Why would today's environment be any more beneficial.

 

Greenblatt managed to do 40% for 20 years by returning capital. The 40% or 50% can be maintained as long as the amounts are small which is the basic assumption for this entire thread.

 

 

To get to such returns over long periods of time one has to aim for it and invest with the matching potential upside.  Greenblatt did. Did Buffett aim for 50% return in his partnership days?

 

[wescobrk]

Buffett did average 50% a year from when he graduated high school till he started the partnership. He went from (in today's dollars) from 70k when he was 16 to about a million when he started the partnership, so maybe he can only do it with less than a million or around that number.

[ItsAValueTrap]

Would love to hear feedback from people on what's truly market neutral and what isn't.  This is an important component of my portfolio allocation.

 

Personally, I'm not a fan of shorting common stock.  (Even though I am short individual stocks.)  And because of that, I'm not a fan of market neutral strategies.

 

Problems with shorting:

1- You have to pay interest on the borrow.

2- There are too many people shorting, which can make #1 nasty.  ATPG for example had the borrow shoot up to over 90%.  That's way more than credit card debt... or what Warren Buffet can make with less than $1 million.

3- You can get bought-in and be forced to cover.

4- The Jim Cramer and Michael Steinhart types out there will engineer #3.

5- Crazy stuff like CMED(Q) and Volkswagen will happen and a bunch of shorts will get hurt.

6- In general, most hedges won't work all the time.  When they don't work, sometimes supposedly safe strategies can blow up in an awful way (e.g. LTCM).

7- There is a tendency for people to pile into positive carry trades.  Whenever people pile into a trade... things get really nasty when they all try to exit that trade at the same time.  It also reduces the profitability of the trade.  I think that this fits the innovators -> imitators -> idiots pattern.

 

At the end of the day, it might just be more profitable and less risky to buy quality businesses at fair prices (with honest management that is not incompetent).  The problem is that understanding businesses is hard, most people don't have the patience/time horizon, etc.

[wescobrk]

Correction he went from 90k to about 1.4 million in 6 years not 10 or about 56 cagr

[tombgrt]

Buffett did average 50% a year from when he graduated high school till he started the partnership. He went from (in today's dollars) from 70k when he was 16 to about a million when he started the partnership, so maybe he can only do it with less than a million or around that number.

 

Which, by accident, is $10 million in today's world adjusted for inflation.

 

I'm very confident that he would pull it off. He was extremely talented and driven then already and now he has an additional 50+ years of experience to do the same in a somewhat harder market (questionable?). I would actually be surprised if he didn't get more than 50% annualized over a 5-10 year stretch unless markets became overvalued everywhere.

[wescobrk]

Which, by accident, is $10 million in today's world adjusted for inflation.

 

I'm very confident that he would pull it off. He was extremely talented and driven then already and now he has an additional 50+ years of experience to do the same in a somewhat harder market (questionable?). I would actually be surprised if he didn't get more than 50% annualized over a 5-10 year stretch unless markets became overvalued everywhere."

 

That 70k is adjusted for inflation. He had about 10k and grew it to 150k in 6 years. As pointed out in the board, his partnership returns were "only" 30%.

[JSArbitrage]

Buffett also knew a lot more today about investing than when he started, so if he did 30% then..

 

Maybe he's saying based on what he knew today, that if he only had $1 million, he could achieve those returns.

 

That's what he was saying.

 

My personal belief is that if Buffett decided to start over with $1M today, he wouldn't be doing great business, fair price nor would he be doing a pure Graham.  He'd be trolling derivative markets where he wouldn't be required to put almost any capital up.  The modern Buffett is a brilliant insurance/derivatives calculator.  I think he'd be making those 50% returns that way.

[nkp007]

Buffett also knew a lot more today about investing than when he started, so if he did 30% then..

 

Maybe he's saying based on what he knew today, that if he only had $1 million, he could achieve those returns.

 

That's what he was saying.

 

My personal belief is that if Buffett decided to start over with $1M today, he wouldn't be doing great business, fair price nor would he be doing a pure Graham.  He'd be trolling derivative markets where he wouldn't be required to put almost any capital up.  The modern Buffett is a brilliant insurance/derivatives calculator.  I think he'd be making those 50% returns that way.

 

With only $1mm, he wouldn't have access to the derivatives market.

[txlaw]

Buffett also knew a lot more today about investing than when he started, so if he did 30% then..

 

Maybe he's saying based on what he knew today, that if he only had $1 million, he could achieve those returns.

 

That's what he was saying.

 

My personal belief is that if Buffett decided to start over with $1M today, he wouldn't be doing great business, fair price nor would he be doing a pure Graham.  He'd be trolling derivative markets where he wouldn't be required to put almost any capital up.  The modern Buffett is a brilliant insurance/derivatives calculator.  I think he'd be making those 50% returns that way.

 

With only $1mm, he wouldn't have access to the derivatives market.

 

Are you referring to OTC derivatives?  Because he would almost certainly be looking at the cleared options market.

[nkp007]

Buffett also knew a lot more today about investing than when he started, so if he did 30% then..

 

Maybe he's saying based on what he knew today, that if he only had $1 million, he could achieve those returns.

 

That's what he was saying.

 

My personal belief is that if Buffett decided to start over with $1M today, he wouldn't be doing great business, fair price nor would he be doing a pure Graham.  He'd be trolling derivative markets where he wouldn't be required to put almost any capital up.  The modern Buffett is a brilliant insurance/derivatives calculator.  I think he'd be making those 50% returns that way.

 

With only $1mm, he wouldn't have access to the derivatives market.

 

Are you referring to OTC derivatives?  Because he would almost certainly be looking at the cleared options market.

 

I'm thinking about the long-term derivatives. Credit default swaps, Ackman-style equity exposure derivatives, etc.

 

Edit: My definition may be too narrow. For example, the BAC, AIG warrants allow for LT derivative exposure. However, you do have to put capital down.

[jay21]

I believe Buffet could do 30 to 50%.  I am sure he would use LEAPs, warrants, and some other strategies to get there instead of buying and holding great companies.  I don't think it matters much.  I feel the most important question is what type of returns is he capable of with >$200b in equity. 

[txlaw]

Buffett also knew a lot more today about investing than when he started, so if he did 30% then..

 

Maybe he's saying based on what he knew today, that if he only had $1 million, he could achieve those returns.

 

That's what he was saying.

 

My personal belief is that if Buffett decided to start over with $1M today, he wouldn't be doing great business, fair price nor would he be doing a pure Graham.  He'd be trolling derivative markets where he wouldn't be required to put almost any capital up.  The modern Buffett is a brilliant insurance/derivatives calculator.  I think he'd be making those 50% returns that way.

 

With only $1mm, he wouldn't have access to the derivatives market.

 

Are you referring to OTC derivatives?  Because he would almost certainly be looking at the cleared options market.

 

I'm thinking about the long-term derivatives. Credit default swaps, Ackman-style equity exposure derivatives, etc.

 

Yeah, that's true, but he probably would go into mispriced LEAPS as a hybrid strategy. 

[bennycx]

Don't think he would do that.. One of his principles is to not use excessive leverage and not even use it if you don't need it

[jay21]

Don't think he would do that.. One of his principles is to not use excessive leverage and not even use it if you don't need it

 

What do you call all that insurance float? 

 

He's been known to dabble in options in his personal account as well.

[rukawa]

He had about 10k and grew it to 150k in 6 years.

 

Yes but he was making 12K a year during those 6 years. He was also supporting a family. I attached a spreadsheet with some assumptions. I am unable to reproduce the 50% figure.

 

EDIT: Buffet was in university up to 1951. In addition he lost money buying a Texaco station after he started working. He worked for Graham only from 1954-56 and worked for his father's firm from 1951-54. The rest of time he was employed as a stock-broker. Given this the 50% return is more plausible. >40% returns were highly likely.

buffetts_rate_of_return.xls

[rukawa]

"What do you call all that insurance float?"

 

A very very special and unique form of leverage that is very different in its characteristics than debt. Float often has a negative interest rate for instance. Buffet is in a very special position that he wouldn't be in if he had less capital. The derivatives are also special because he doesn't have to post collateral or meet any margin requirements. Plus they are very long term bets.

[SharperDingaan]

We would put it to you that the overall approach wouldn't be much different to what he has already done. 1) Barbell approach (Taleb): T-Bills + calls; 2) Operations replacement (HW): Insurance float replaces the T-Bills; 3) Financial innovation: long-short calls/puts to nullify cash carry, & strip out alpha.

 

In short ... a P&C insurance company getting paid thrice on its T-Bills (UW profit, T-Bill yield, securities lending) with zero cost options to exposure it to market volatility without any downside. Unfortunately, nobody would be able to buy into it  :'(

 

SD

 

 

[wabuffo]

Munger's doing nearly 40% returns (~37-38% CAGRs) with small sums (>$50 million of cost basis) at the Daily Journal since changing the investment strategy in early 2009.  And he's not buying small caps ("Fortune 100 companies", etc).  It has been a good period to own stocks but even so, he's beaten the broad averages handily (S&P 500 Total Return, Russell 2000).

 

Imagine if he wasn't a billionaire and was a little hungrier....

 

wabuffo