A great quote from The Warren Buffett Way, Third Edition, (2014) by Robert G. Hagstrom.
The difference between Warren Buffett and most investors has more to do with discipline than just about any other quality. There are plenty of smart investors, and most of them failed to deliver results that compare with Buffett (I will soon write another blog post that summarizes Howard Marks’s forward to this third edition in which Marks identifies ten qualities that make Warren, Warren).
I last read TWBW around 2003 when I picked up the paperback printing of the first edition. The third edition is a worthy update. Every time I read the quote below I am reminded that it is discipline that makes the difference in investing, as in most things in life:
“In 1969, Buffett decided to end the investment partnership. He found the market highly speculative and worthwhile values increasingly scarce. By the late 1960s, the stock market was dominated by highly priced growth stocks. The Nifty Fifty were on the tip of every investor’s tongue. Stocks like Avon, Polaroid, and Xerox were trading at fifty to one hundred times earnings. Buffett mailed a letter to his partners confessing that he was out of step with the current market environment.
‘On one point, however, I am clear…I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean foregoing large and apparently easy profits, to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.’”
Warren was finding it difficult to find any businesses that were trading with a Margin of Safety. Rather than stretch his logic or his principles, he closed his hedge fund. Of course, he replaced his hedge fund with an insurance holding company in which he also had a decided funding advantage.
As a hedge fund manager, Buffett had to promise the lion’s share of returns to his limited partners in order to entice them to deliver capital for him to invest. As an insurance company, he did no such thing. Instead, he raised his capital for “free.” Buffett invested the float–the premium collected today for insurance claims that did not have to be paid for a long time.
As long as he maintained underwriting discipline (that word again), he could pay claims plus operating expenses that were equal to the premium he received. The ratio of the former to the latter is known as a “combined ratio,” and as long as that figure is 100% or less, Buffett got his investment capital for free. Investing free capital with discipline over several decades is how one becomes one of the richest people in the world.
The above thought should be followed up by Warren Buffett’s other strategy for overvalued markets, found in the following quote:
“Our holdings, which I always believe to be on the conservative side compared to general portfolios, tend to be more conservative as the general market level rises. At all times, I attempt to have a portion of our portfolio in securities at least partially insulated from the behavior of the market and this portion should increase as the market rises.” Buffett Partnership, Ltd. July 22, 1961. page 1.
In the overvalued market of 1969 the alternative was “…in securities…” “partially insulated from…” the market. This is in spite of the fact that Buffett was more specific about the term “securities”.
This same strategy was also outlined by Hetty Green who owned Hathaway Manufacturing Company before it merged with Berkshire which was later was acquired by Buffett. Green preceded Buffett by several decades but the strategy is clearly useful in any market.