Buffett’s three categories of Investments

 

Warren Buffett, in his early partnership days, referenced three buckets that he invested in:

  • Generals
  • Work-outs
  • Control Situations

These categories are not necessarily mutually exclusive and often a general might turn into a control situation etc. No category is intrinsically more risky than another but they all contain different types of risks. He let the current markets decide which categories he would emphasize.

Generals

Generals refer to generally undervalued companies. These companies didn’t have a catalyst to realize value. This category included both high-quality companies such as the infamous American Express investment and in Disney as well as lesser known cigar-butt-style investments in generally undervalued companies like Western Insurance (technically invested in when Buffett worked for Graham-Newman). Investments such as these often allowed for greater absolute returns than in the workouts category but have higher correlation with the overall market than workouts. These were initially mostly qualitative Graham style net-nets and other similar style investments but later evolved more and more into qualitative style investments. An increase in the size of Buffett’s portfolio and a decrease in obvious shooting dead fish in a barrel investments such as net-nets also helped him to change his ways. Buffett didn’t mention many

Workouts

Workouts, probably more often referred to as special situations or risk arbitrage nowadays, are situations where a return and time frame are knowable ahead of time. This can be a liquidation, merger, tender offer, spin-off or other complex transactions.

In the 1965 partnership letter Buffett described workouts as:

He had invested in numerous merger arbitrage situations, notably using quite a bit of leverage going so far as to say that, “borrowed money is appropriate in most workout situations.” One area of particular interest during his partnership years was merger arbitrage between Oil and Gas companies. It could have been a sign of the times but also it could have been related to how few holdups there are in O&G mergers. There are/were no unions, trade creditors, regulatory issues etc in any small O&G company getting bought out. Buffett would buy any of the securities of a company if so was warranted, not just the common stock. In the example of Texas National Petroleum he purchased debentures, common stock and warrants making 20%+ annualized returns.

One infamous example, (also from Buffett’s Graham-Newman days) was a split-off transaction involving Rock-wood Cocoa where one could exchange shares of stock priced at $34 for warehouse certificates for Cocoa worth $36 for a profit of $2. Graham instructed Buffett to pursue the arbitrage situation selling the certificates using the futures market. Buffett however, for his personal account, simply bought and held the shares anticipating that because so many other investors were tendering their shares that the reduced amount of shares outstanding would increase the net asset value per share dramatically. Say if Rock-Wood Cocoa had $50/share in net asset value (NAV) before the tender offer and 70% of shareholders accepted the tender offer then the NAV would jump to ~$82.

Control Situations

Control situations are Buffett’s main investment category these days. Back in the partnership days he saw control situations as a way to reduce risk in his portfolio. But also noted that mark to market returns of control situations could often drag behind bluechip stocks of the day.

Many people would perhaps attempt to split control situations into proper control situations and into activist situations. Buffett did a little of both. Ben Graham, Buffett’s investment hero, also did quite a bit of both.

Graham had been the major control investor in Geico, until he was forced to spin-off the company to Graham-Newman shareholders (from Graham initial purchase price to its high price during his lifetime was 605x). Graham had potentially numerous control positions but not many are well known to this day. Graham controlled a company called Philadelphia and Reading Coal & Iron company which he had used to purchase another company (later Philadelphia and Reading would be managed by Howard Newman the son of Ben Graham’s partner Jerry Newman).  Graham was an activist in several Rockefeller pipeline companies. In these situations the pipeline companies often had excess investments worth more than the entire market caps of the companies. One company called Northern Pipe Line, had investments worth $95 and the stock was trading for $65. Graham tried to persuade management and when he failed to do so initiated a proxy contest. After a protracted period he was able to persuade investors even the great Rockefeller himself to vote management to distribute excess funds. Rockefeller later instructed many of his other pipe line assets and likewise companies to distribute excess funds.

A very similar situation to the Northern Pipe Line was Buffett’s investment in Sanborn Maps. The stock was selling for $45 a share but had $65 a share in investments. He eventually succeeded in having the company payout (through a tender offer) a significant portion of the cash and investments in-kind making a more than 20% per year for the two year investment.

Buffett later went on into Dempster Mills and Berkshire Hathaway as more of a builder than a liquidator. Although he did partially liquidate both companies he did not do a wholesale tear-down of either company. Dempster mills helped to change Buffett. After the Dempster Mills experience he was less interested in investing in cigar butts and more interested in great companies at fair prices. A similar experience with Carl Icahn in his investment in Dan River has never deterred him from investing in cigar butts. Buffett had control investments through many vehicles including top level vehicles of Berkshire Hathaway, Diversified Retailing Company and Blue-chip Stamps. A list of his many vehicles is as follows:

Blue Chip Subsidiaries.png

He would later simplify these vehicles into ownership under Berkshire Hathaway.

As we can see from the foregoing post Buffett’s tactics were close approximations of Ben Graham’s strategies. Even in the field of control/activist investments Buffett initially mimicked Graham. Buffett later made a few twists such as having a way less diversified portfolio as well as buying higher quality businesses.

Links and sources:

Alice Schroeder’s book about Buffett, The Snowball, is definitely my favorite Buffett biography.

Dear Chairman, also a fantastic book, Has excellent details about the fight Graham had with Northern Pipe Line Company as well as several other prominent activist campaigns.

Link to all Buffett Partnership Letters: http://www.rbcpa.com/WEB_letters/WEB_Letters_pre_berkshire.html

Link to a free copy (kindle version only) of Benjamin Graham the Father of Financial Analysis an excellent and brief biography with input from the late great Irving Kahn: https://www.amazon.com/Benjamin-Graham-Father-Financial-Analysis-ebook/dp/B0055OC50Y

 

 

Closed-end fund Liquidations

Closed-end fund liquidations

Closed-end fund liquidations and similar actions can be a fairly attractive opportunity for most investors. This is where a closed-end fund decides to go out of business and sells all of the securities the company owned and sends the proceeds back to the investor in the fund while also canceling the stock of the fund. Alternatively a way for a closed-end fund to eliminate the discount a fund trades at is to convert the fund from a closed-end fund to an open-end fund or an ETF.

There are currently a few opportunities such as $KEF and $JFC that offer decent returns with low correlation to the U.S. stock market because they both have foreign emphasis. Both funds have announced their intention to liquidate but both funds have to have votes on the matter. $KEF is a Korean focused firm and $JFC is a regional china focused firm with holdings in the mainland, Singapore, Hong Kong and Taiwan. Both of these opportunities can be bought at ~5% discounts to the net asset value of the funds. On an annualized basis the returns from liquidation are 10-30% if the underlying assets remain the same as today.

If there were specific dates as to when the liquidation would occur in either case the discount would probably be in the 2% or less range for a month or less. An investor such as myself would probably not require a giant hurdle rate to invest in liquidations of all types but I think my required rate of return is at a minimum 12-15%. So an investment in a company trading at a 1% discount that requires a 2 month investment is probably not in the cards for me but I can see the interest for different investors.

The major risk is an overall dislocation in the various geographies the funds cover. Is say a 5% correction possible in either market within 2-5 months? The answer is in the affirmative. Many funds will take the additional step to hedge out the underlying assets to eliminate said market swings. I usually do not hedge because it’s expensive and it can cause one a great deal of damage under certain low probability, high hazard scenarios.

Pre-liquidation announcement opportunities

A possibility at higher returns can be had through an investment in funds that are currently being attacked by activists. Some of the usual suspects in such activist attacks are: Bulldog Investors, City of London Investment Group, Saba Capital Management, Karpus management as well as a few others. Usually at this point the returns are slightly higher than the 5% or lower “after liquidation announcement,”-type returns. Maybe the discount to NAV is in the 7-10% range.

Third Level Thinking on Activist situations

A third level of thinking on closed-end fund activists is just to buy a poorly defended closed- end fund trading at a mid-teens + discount to it’s NAV. There are probably more closed-end fund activists in the current markets then there ever have been. There is an increased prospect of activists swooping in on highly juicy yields to the benefit of coat-tail riders. The risk is that you are likely buying into funds that either have terrible management or terrible management fees (or both) and no activist takes notice. If successful returns in this arena can be much higher but there is greater uncertainty (not risk but uncertainty).

Unusual characteristics of an Investment in closed-end fund liquidations

Some things to think about with an investment in this asset class. Unlike in regular investing, variance in stock prices of the underlying securities matters quite a bit because the only valuation input into an investment in a widely diversified closed-end fund that makes sense is the actual trading value of each security added up.

The underlying assets as a whole must be glanced at for their overall risk. On average bonds are a “safer” investment than stocks. This was certainly true before the financial crisis. Now however most bonds are probably quite risky from the perspective of short-term investors (which in the case of closed-end fund liquidations we would be). Closed-end bond funds during most time periods would be considered like-wise less risky (certainly in the price-heavy academic sense). Certain funds in emerging markets would be considered more risky, all else equal, than their developed market counterparts. Etc Etc. There is a lot more short-term risks than long-term investors are usually accustomed to in this field of investment.

Many Closed-end Funds have strong income components. Some funds in liquidation/being engaged by activists have high single digit dividend yields. This allows an investor to shift focus away from the time component of the investment. An investor in a liquidation situation where a fund pays no interim dividend that trades at a discount of 5% would need the fund to liquidate in 5 months in order to achieve a 12% rate of return whereas an investor in a fund that also trades at a 5% discount but pays a dividend of 6% per year could hold the position for 10 months and still achieve a similar annualized return.