A Simple Way to Improve Returns

Buffett always allocates his capital to what he judges to be the optimal opportunity. He wants his capital in stocks that give him the greatest chance of success, which he defines as situations where there is a minimal chance of losing his capital and the greatest expected payoff. In 1958, when his stock in Commonwealth rose to $80 per share it was still undervalued given the $135 per share that Buffett estimated it was worth. However, he sold it because he could purchase another stock with an intrinsic value of $125 per share for $50. As Buffett wrote, “The relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price of $50 with an intrinsic value of $125.” Buffett sold Commonwealth when its price rose to $80. In this case, Buffett chose an investment that was more undervalued than Commonwealth but not more so than other opportunities that were available to him. He chose it not only on the basis of its undervaluation, but also because he would be the largest shareholder in the new position which would give him the opportunity to correct the undervaluation and optimize his portfolio’s internal rate of return.

Takeaways:

  1. Although transaction costs and taxes need to be given their due, don’t marry your stocks. Each holding should be regularly evaluated against your other opportunities.
  2. You should be willing to sell an undervalued security to purchase another security of greater undervaluation or that is equally undervalued but safer.
  3. The greater the level of undervaluation in your portfolio holdings the greater the expected return.
  4. Given the time value of money, all other things being equal, you should prefer situations with an identifiable catalyst.
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