How Buffett Got an Edge

A commonplace about Buffett that only captures a portion of the truth is that he made his fortune as a virtuoso stock picker. No doubt he has an enviable – but not perfect – record as a stock picker. In addition to great stock picking, he has always looked for en edge to boost performance.

Buffett recognized from Ben Graham that undervalued stocks usually go down in sympathy with, and in proportion to, the general market. Therefore, it was important to try to limit the downside by having a portfolio that went down less than the general market in periods of a declining market. (This is the same reason today’s hedge funds use shorts and attempt to invest in uncorrelated assets.)

Buffett did this by reducing commitments to stocks when the general market was overvalued. He did this – not by forecasting – but by consistently using a few common sense measures of market valuation, such as the earnings yield of the general market compared to that of quality bonds or simply by being increasingly cautious as the market rose faster than the progress of the underlying businesses.

In addition, he invested a material portion of the capital in investments which were not correlated with the general market, such as control situations and arbitrage situations. Again, this allowed him to reduce drawdowns in the portfolio during periods of market decline, which are highly disruptive to long-term compounding – something Buffett understood so well.

Buffett was creative in looking for an edge. When he purchased net-nets (undervalued securities that were selling for less than the value of their current assets less their current liabilities – a level which priced them below liquidation value), he gave himself a safety valve. He knew that if the price went up after he bought stock he would cash out and realize a profit. If the prices stayed low, he would continue to accumulate stock until he obtained a controlling position. He could then make the necessary changes required to realize a profit on his investment. Heads I win, tails I win too.

He also invested in relatively undervalued larger cap stocks where the prospect of accumulating a control position did not exist because of the companies’ size. Here, he feared the risk of an unexpected reduction in the multiple at which these stocks traded. He revealed that he had found a way to hedge the position if the market reappraised all companies at a lower multiple due to an emerging negative outlook on future prospects. Unfortunately, he does not reveal specifics.

Later Buffett would use insurance float as a source of cheap funds to purchase stocks and businesses in amounts far greater than his underlying equity capital would allow.

Buffett is far more than a simple stock picker and is always looking for an edge. He is fully aware that what worked in that past may no longer work given his present circumstances, perhaps because the past opportunity was recognized by too many market participants and was arbitraged away, or perhaps because a given strategy no longer works given the enormous capital he now works with.

It still makes a lot of sense to look for ways to hedge. Few things add more to long-term performance that finding ways to mitigate the downside. Buying right is a great place to start and then having the discipline to make additional purchases after re-checking your valuation work. Becoming fearful as the market rises is another powerful technique. Beyond that, each investor should consider what level of hedging is appropriate, if any, based on skill, experience, etc., remembering that if you don’t know what you’re doing, you’re speculating.

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