Warren Buffett used a three-bucket approach in his portfolio during his partnership days. It’s a nice example of how to think about portfolio construction.
Each of Buffett’s buckets filled a role in meeting his long term objective. That objective can be broken down into two parts:
- Beat the Dow by 10% over the long term.
- Outperform in bear markets while matching performance during bull markets.
The only way he achieves either objective is by building a portfolio that looks nothing like the Dow. How did he do it?
First, he used a conservative deep value strategy. Stocks selling at a deep discount, with a wide margin of safety, offered a lot of room to be wrong on valuation but still make money.
With that strategy as a base, the three buckets did the rest — what he called Generals, Workouts, and Controls:
- “Generals” – A category of generally undervalued stocks, determined primarily by quantitative standards, but with considerable attention also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation on the enterprise substantially below what careful analysis indicates its value to a private owner to be…
- “Workouts” – These are the securities with a timetable. They arise from corporate activity – sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper…
- “Controls” – These are rarities, but when they occur they are likely to be of significant size. Unless we start off with the purchase of a sizable block or stock, controls develop from the general category. They result from situations where a cheap security does nothing price-wise for such an extended period of time that we are able to buy a significant percentage of the company’s stock. At that point we are probably in a position to assume some degree of, or perhaps complete, control of the company’s activities..
The buckets can be broken down based on how they track market behavior. One moves with the market. The other two are detached from it. Having two buckets uncorrelated with the market becomes helpful when you prioritize outperforming bear markets.
The Generals made up the largest portion of the portfolio and was his bread and butter. It earned the best total return of all the buckets. In total, the bucket held five to six stocks — ranging from 5% – 10% per positions — with 10 to 15 smaller positions. Overall, Buffett was more concerned with buying at the right price than selling at the highest price. He was happy selling below fair value.
These were the deep value stocks with no timeline on when that value might be attained. About halfway through the partnership years, Buffett added two qualitative factors — good or new management, in a good industry — in addition to a bargain price.
The Generals were expected to behave like the market. So if the Dow performed well, the Generals did well. And if the Dow did poorly, so did the Generals.
The next bucket was Workouts or special situations and arbitrage plays. It was the second-largest bucket in the portfolio, with about 10 to 15 workouts at any time.
These had a short term catalyst or timeline attached that presented two big benefits. It helped insulate the Workouts bucket from short term market behavior since the stock price was tied to a timeline. It also made it easier to predict when and how much could be earned from each deal, along with the risks.
The risk was in the deal the falling through. Something — antitrust issue, shareholder disapproval, etc. — that causes management to cancel their plans. Misjudging it can get expensive. So Buffett avoided anything he wasn’t absolutely confident in (he used borrowed money for workouts — limited to 25% of the portfolio’s net worth — because of the inherent safety that came with the predictability and lower chance of short-term declines).
So overall, returns from Workouts were more steady annually. The bucket performed great in declining markets but acted as a drag during bull markets.
Finally, Controls were activist positions. The goal was to buy a big enough position to influence management or control the company outright to control the outcome.
He bought these at a deep discount to liquidation value which gave him a built-in profit but also a few options. The worst-case scenario would be to shutter the business, sell all the assets, pay any debts, and collect a nice gain. The best case was to make the company financially sound, then turn it profitable again, and use any excess cash to create a new investment portfolio within the company. From there, he could separate the portfolio from the business operation and sell the business or continue running both as-is.
These took several years to play out because it took time to build a large enough position and realize a profit. Being often highly illiquid stocks, patience was key. In fact, the partnership benefited when the stocks languished or fell further. It made it easier for Buffett to build a large enough position to seize control.
So Controls insulated the portfolio from the market too. And when it didn’t, when the stock moved with the market, Buffett had an opportunity — a lower price to buy, a (much) higher price to sell out early. But once he controlled the company, what the stock price did in the short term was irrelevant because he controlled the outcome. A nice gain — the worst-case liquidation sale — was the guaranteed minimum profit.
Collectively, when one bucket performed poorly, the other two picked up the slack. The Workouts and Controls protected the portfolio on the downside when the market declined. The Generals did the opposite by protecting the portfolio when the market rose. Buffett’s three buckets not only achieved but exceeded his goals.
Buffett Partnership Letters