Many of the articles on this blog is about long term investing in companies that can compound for years, if not decades. Today, we’re going to take a look at some other ways to think about investing in stocks based on Warren Buffett’s early strategy for his hedge fund partnership. Although Warren’s early portfolio included undervalued stocks, he also had different types of investments including businesses that he controlled and event driven stocks.
Generals, workouts, and controls
Warren Buffett categorized his investments into 3 different groups – generals, workouts, and controls. Generals were undervalued companies based on fundamentals and is what most people today would associate with value investing. Some generals were compounders like American Express, while others were companies with poor business prospects selling at a compelling valuation for a potential short term gain. Workouts were event driven investments with a clear catalyst for value realization. Many of the partnership’s workouts fell in the merger arbitrage category of investing and utilized leverage to enhance returns. Finally, controls were businesses that Warren Buffett influenced through the shares that his hedge fund owned. Controls usually involved returning money to shareholders through dividends, share buybacks, or liquidations. While the names are different now, the types of investments from Warren Buffett’s partnership days are still around today.
Modern day examples
While controls is a strategy that is unavailable to most investors, generals and workouts are both types of investments that are accessible to most investors. For example, a general in the past few years would be a company like Microsoft. Microsoft stock fell after the dot com crash and languished for years. While the company grew revenues and earnings, the stock became undervalued since the shares barely moved. Eventually, Microsoft’s stock increased in price to reflect its true value and earnings power. The story of Microsoft is typical of stocks that fit in the general category. A company that is a general is undervalued, but does not have a specific reason for value to get realized by the rest of the market. Although the market eventually gets the price right, no one really knows when it will happen.
Stocks that are generals today are found in various industries. For example, some undervalued generals with good long term prospects today might be found in the healthcare industry, while short term and cheap generals might be found in the retail industry with operating leverage.
Workouts today include merger arbitrage and companies such as Monsanto. The current offer for Monsanto is $128 a share. With a current share price of $115, Monsanto offers an 11.3% return if the deal succeeds. Since the upside is usually capped while waiting for a deal to complete, timing is a big factor when it comes to workouts like merger arbitrage. The longer it takes, the lower the rate of return.
Although merger arbitrage is market neutral and a way to reduce volatility, if the merger fails, the losses can be catastrophic. This is because offers to buy out a company often carry a premium to the prior market price for the stock. If the merger fails, the premium is lost and the stock can fall back to where it was before the offer was made. A current example is the Rite Aid and Walgreens merger. Originally, Walgreens offered $9 a share for Rite Aid stock and shares traded at more than $8.50. However, after some time, Walgreens decided to change the offer to $6.50 to $7.00 a share. Rite Aid stock immediately declined and is currently trading around $4.00. Although it is still a workout situation, it is a good example of what can happen when deal terms change or fall apart.
Are the types of investments from Warren Buffet’s partnership right for you?
As you can see, there are many different reasons to invest in a particular stock. Some people choose to invest in generals that are high quality compounders, while others choose generals that are like cigar butts with one last puff of value. A few choose to use leverage and invest in workouts with a catalyst for share price appreciation. Regardless of what method an investor chooses, it is important that they are clear as to why they invest in a particular company and develop a hypothesis.