Reflection on Warren Buffett’s Career: The Partnership Years

This post is part of an ongoing series reflecting on Warren Buffett’s career and investment philosophy.

• Part 1: Reflections on Warren Buffett’s Career
• Part 2: Reflections on Warren Buffett’s Career: Early Influences

Buffett on Scale and Structural Advantage

In 1999, at the height of the dotcom bubble, Warren Buffett gave an interview for BusinessWeek. Buffett was discussing how the combination of an over-heated stock market and Berkshire Hathaway’s large size made it incredibly challenging to find attractive stocks to buy. In the interview, Buffett said the following:

“If I was running $1 million or $10 million for that matter, I’d be fully invested. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts back then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

The Structure of Buffett’s Early Partnerships

When Warren Buffett returned to Omaha in 1956, he was ready to set up his own investment operation. Starting with seven investors and a little over $100,000 in investment capital, Buffett set up shop.

Initially, Buffett established multiple partnerships. These partnerships were more like separate accounts, each with a unique arrangement tailored to the needs of the account holder. While the compensation structures for these accounts differed in their details, the broad arrangement was the same: Buffett would grant each investor a specified return after which the profits would be split between him and the limited partner.

In 1962, Buffett consolidated the various accounts into a single partnership, Buffett Partnership, Ltd (BPL). Buffett’s arrangement with his partners in BPL was as follows:

For example, suppose that in a given year the partnership made 30%. The limited partners would receive 6%, and the remaining 24% would be split three-quarters to the limited partners and one-quarter to Buffett. The net return to the limited partner would be: .06 + (0.75 x 0.24) = 24%. Suppose that in the next year, the partnership lost 5%. In the money-losing year, Buffett would receive no compensation. Both the 5% loss and the missed 6% preferred return would carry over to the next year. Thus, the preferred return for year 3 is (a) the 11% carried over from the prior year and (b) the 6% preferred return for the current year. With Buffett’s arrangement, he only profited if he made money for his partners. His incentives, in other words, were aligned with the interests of the limited partners.

Compare this structure with one more typical of the hedge fund industry. For many hedge funds, the standard compensation structure is “two and twenty.” In other words, the fund charges 2% on the value of the assets in the fund (assets under management, or AUM). Then the fund takes 20% of the returns on profits. Usually, the profit split kicks in after a high-water mark (preferred return), just as with Buffett’s arrangement. The key difference between this compensation structure and Buffett’s is the 2% fee levied on fund assets. This fee is charged regardless of performance. Because the costs of running a fund does not rise proportionally with fund size, hedge fund managers are incentivized to be “asset gatherers,” increasing the size of the fund even if it worsens investment performance.

Today, money managers are often benchmarked against the S&P 500. The index is chosen because (a) it is considered a proxy for the broader stock market, and (b) it is the most popular “passive” alternative to active investment management. Investors can simply buy one of the many low-cost index funds that track the S&P index. While doing so eliminates the possibility the investor will do better than the benchmark, it also eliminates the risk of doing worse. And truthfully, most large equity funds fail to beat this benchmark.

When Buffett was managing his investment fund(s), the Dow Jones Industrial Average (DJIA), the “Dow”, was the better-known market benchmark. The S&P 500 did not yet become a widely-followed benchmark until the 1970s. And Buffett’s performance against the Dow was stunning. From 1957 to 1969, the Dow returned an average annual compounded rate of 7.4%, while Buffett returned 23.8% per annum to his limited partners.

Buffett’s Early Investment Philosophy

Buffett’s investments consisted of what he called “Generals,” “Workouts,” and “Controls.” The most prominent of these was “Generals,” short for generally undervalued.

These undervalued stocks were typical of what Buffett learned from Ben Graham, first at Columbia and later working for Graham’s investment partnership. The key characteristic of these investments was the bargain price:

“This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential.”

How did Buffett value these stocks? Mostly, Buffett used the “private owner method,” estimating what a well-informed buyer would pay for the entire company. Buffett would look for these stocks selling at a discount to private market value. He would value these stocks based on assets or earnings, depending on whether the company could persist as a “going entity.” If a company’s future was in question, Buffett would value the business conservatively based on what assets, net of liabilities, would sell for in a liquidation. If the company could produce future profits, Buffett would value them based on a multiple of earnings. Often, Buffett would use both methods as a way of cross-checking his valuation work.

Because often there was no known catalyst for uncovering the stock’s value, the “generals” were a “buy cheap and wait” approach to investing. The hope was that these investments would increase closer to business value and Buffett could sell the stock at a profit:

“We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner.”

As the partnership’s assets grew, Buffett began to look for larger companies trading at a discount to their “peer group” – i.e., similar companies in the same industry. When he started to invest in these relatively undervalued stocks, he separated the generals category into “generals – private owner” and “generals – relatively undervalued.” Buffett would often hedge these relatively undervalued stocks by shorting the more expensive stocks in their peer group.

Buffett did not disclose his investments to his partners. The primary reason for this was that many of the stocks were small and only a limited number of shares could be acquired. In addition, the small size meant that if anyone else was buying shares, the bargain could be eliminated before Buffett could acquire a position in the stock.

But he did disclose one investment in the “generals” category, Commonwealth Trust of Union City, New Jersey. Commonwealth was generating earnings of approximately $10 per share. Buffett estimated that the earnings were worth $125 per share, which translates to a multiple of 12.5 times earnings. The stock at the time that Buffett bought it was trading at $50 per share.

Often, these cheap stocks would attract an “activist investor,” someone who could purchase enough shares that they could influence how the company was managed. Buffett made money investing alongside these activists, an activity he called “coattail riding.” Occasionally Buffett would himself act as an activist.

In the next post, we’ll look at another category of Buffett’s early investments.

Summary

During the partnership years, Warren Buffett benefited from a structural advantage that no longer exists at scale: the ability to deploy small amounts of capital into deeply undervalued opportunities. His partnership structure was designed to tightly align his incentives with those of his limited partners, ensuring that he only profited when they did.

Buffett’s compensation arrangement stood in sharp contrast to the asset-gathering incentives common in the hedge fund industry today. Combined with flexible redemption terms and a focus on absolute returns rather than benchmark-relative performance, this structure allowed Buffett to focus purely on investment results.

Equally important was Buffett’s early investment philosophy. Influenced heavily by Ben Graham, Buffett relied on a margin of safety, private owner valuation, and patience. By buying stocks at prices well below business value and waiting for that value to be recognized, Buffett produced extraordinary results during the partnership years.

Key Takeaways

• Buffett’s early success was aided by the structural advantage of managing a small pool of capital.
• The partnership structure aligned Buffett’s incentives directly with those of his investors.
• Unlike modern hedge funds, Buffett did not charge asset-based fees that encouraged asset gathering.
• Buffett measured success against absolute returns and market benchmarks, not peer performance.
• His early investments emphasized margin of safety, private owner valuation, and patience.

Investor Takeaways (Applying These Lessons Today)

• Structural incentives matter just as much as investment skill.
• Smaller pools of capital can exploit opportunities unavailable to large funds.
• Valuation discipline and patience can outperform benchmarks over time.
• Thinking like a private owner provides a powerful framework for public market investing.

Sources:

Biano, Anthony. “Homespun Wisdom from the ‘Oracle of Omaha’.” BusinessWeek. July 5, 1995.

Miller, Jeremy. Warren Buffett’s Ground Rules. Harper Business. 2016.