Jeremy C. Miller - Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor

Dedicated to the memory of my dear friend and

colleague, Peter Sauer (19762012). Peter, you left us all too

early. While you were here, your many great achievements

were equaled only by your humbleness.

The excerpts from Warren Buffetts Partnership Letters are being used with his permission.

Mr. Buffett has had no other connection with this book whatsoever. In other words, while all the wisdom is his, all the errors are mine.

To maintain the narrative flow of the excerpts, omissions are not always indicated.

If I was running $1 million, or $10 million for that matter, Id be fully invested. The highest rates of return Ive ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts back then. Its 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.

WARREN BUFFETT, BUSINESSWEEK, 1999

I n 1956, Warren Buffett was working in New York with his mentor, value investings founder, Benjamin Graham. When Graham decided to retire, he offered his best student a stake in his partnership, Graham-Newman, but the twenty-five-year-old Buffett opted to return home instead. Not long after, at the bequest of four family members and three friends, a new investment partnershipBuffett Associates, Ltd.was formed. Before agreeing to accept their checks, however, he asked them to meet him for dinner at the Omaha Club. Everyone went Dutch.

That night, Buffett handed each of them a few pages of legal documents containing the formal partnership agreement and suggested they not worry too much about what was in them; he assured them there would be no surprises. The gathering was intended to discuss something he considered much more important: the Ground Rules. He had made carbons of this short list of precepts and carefully went through each point. Buffett insisted on complete autonomy. He was not going to talk about what the Partnership was actually doing; he gave very little detail on his actual holdings. He told them, These ground rules are the philosophy. If you are in tune with me, then lets go. If you arent, I understand.

The Ground Rules

In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just thatwithdrawing. If we earn more than 6% per annum over a period of years, the withdrawals will be covered by earnings and the principal will increase. If we dont earn 6%, the monthly payments are partially or wholly a return of capital.

Any year in which we fail to achieve at least a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered.

Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at yearend against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.

Whether we do a good job or a poor job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.

While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.

I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership.

I cannot promise results to partners. What I can and do promise is that:

a. Our investments will be chosen on the basis of value, not popularity;

b. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments; and

c. my wife, children and I will have virtually our entire net worth invested in the partnership.

Everyone invited to the Omaha Club that night signed on and Buffett took their checks. As new partners joined, they were each carefully taken through the ground rules. Then, every partner was sent an updated copy annually.

Over the years that followed, Buffett communicated his performance and described his activities through a series of letters to this small but growing band of followers. He used them as a teaching tool to reinforce and expand upon the concepts behind the ground rules, discuss his expectations for future performance, and make comments about the market environment. At first these were annual updates but when enough partners griped that a year was a long time between drinks, he began writing at least semi-annually.

These Partnership Letters chronicle his thoughts, approaches, and reflections in the period immediately prior to his better-known tenure at Berkshire Hathaway; it was a period that delivered an unprecedented record of investing success, even when compared to his track record at Berkshire. While he expected to have good years and bad, he thought that a 10% advantage to the Dow was achievable over most 35 year periods and thats what he set to do.

He did far better. He consistently beat the market and never had a down year. For the entire period, he compounded partners capital at nearly a 24% annual rate, after fees. This earlier period produced many of the best performance years of his career.

The lessons that come out of this commentary offer timeless guidance for every type of investorfrom beginners and amateurs to sophisticated pros. They lay forth a consistent and highly effective set of principles and methods that avoid the trendy and technical temptations abundant in todays (or any days) market. While they do contain the type of sophisticated analysis that should appeal to seasoned professionals, the letters also are Buffetts take on Investing 101they provide a basic, commonsense approach that should resonate with everyone.

The Partnership Letters and their wisdom have been compiled comprehensively and accessibly for the first time in this book and include such bedrock principles as his contrarian diversification strategy, his almost religious celebration of compounding interest, and his conservative (as opposed to conventional) decision-making process. They also include his methods for investing in Generals, Workouts, and Controls, his three principal methods of operation, which evolved in interesting and important ways over time, ways that well explore.