If I told you there was a hedge fund manager who specialised in merger arbitrage and charged a 25% performance fee, would you ever guess that I was describing Warren Buffett?

I doubt it.

After all, the 93-year old Sage of Omaha that we know is not greedy. He has earned a flat salary of $100 000 for more than 40 years (since 1980). His favourite investment holding period is forever and he doesn’t use debt at Berkshire Hathaway.

But that is not how this young buck started.

Young Warren

In 1957, 27-year old Warren did not yet own Berkshire Hathaway. He was a fund manager running the Buffett Partnership. These were partnerships with family members and friends where he would invest their money in return for a performance fee.

To be fair, Warren was not your typical avaricious hedge fund manager. He didn’t charge annual management fees. He also didn’t take any fee until he had earned a return of 6% for his investors, but thereafter he shared in 25% of the profits.

In contrast, modern hedge funds typically charge a 2% management fee, which must be paid annually no matter what happens. Thereafter they share in 20% of the profits. In industry jargon, this is called the 2 and 20 fee structure. 

Young Warren focussed on two things, value investing and work-outs. We know that his idea of investing was deeply rooted in value investing because his mentor Ben Graham popularised that philosophy. At that time, Buffett described his job in this way: “primary attention is given at all times to the detection of substantially undervalued securities”.

Young Warren also favoured investing in work-outs. He defined that term as “an investment which is dependent on specific corporate action for its profits rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc”.

Work-outs can take years to play out and the only way to make it happen is to buy enough of the company to have a say in what course it pursues in future. Young Warren had about 30% of the partnership funds tied up in work-outs and 70% in stocks.

One might say that he was an activist investor. And as we know, activist investors don’t mind stepping on some toes.

Young Warren also thought that the use of leverage (i.e. borrowed money) was acceptable. In 1957, he was concerned that the general level of the market was too high. But he also said: “if the general market were to return to an undervalued status our capital might be employed exclusively in general issues and perhaps some borrowed money would be used in this operation at that time”.

This sounds very hedge fund-ish.

Modern Warren

But something changed and that change was Charlie Munger. Over the years Charlie convinced Warren that it was better to pay up for good companies rather than to buy cheap companies.

In 1989, Warren wrote:

“Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way - in fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras - unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o - three years later I was lucky to sell the business for about what I had paid. After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, "My Wife Ran Away With My Best Friend and I Still Miss Him a Lot."

I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture: It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements”.

What we notice at this point in time is that Warren is no longer merely a value investor. He had clearly realised that buying good businesses was superior to buying cheap businesses.

Modern Warren was also against the use of leverage, which is very un-hedge fund-ish and a big shift from his 1957 ideas.

In 2017, Warren wrote: 

“Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire”.

Warren also described his aversion to leverage in interviews with these quotes:

“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies, and leverage. Now the truth is, the first two he just added because they started with ‘L’ – It’s leverage”.

"If you don't have leverage, you don't get in trouble. That's the only way a smart person can go broke, basically. And I've always said, 'If you're smart, you don't need it; and if you're dumb, you shouldn't be using it.'"

Conclusion

Famous economist John Maynard Keynes said “when the facts change, I change my mind – what do you do sir?”.

As investors, I think it is sensible to change your mind as your ideas improve and as the market changes. The modern stock market is a highly competitive beast with millions of investors analysing data to make investment decisions. I would venture the opinion that the modern stock market could be the most competitive sport in the world. No other endeavour has so many people chasing after the same thing.

That is why I urge you to be wary when investing in stocks. If you aren’t putting in the work to understand the stocks, rather buy an index, which requires no work.

But is it bad to change as an investor? The answer to that is best encapsulated in a quote from Maya Angelou “when you know better, you do better”.

So as you get better as investors, you will naturally change how you invest. I have certainly changed how I invest. These days, I am horrified at some of my earlier investments. What was I thinking?

My conclusion is that we learn by doing and we often learn the most from our mistakes. So you should be horrified by a few past investments because those are the ones that teach you the most. I also think that you should not judge your younger self who was learning, with your mindset of today. If you knew better at the time, you would have done better at the time.

Allow me to save you some investment pain, by giving you a few resources for your investment journey:

• How to become an Extraordinary Investor

• The mindset of wealth investors

• How to buy highly priced stocks

• How to outperform the market

• Ten investing lesson from legendary fund manager – Peter Lynch

• Beliefs that make you stick with bad investment decisions

• The core-satellite portfolio

I would like to hear what you’re up to.

DM me on social media or email me.