From Buffett's 1961 partnership letter

(expect some goose-bumps) :

• I do not present the tabulations with the idea of indicting investment firms. My own record of investing such huge sums with restrictions on the degree of activity I might take in companies, would be no better, if as good.
• The first section consists of generally undervalued securities (general) where we have nothing to say about corporate policies and as to when the undervaluation may correct itself. This has been our largest category, and more money has been made here than in the other categories. We usually have large portions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen.
• Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour, they are available at very cheap prices. A lot of value can be obtained for the price paid. 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.
• Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these with the idea of getting the last nickel, but are usually content selling out at some intermediate level between our purchase price and what we regard as fair value.
• The generals tend to behave market-wise very much in sympathy with the Dow.
• Just because something is cheap does not mean it is not going to go down.
• With abrupt downward movements in the market, this segment may very well down percentage-wise just as much as the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market.
• Out second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, when we will get how much. Corporate events such as mergers, liquidations, reorganizations, spin-offs, lead to work-outs.
• This category will produce reasonably stable earnings, a large extent irrespective of the Dow. Work-outs have produced our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development.
• I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both even results and intermediate market behavior. Results, usually fall in the 10% to 20% range.
• My self-imposed limit regarding borrowing is 25% of partnership net worth.
• Final category is “control” situations where we control the company. Such operations should definitely be measured on the basis of several years.
• Conscious, of inflation, many people now feel that they are behaving in a conservative manner by buying blue chips although regardless of price-earnings ratios, dividend yield, etc. I feel this course of action is fraught with danger.
• There is nothing at all conservative about speculating to just how high a multiplier a greedy and capricious public will put on earnings.
• You will be right, over the course of many transactions, if your hypothesis is correct, your facts are correct, and your reasoning is correct.
• True conservatism is only possible through knowledge and reason.
• I feel the most objective test as to just how conservative our manner of investing is arises through evaluation of performance in down markets. Preferably these should involve a substantial decline the Dow.
• We have never suffered a realized loss of more than ½ of 1% of total net assets, and our ratio of total dollars of realized gains to total realized losses is something like 100 to 1.
• Of course, this reflects the fact that on balance we have been operating in an up market. However, there have been many opportunities for loss transactions even in markets such as these so I think the above facts have some significance.
• Our job is to pile up yearly advantages over the performance of the Dow without worrying too much about whether the absolute results in a gibes year are a plus or a minus.
• I would consider a year in which we were down 15% and the Dow declined 25% to be much superior to a year when both the partnership and the Dow advanced 20%.
• For the reasons outlined in my method of operation, our best years relative to the Dow are likely to be in declining or static markets.
• My father is sharing office space with us (he also shares the expenses) and doing a brokerage business in securities. I expect our overhead, excluding interest on borrowings and Nebraska Intangibles Tax, to run less than .5 of 1% of net assets.
• We have over 90 partners and probably 40 or so securities.
• We presently have partners residing in locations from California to Vermont, and net assets at the beginning of 1962 amounted to $1,178,500.00. Susie and I have an interest in the partnership amounting to $1,025,000.00.