The category suitable for most investors

Among the three investment categories, general situations were the most important for Warren Buffett. He describes them in great detail in his 1961 letter:   

"Generally undervalued securities (hereinafter called ‘generals’) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories [note: specials and controls]. We usually have fairly large positions (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 our 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 or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot 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 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.

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. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform 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.” - Warren Buffett’s letter to partners, 1961

It may be noted that at Valuequity, we limit our research service mainly to the ‘generals’ category. While ‘specials’ and ‘controls’ are also valid investment themes, they are unsuitable for the common investor. In any case, a large chunk of the portfolio of even a highly skilled investor like Buffett also consisted of generals.

What to expect from investment in undervalued stocks

Buffett clearly outlines the features of investing in generals. They are:

• Which stocks to invest in? Seek stocks whose prices are demonstrably lower than their intrinsic value. This provides individual margin of safety. Further, moderately diversify (hence the portfolio of 20 stocks). These two factors, taken together, reduce the risk arising from an error in judgment or due to unforeseen circumstances.

• How many stocks to invest in? A concentrated portfolio. The portfolio should consist of 15 to 20 stocks. Almost 50% of the portfolio should be concentrated in about 5 main ideas.

• Why will the stocks move up? Due to normal actions of the stock market. Specific catalysts are unknown. We cannot predict why exactly the undervaluation should correct.

• How will the portfolio behave? In the short term, we can expect the portfolio to be in synch with the broad market direction (both upwards and downwards). In the longer term, we can expect to outperform the broader market.

• How long do we hold the portfolio? It is impossible to predict a time table beforehand. We must work with a minimum investment horizon of 5 years.

• When to sell? Focus more on buying than selling. Value investors tend to be better at knowing when to buy rather than when to sell. It is fine to leave some money on the table.
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  Investment checklist
  Here then, is a list of new additions to our investment toolkit:
     1.  Classify investments into categories based on their underlying characteristics.
     2.  Set your expectations from investments in advance. Match your expectations with the category.
     3.  Seek a margin of safety in individual stocks.
     4.  Construct a portfolio of around 20 stocks. Concentrate in about 5 of your best ideas.
     5.  Work with an investment horizon of 5 years.
     6.  Expect to outperform the broader market only in the long term.
     7.  Focus more on when to buy than when to sell.