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Invest Like Buffett -- Circa 1961

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In 1999, Warren Buffett told BusinessWeek:

If I was running $1 million today, or $10 million for that matter, I'd be fully invested ... 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.

Nowadays, people argue that Buffett's investing success depends on deals to which only he has access. That's partially true – think of his recent investments in Goldman Sachs (NYSE: GS  ) and General Electric (NYSE: GE  ) at the height of the financial crisis -- but here, Buffett is telling us that we have an advantage over him. Better yet, his early career shows just how he would make the most of that advantage, if he were in our shoes.

Generals and workouts
In his 1961 year-end Buffett Partnership letter, the enterprising young investor described two approaches that are still relevant to individual investors. "Generals" refers to buying dirt cheap stocks, the deep value strategy pioneered by his mentor, Ben Graham. That approach has been extensively documented by practitioners and academics, losing some of its attractiveness in the process. But his second approach, "workouts," is less well known, and it remains a rich area of opportunity for individual investors today.

What Buffett then called "workouts" are now referred to as "special situations," or even "event-driven investing," if you want to sound really sophisticated. As the latter expression suggests, special situations typically focus on stocks that are undergoing a corporate event (spinoff, bankruptcy, merger, etc.).

An odd transaction
In his 1988 Berkshire shareholder letter, Buffett describes one such transaction dating back to 1981. KKR had made an offer to buy out Arcata, a printing and forest products company. There was one quirk: Arcata was in litigation with over the final price tag for 10,700 acres of timber to which the government had taken title. Thus, KKR's initial offer was $37 per share plus two-thirds of any additional payments Arcata would receive from the government.

At $33.50, Buffett figured the shares offered value even if no additional payments arrived. That's where he started buying Arcata shares. Once he determined that Arcata's claim was worth something, Buffett increased his stake, paying roughly $38. Ultimately, another investment group bought Arcata for $37.50 per share, plus half of Arcata's claim amount. Buffett made an immediate 15% annual rate of return on the transaction, but he still had a right to extra monies paid by the government. Roughly six years later, the government settled the case, and Buffett ended up with a nice sweetener -- to the tune of $30.60 per share.

Berkshire then and now
Of course, in 1981, Berkshire's stock portfolio looked completely different than it does today: The only stock that remains from that era is Washington Post (NYSE: WPO  ) , a core holding that Buffett is unlikely to ever sell. I don't see Buffett dabbling in merger arbitrage now; it's not a good use of his time and capital, due to the size of his portfolio. But if he were going to, where might he find today's Arcatas?

"Large and prominent" is not your friend
You're very unlikely to find them among prominent acquisitions, which are heavily followed by funds that specialize in that business. For example, Intel (Nasdaq: INTC  ) is set to acquire McAfee (NYSE: MFE  ) for $48 in cash. Yesterday, McAfee shares closed at $47.91. Since the transaction was announced on Aug. 18, the spread between the stock price and the acquisition price has never exceeded 4.5%. For an individual investor, betting on that acquisition amounts to too much work for a too little return. Smaller, more complicated situations are usually the ticket.

Look for "messy and underfollowed"
It's not strictly speaking a merger arbitrage, but I'd be tempted to look at Dynegy (NYSE: DYN  ) , which received a $5.50-a-share tender offer from Carl Icahn's Icahn Enterprises' (NYSE: IEP  ) . The tender failed, and the company is now replacing its CEO and its board of directors. Icahn and Seneca Capital, the second-largest shareholder, will both receive board representation.

The conflicting messages coming from different parties indicate a high degree of uncertainty -- which is often the mother of opportunity. On the one hand, the market clearly thinks the company is worth more; shares are trading slightly around $5.90. However, investment banks shopped Dynegy to more than 50 potential buyers without producing a single bid. Icahn himself described his offer as a "stalking horse bid," adding: "I believed that higher bids would materialize." Coming from a shark like Icahn, that comment suggests to me that he sees his offer price as an absolute floor on Dynegy's intrinsic value.

Want to know more?
I'm not recommending that investors buy Dynegy on this basis, but the stock is an interesting candidate. It's just the sort of situation that an investor like Tom Jacobs might look at. Tom manages a real-money portfolio as part of Special Ops, The Motley Fool's special situations newsletter; he and a team of analysts comb the edges of the stock market for overlooked opportunity. If you're interested in finding out how investing in special situations can contribute to your portfolio, just enter your email address in the box below for a video on three stocks Tom likes right now, plus a private invitation to join Special Ops when it opens later this week.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Intel is a Motley Fool Inside Value pick. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 23, 2011, at 11:34 AM, gilsh wrote:

    3 remarks:

    1) as far as i recall, berkshire held in 1981 KO

    stocks as well.

    2) the INTC/MFE deal meant that patient

    investors, purchasing the stock on december,

    could have made a confident ~4% profit

    (minus buy&sale costs) in less than 3 months.

    3) but the INTC/MFE deal had another interesting

    aspect - INTC has become slightly more

    interesting after this deal, as it has

    strengthened its mobile market capabilites, a

    market in which it has been lagging behind. It

    might be more relevant to the "general"

    approach than to the "workout" approach, but

    it clarifies the ancient truth, that somewhere,

    somehow, all theoretical approaches coincide.

  • Report this Comment On February 23, 2011, at 3:05 PM, mikecart1 wrote:

    Buffet = Lucky investor

    He's living off decisions he made in the 1960s and 1970s and people are still bowing down to him. I respect Jim Cramer more than Warren Buffet. Until Warren Buffet starts calling out stock picks regularly - stocks in the year 2011, not of companies he bought 30+ years ago, I will assume he is a terrible investor in today's market.

    Bill Russell might have been the best basketball player in the world 30 years ago. But you don't see people going to him, calling him the best basketball player in 2011. Why is it that investing, people think that rule is excluded?

    Bill Gates won't make anything better than Windows

    Apple won't make anything better than iPod

    Buffet won't make any deals better than his acquisitions 30+ years ago

  • Report this Comment On February 23, 2011, at 4:12 PM, TMFAleph1 wrote:

    Jim Cramer really doesn't belong in the same sentence as Warren Buffett.

    Alex Dumortier

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