Understanding Buffett

If you could travel back in time to 1965 and invest in one single stock or mutual fund, you’d be wise to pick Berkshire Hathaway.

Warren Buffett bought Berkshire in May of that year and transformed it from a failing textile company into a supremely successful investment conglomerate. $1,000 invested in Berkshire stock at the time of purchase, would have grown to more than $8.8 million today. An astounding average return of over 20% per year, that handsomely beats any other stock or mutual fund over such a period.1

You have heard us claim that to outperform the market you have to be lucky and take risks. Surely you cannot be lucky for 47 years? So how do we explain Mr. Buffett’s amazing track record?2

Manager or investor?
One reason that is often given for Mr. Buffett’s success is that he is a private equity investor, rather than a stock picker. Therefore, the reasoning goes, it is his management skills of those private companies and the coaching of their CEO’s that explains his success. Not his ability to pick individual stocks.

That claim is not without grounds. Since 1980 an average of 63% of the value of Berkshire’s investments has been in private companies.3However it turns out that the return on his publicly listed companies has been at least as successful as his private investments. Therefore the ‘manager’ argument – which we admit to have used ourselves – does not seem to solve the Buffett riddle.4

Bargain hunting
Another often cited reason is that Mr. Buffett is generally regarded as the ultimate value investor. Unlike the general public – who likes to invest in sexy, high growth companies – value investors prefer companies that have fallen out of favor and are therefore ‘cheap’. In Buffet’s own words: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

There is a catch however. These companies trade at ‘bargain prices’ for a reason. They face real issues that really need to be solved. Investors have however tended to overestimate the severity of those issues, which is why unglamorous ‘value’ companies have outperformed their sexy ‘growth’ counterparts by 1-4%5per year since 1926. This is a substantial difference, but not enough to explain Mr. Buffett’s outperformance. Especially since an important part of Berkshire’s portfolio does not consist of what is traditionally considered ‘value stocks’.

Finding quality
It is true that Mr. Buffett likes a bargain, but never more then when the merchandise consists of safe, high quality stocks. As usual he has a nice way of describing his preference: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

You could define safe stocks as stocks with valuations that show low correlation to the overall market: when the market plummets, their prices fall by less, but equally, when stock prices soar, their performance stays behind. Because investors call the correlation to the market ‘beta’, these type of stocks are called ‘low beta stocks’. High quality companies can be defined as companies that are profitable, growing and pay out a decent dividend. So ‘safe, high quality stocks’ – Buffett’s favorite mix – are profitable, sound and steady stocks. They are the traditional blue chips like Coca Cola, American Express and IBM that many investors might find boring.

In order to test whether this preference, rather than a unique stock picking ability, explains Buffet’s success, researchers compared the performance of all safe and high quality listed companies to the performance of Berkshire’s individually selected stocks.6Interestingly they found that this safe, high quality group outperformed the general stock market and, on a risk adjusted basis, also performed slightly better than the specific companies that were bought by Berkshire Hathaway. So this preference, rather than specific stock selection, does explain part of Buffett’s success.

Leverage
However, Berkshire’s overall net results were still significantly better than the group of safe, high quality stocks. It turns out that this difference was caused by Mr. Buffett’s use of borrowed money, or ‘leverage’. Leverage can after all, significantly increase performance. Especially when you can borrow at low costs. This is precisely what Berkshire did. For every dollar invested out of its own pockets, it used approximately 0,6 dollars of borrowed money.7

Berkshire’s excellent credit rating helped keep the costs of borrowing down, but even more effective was its use of the insurance companies, which form a large part of Berkshire’s private investments portfolio. Insurance companies collect insurance premiums today, to pay out claims in the future. This provides them with a steady flow of ‘natural leverage’ at a cost that in Berkshire’s case was lower than the US government’s cost of borrowing!

Adding this kind of leverage to the ‘safe’ and ‘high quality’ portfolios that the researchers constructed, resulted in investment returns that matched Berkshire’s track record. Does this mean the riddle was finally solved?

Risk management
Before we answer that question, it is important to note that leverage is a double-edged sword: it magnifies profits, but can give losses the potential to wipe you out. Leverage means that Berkshire has been a volatile stock, and in three instances it lost around 50% of its market value. Few levered investors are able to manage one, let alone three such storms. Berkshire managed it by focusing on risk management, diversification of its portfolio and last but not least, by keeping a huge cushion of cash, currently around $40 billion.8As Mr. Buffett said: “I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Discipline
Not only did Berkshire weather these storms. It came out better each time, because Mr. Buffett had the discipline to stick to his investment principles throughout every market cycle. This discipline, combined with his pile of cash, enabled him to ‘rescue’ companies at the brink, when everyone else was running for cover. In Buffett’s words: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” Needless to say it is exactly at these times that negotiations tend to go in your favor and some of Berkshire’s most lucrative deals were done in the direst of times.

Expenses
Leveraging safe, high quality stocks, with excellent risk management and iron discipline turned out to be a strategy for success. Still, if implemented by almost any other active manager, the results would have been markedly less spectacular. To understand why that is the case, we have to look at perhaps the most underestimated reason for Berkshire’s stellar performance: its unparalleled low level of costs. At the end of 2011 the holding company employed just 24 people to manage around $400 billion in assets. This equates to over €16 billion on average per employee. For comparison, the 13,000 employees of Vanguard – the world’s lowest cost mutual fund manager – each oversee on average $130 million, less than 1% of their Berkshire peers.

Mr. Buffett’s frugality is famous. He still lives in the same 5-bedroom house that he bought in 1957 for $31,500 and he is still paid the same salary of $100,000 that he has been receiving for 30 years. The only extravagant expense he has been known to make is buying a corporate jet, which he appropriately named ‘The Indefensible’. Still, we don’t have to feel sorry for him. As is well known, Mr. Buffett is the biggest investor in his own company. This is great for him, as it made him one of the wealthiest people on earth. It is also good for his investors, because their interests were totally aligned with their manager’s. As Mr. Buffett likes to tell his co-shareholders: ”we will only do with your money, what we do with our own.”

The difference this has made for his investors is truly remarkable. If Buffett had adopted the conventional hedge fund remuneration model charging an average 1.6% in annual management and 19.2% in performance fees, Berkshire’s market value would have been a whopping 90% less than it is today! Put in another way, Berkshire’s unconventionally low costs made his shareholders 10 times as rich.9

Conclusion
The research suggests that it is not Mr. Buffett’s stock picking ability that has been the major contributor to his success. If you could have bought a diversified portfolio of safe, high quality, and value stocks and ran it at virtually no investment costs, whilst boosting results with cheap borrowed money, including insurance float (easier said then done), you would have achieved similar results.

Now that we know the secret, can we replicate Berkshire’s performance? Normal investors don’t have the same access to cheap leverage as Berkshire, so we can’t ‘spice up’ our investment return (and risk!) like Warren Buffett. However, we can invest in a globally diversified portfolio with a focus on cheap, safe and high quality companies, stay disciplined through the inevitable ups and downs of the market and keep expenses low. In fact a globally diversified, low cost equity portfolio would have comfortably (over 3% per year) outperformed Berkshire Hathaway shares over the last 10 years.

Unfortunately, many of us are not able to stick to our investment plan, we don’t pay attention to costs and we do not spread our risks globally. To quote Mr. Buffett one last time “There seems to be some perverse human characteristic that likes to make easy things difficult.”

Why not adhere to his words and keep things really simple: let Mr. Buffett run our investments at virtually no costs, by buying Berkshire stock? Will his success continue for another 50 years? This seems unlikely. Mr. Buffett is 82 and his main investment partner, Charly Munger, is 89 years old. But even if we could clone his successor from Buffett’s genes, it is unlikely that we will see a repetition of the past’s results, if just for the fact that compounded at 20% Berkshire’s market value in 2062 would equal around $2,000 trillion, or 28 times today’s world GDP.

All this does not take anything away from the fact that Mr. Buffett recognized the forces that built his success half a century before researchers identified them as such and applied them with unflinching discipline at virtually no costs to his investors. That remains a truly remarkable accomplishment and given his energy it would not surprise us if he continues to be successful. However, we don’t know what the future will hold. Our partners who are fans of Mr. Buffett can perhaps take comfort in the knowledge that as an investor in the Triple Partners Core portfolio, you already own a piece of Berkshire Hathaway.

Warm regards, and lots of investment peace of mind,

Marius Kerdel and Jolmer Schukken

 

P.S. Mr. Buffett has not only been very frugal, he has also been an eloquent critic of those investment managers who are not. His story about the ‘Gotrocks’ is a great example. We have translated that story for the Dutch version of ‘The Investment Illusion’ that we are working on. You can find a copy the story here (NL) or here (ENG).


Notes:

  1. As comparison: the S&P 500 returned 9.2% on average over the same timeframe. $1000 dollars invested in the S&P index, even assuming no investment costs, would therefore have grown to $69,284, or 1,2% of the value of your Berkshire investment!
  2. This investment letter and much of the data used, draws heavily from the research paper: “Buffett’s Alpha”, by Frazzini, Kabiller and Pedersen, May 2012
  3. This percentage has been growing over time, starting at 20% in 1980 and exceeding 80% by 2011.
  4. The performance of Berkshire’s private companies cannot be easily measured directly. Estimating their performance by comparing the performance of Berkshire’s own share price versus that of the public companies it owns, suggests that its public holdings may have actually outperformed the private equity arm.
  5. Depending on the region and market segment. Data from Dimensional Fund advisors.
  6. They did this both by constructing portfolios that were long on ‘safe’ and ‘high quality’ and short on ‘high beta’ and ‘low quality’ and by using long only portfolios.
  7. All liabilities are included under this definition of borrowed money, so it includes insurance float (collected insurance premiums that may still need to be paid out in future claims). This number is based on net leverage, so after subtracting cash reserves from borrowing. Specifically, Berkshire’s leverage was estimated to be 1.6. ((Total assets – cash) / equity = 1.6), meaning that after subtracting cash, every dollar of equity was matched by 0.6 dollars of borrowed money.
  8. The Sept 30, 2012 balance sheet showed cash and cash equivalents of $42 billion. It consisted mostly of ultra short-term government bonds with yields of around zero. Such an approach for excess cash only makes sense if its role is to preserve liquidity and limit the potential damage associated with riskier investments. It is not invested to generate satisfying returns.
  9. This was calculated assuming conservatively that a Berkshire ‘Hedgefund’ would not have incurred any more operating expenses (in other words, the TER would be equal to the 1.6% in management fees plus Berkshire’s minimal existing overhead) and performance fees would only be paid in years that the performance was over 12%. No price data was available for the period from 1965-1967, so we estimated the returns using Buffet’s original average purchase price, which is known