Buffett's Investment Record-Luck or Skill?

Nassim Taleb, author of Black Swan, was recently quoted as saying "I'm not saying Buffett doesn't have skill-I'm just saying we don't have enough evidence to say Buffett isn't doing it by chance."

For the record, over the past 45 years the book value of Berkshire Hathaway's stock has grown at a rate of 20% plus while the Standard & Poors 500 index has appreciated by a rate of 10% plus. It's difficult to understand what evidence Mr Taleb is missing.

I suggest that he read Mr. Buffett's article, The Superinvestors of Graham-and-Doddsville, an edited transcript of a talk he gave at Columbia University in 1984.

A few excerpts follow:

Is the Graham and Dodd "look for values with a significant margin of safety relative to prices" approach to security analysis out of date? Many of the professors who write textbooks today say yes. They argue that the stock market is efficient; that is, that stock prices reflect everything tat is known about a company's prospects and about the state of the economy. There are no undervalued stocks, these theorists argue, because there there are smart analysts who utilize all available information to ensure unfailingly appropriate prices. Investors who seem to beat the market year after year are just lucky......Well, maybe. But I want to present you with a group of investors who have, year in and year out, beaten the Standard & Poors 500 stock index.

The common intellectual theme of the investors of Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market.....Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of interest to them. In fact, most of them would have difficulty defining these terms. The investors simply focus on two variables: price and value.

While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.

I urge Mr. Taleb read the entire article, which many consider to be the best on investing ever written.

You Don't Have to Swing at Every Ball

In his excellent account in yesterday's Wall Street Journal of Warren Buffett's investments the past year, Scott Patterson writes:
"Warren Buffett believes his best deals during the economy's biggest belly flop since the crash of 1929 may well turn out to be the ones he didn't do..... I don't think Buffett gets enough credit for all the pitches he doesn't swing at," says Paul Howard, an analyst at Janney Montgomery Scott. "And he gets a lot of pitches."
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Scott Patterson, In Year of Investing Dangerously, Buffett Looked 'Into the Abyss', Wall Street Journal, December 12, 2009

Buffett would agree. He frequently refers to the following baseball hitting analogy when describing his investment philosophy.

"Ted Williams wrote a book called “ The Science of Hitting.” In that
book he had a grid of 77 little zones in the strike zone. He said if he
only swung at the balls in this one area, “the sweet spot,” he would bat
over 400; if he swung at the balls on the outside corner and low but
still a strike, he would bat at about 225. So he said everything in life
is about waiting for the right pitch. In baseball if you have 2 strikes
already and you get one of those 225 balls you still have to swing at
it because there aren’t any more balls. In investing, you never have to
swing. Now, if you swing and miss, it’s a strike, but if you wait and the
pitcher gets tired and he keeps throwing balls at you and finally you see
one right in your sweet spot and you understand and you swing at it
and you only have to do that a few times in a lifetime. You only have to
get a few hits, you don’t have to get up everyday and take five at bats
and swing at every ball."
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Warren Buffett, "In His Own Words-Conversation With Charlie Rose," PBS (May 2, 2004).

"Active" versus "Passive" Investing

Today, the Wall Street Journal reports on a recent study by Morningstar. Selected excerpts follow:

"While it has been established that most actively managed mutual funds lag behind their indexes over time, a new study further twists the knife: Active management suffers even more by comparison on a risk-adjusted basis.

The study found that in many cases where an actively managed fund beats its index on an absolute basis, the additional risk it took didn't justify the returns earned. Not only should that be a warning sign for investors -- because greater risk means greater volatility -- but it also suggests that fund managers aren't living up to what is expected of them.

The study by Morningstar Inc. found that, over the past three years, while about half of actively managed funds outperformed their respective Morningstar indexes -- which cover the nine different Morningstar investment styles -- only 37% did on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns.

"It's not enough to beat an index in a way (that assumes more risk)," said Travis Pascavis, director of equity indexes at Morningstar. A riskier fund should provide greater returns, he added.....

The key to thinking of risk in terms of returns versus an index, he said, is that, in theory, if investors wanted to take on more risk for greater returns, they could simply buy an index fund and lever up their exposure. That would also increase returns while adding risk -- and do so at a cheaper cost than most actively managed funds. It is against this standard that actively managed funds should be judged, he said....

Mr. Pascavis said it is important for investors to be comfortable with the risk they are taking on when they buy a mutual fund. What is more, his study found that if a fund has higher risk, it is often a sign of an underperformer: Funds performing in the top 25% over the past three years had much lower risk and volatility than their peers.

"There is generally a positive relationship between risk and return, where better-performing funds are riskier; however, this has not been the case over the last three years," noted the study, which added that poor returns of the recent market likely helped less-risky funds.

Even in absolute terms, the results highlighted the shortcomings of many actively managed funds. Over the past five years across the nine Morningstar-style boxes -- value, core and growth in the small-cap, midcap and large-cap sectors -- only large-cap growth and midcap value saw more than half of active managers beat their indexes..... "
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Sam Mamudi, Active Management Loses in Risk Study, New York Times, September 8, 2009

Buffett would agree with the findings of this study

"Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders......."

Warren Buffett, 1996 Letter to Berkshire Hathaway Shareholders

In January 2008, to prove his point, Buffett entered into a bet (each side put up $320,000, with the final proceeds going to the winner's favorite charity) with Protege partners, a fund-of-funds hedge fund, that their handpicked funds will not beat the S&P 500 index over the next 10 years. A principal of Protege said, "Fortunately, for us, we're betting against the S&P's performance. not Buffett's"

The 2-and-20 Crowd

In his recent New York Times article, Andrew Ross Sorkin reports on a conversation he had with Guy Hands, a longtime private equity manager who “offered the most frank assessment of the private equity world-including his mistakes-I had ever heard from anyone still gainfully employed in the business.”

“We all had too much money. It was just too easy.” That’s the unvarnished appraisal of the private equity business by Guy Hands, perhaps best known for his unfortunate $4.73 billion purchase of the record company EMI in March 2007, the peak of the buyout boom — a bet that will almost certainly lose his investors and his firm, Terra Firma, a fortune.

That ill-timed acquisition aside, Mr. Hands’s surprisingly candid assessment of the private equity industry is worth sharing. He was in the midst of the industry’s growth to dizzying heights during the debt-fueled boom, and he is now having to deal with the aftermath of its shopping spree. Like others, he is desperately trying to keep businesses afloat and pay off the equivalent of huge monthly mortgage payments to the banks that financed them.

The problem, he said, was that the funds had grown so big that the 2 percent became just as important as the 20 percent.

"Clearly a large number of P.E. firms were totally overpaid at the peak of the market,” he said. “The fees were an entirely unwarranted windfall....."
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Andrew Ross Sorkin, A Financier Peels Back the Curtain, New York Times, September 22, 2009


Warren Buffett has long been critical of the private equity business.

“In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee.

…. the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.”
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Warren Buffett, 2006 Letter to Berkshire Hathaway Shareholders

"Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private."
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Warren Buffett, 2008 Letter to Berkshire Hathaway Shareholders