As we approach Warren Buffett’s the Berkshire Hathaway (BRKA) annual shareholder’s meeting next weekend (April 30th) in Omaha – attended by thousands of investors who are seated in a sports arena with the overflow seated in other venues - several interesting academic issues arise regarding the company and Mr. Buffett. Ranking as one of the wealthiest individuals in the world Mr. Buffett is widely regarded as one of the most successful investors ever. He is commonly referred to as the "Oracle” or "Sage” of Omaha or as the “Legendary Investor” or “The Master” due to his investment expertise.
More than a dozen books have been written on the man and his investment strategy. Hundreds of articles have addressed how to ‘pick stocks’ like Warren Buffett, how Buffett is ‘playing the market’ now, ‘where will Buffett invest next’, ‘stock Warren Buffett has sold recently’, and the like. He is regularly interviewed on CNBC and other business news networks for his wisdom on the economy and markets.
Noted for his ‘value’ based investing philosophy Mr. Buffett started managing money in the late 1950’s, eventually acquiring control of Berkshire Hathaway (BRKA). He now serves as the Chairman and CEO of Berkshire and is the primary shareholder. Co-Chairman of Berkshire Hathaway is Charles Munger, another excellent investor who began managing money about the same time as Buffett – and also generated substantial excess returns for his investors.
Why do we care?
Why should we care about Mr. Buffett and Munger and their historical investment exploits? Both men have displayed a unique skill for outperforming the Dow Jones Industrials Index, their major market benchmark – by a reported 21% and 17% per year before fees for more than a decade!
Early investors who invested $25,000 or $50,000 with Buffett in the 1960’s now have a net worth of hundreds of millions as their investment compounded – and Berkshire Hathaway stock increased in value from $40 to a value of roughly $125,000 per share today. Buffett investors who invested in Berkshire saw share prices increase exponentially (as predicted by the Kelly formula, see discussion below):
Note Berkshire did not outperform the S&P 500 index every year – in fact 13 years out of 38 Berkshire underperformed the S&P index, but over time Berkshire significantly outperformed the index (the ‘law of large numbers’ applies here). Stock pricing data courtesy Barron’s (August 11, 2003).
Some may argue that it is not unusual for an investment manager to outperform the market, but academic studies indicate otherwise. Bloomberg Press recently published a book entitled “The Quest for Alpha” detailing the dozens of studies and experts that advance the notion that it is very rare for an investment manager to outperform the market after costs. And it is incredibly rare for a manager to outperform the market by more than 10% per year for more than a decade – it just does not occur.
The Bloomberg Press book points out that due to the underperformance of active money managers the trend is for institutional money to invest in funds that track the major market indexes and do not rely on active portfolio managers who buy and sell stocks based on their research. Every year individuals are also moving more of their investable assets in the index tracking funds and away from actively managed portfolios.
Buffett and Munger’s elements of success
If Mr. Buffett and Munger were so unusual in their display of investment skill and decision making it might be possible to review their historical decisions to determine what made them so unique – and why their record stands above thousands of other investment managers. It helps that more than a dozen books have been written on Mr. Buffett and a couple on Mr. Munger, and dozens of papers and articles exist discussing both.
What we find is that both Buffett and Munger developed strategies independent of each other when they were managing money separately – and these strategies tended to overlap. If we examine their strategies possibly we can learn some of the elements that made them so successful – and incorporate them into our management style.
What were some of the major elements of their investment success? First, they focused on the inefficient sectors of the market and on companies that they understood. Many of the firms the invested in were very small – ‘microcaps’ would be the term used today. And when they found situations where the stock was so mispriced that the odds were tilted heavily in their favor they invested decisively, running a concentrated portfolio. The academic argument of diversification to reduce company-specific risk was not in their playbooks.
Common investment themes
Several common themes emerge when examining the strategies of Mr. Munger and Mr. Buffett. Common elements of their strategies to generate excess investment returns include the fact that they both:
- focused on very small publicly traded companies,
- ran concentrated portfolios,
- looked for companies with niche markets,
- allocated capital based on a risk/reward analysis (Kelly formula),
- were not afraid to buy illiquid stocks,
- bought firms with growth potential,
- looked for a firm’s ability to generate attractive margins,
- bought their positions at reasonable valuations,
- managed a limited amount of assets (so they could take advantage of the small company sector),
- acted decisively, and invested heavily, when the odds were in their favor,
- bought firms that they felt they understood,
- purchased only after conducting extensive due diligence,
- were not concerned at a lack of Wall Street coverage or interest,
- evaluated dozens of firms for each one they bought,
- tolerated above-average portfolio volatility, and
- focused on the long term.
Using these strategies when they managed money and for Berkshire Hathaway Mr. Buffett and Munger targeted the small, illiquid, volatile, undervalued, un-noticed firms with solid margins and a good market niche – firms like Nebraska Furniture Mart, See’s Candies, GEICO Insurance, Borsheim’s Jewelry, and numerous other firms that had a significant impact on overall company performance.
Unloved and ignored small companies like these were a major factor contributing to Berkshire’s growth. They allowed Mr. Buffett and Munger to take advantage of investment opportunities where the risk/reward relationship was tilted heavily in their favor, giving them a huge statistical advantage. When the odds were strongly in their favor they invested heavily – Mr. Munger claims that a handful of decisions over the last 50 years can explain their incredible investment success.
Berkshire Hathaway Underperforms the Russell 2000 Index!
While many of Mr. Buffett’s early investors became quite wealthy as the company’s stock grossly outperformed the market indexes over the last ten years the excess returns on Berkshire Hathaway stock have been much more modest. In fact, over the last ten years Berkshire Hathaway stock has underperformed the Russell 2000 small cap index!
In theory, an investor in an exchange traded fund which tracked the Russell 2000 index would have had better returns than an investor in Berkshire stock! While he still outperformed the Dow Jones and Nasdaq and S&P 500 indexes the outperformance by Mr. Buffett’s investment vehicle was much smaller than it has been historically. Maybe the Bloomberg Press book entitled ‘The Quest for Alpha’ that claims investors rarely beat the major market indexes is correct after all.
As one young fan exclaimed to a player involved in the Chicago Black Sox baseball scandal almost a century ago: ‘Say it ain’t so Joe’.
Has Charles Munger thrown a wild pitch?
The relative underperformance of Mr. Buffett’s and Munger’s Berkshire Hathaway share price over the last decade not a short time frame where return abnormalities could occur) – raises the interesting academic question: Has Warren Buffett lost his Midas touch?
The short answer is Mr. Buffett and Munger are a victim of their incredible success and talent. But in our opinion many investors can still use their strategies to generate excess investment returns - even if the recent Bloomberg Press ‘Quest for Alpha’ book claims excess returns are nearly impossible to generate.
A more detailed research note explaining our reasoning, and why excess returns might be achievable, was prepared for the finance students enrolled in the Michigan Technological University’s Applied Portfolio Management Program: Has the Oracle of Omaha lost the Midas touch?
