Let Warren Buffett Handle Your Portfolio

Warren Buffett is one of the most celebrated investors of all time. Buffett learned his craft from his mentor, Benjamin Graham, author of the legendary tomes Security Analysis and The Intelligent Investor. Graham ran his own investment partnership for years, grounded on the concept of buying stocks that were cheap compared to their intrinsic value. He preached about buying securities that had a “margin of safety”. After a lifetime spent studying stocks, Graham stated the following in the Financial Analysts Journal (1976):

In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days any well - trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market ” school of thought now generally accepted by the professors.

And Graham came to this conclusion prior to the advent of the Internet, Bloomberg, and other modern research tools! The efficient market hypothesis (EMT) was certainly making the rounds through academia and the investing public at the time. However, Warren Buffett has famously dismissed the theory, stating, “I'd be a bum on the street with a tin cup if the markets were always efficient.” Would the student be able to prove the teacher wrong?

Buffett’s Chairman’s Letter in the 2007 Berkshire Hathaway (BRK.A) annual report indicates that the per-share book value of Berkshire Hathaway has increased at a compounded annual rate of 21.1% since 1965. Compared to an average of 10.3% for the S&P 500 including dividends, the outperformance is astonishing.

For Buffett's style of value investing to be successful, the efficient market theory must not be valid. Buffett himself has said, “the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us.”

While Warren Buffett has practiced some hedge fund techniques such as trading currencies and commodities, merger arbitrage, convertible arbitrage, PIPEs, and private equity, he is known mostly for his equity investments. There have been numerous books that have tried to divine exactly how Mr. Buffett goes about selecting his investments. The American Association of Individual Investors (AAII) and web sites such as Validea.com have developed screens that are designed to find companies that Warren Buffett would buy based on criteria he has promoted in the decades of public speaking, annual reports, and prior transactions. Indeed, some investors simply buy Berkshire Hathaway stock, gaining access to his portfolio management skills, exposure to the operations of an insurance conglomerate, and entree into the Berkshire Hathaway annual shareholder meeting.

An investor who wants exposure to Buffett’s investing acumen can invest in any of the mutual funds that share the Buffett investment style. When Warren Buffett closed his investment partnership in 1969, he advised his investors to place their money in the Sequoia Fund, managed by Ruane, Cuniff & Goldfarb, Inc. (which reopened in 2008 for the first time since 1985). The Tweedy Browne family of funds are another good example — in fact, the firm was founded by several employees of the Graham-Newman partnership.

But why not just buy what Warren buys? I set out in this writing to examine whether following Berkshire Hathaway’s investments, utilizing Form 13Fs, could offer the investor the opportunity to piggyback on Buffett’s stock picks, and consequently, achieve outsized excess returns.

Here is the free clone demo on AlphaClone for Buffett's portfolio. You can go in and play around and test more strategies (how would his portfolio perform if you hedged it 100% with the S&P 500, how would it look if you only took the new buys, etc.)

Following the methodology presented in the previous articles, the following results for the period from 2000 to 12/15/2008 are found below. The Buffett portfolio with 10 long holdings equal-weighted and rebalanced quarterly is compared to the returns to the broad U.S. market (S&P 500). Buffett's current clone portfolio would be:

Wells Fargo (WFC)
Coca-Cola (KO)
Procter and Gamble (PG)
Conoco Phillips (COP)
Burlington Northern (BNI)
American Express (AXP)
Kraft (KFT)
Johnson and Johnson (JNJ)
US Bancorp (USB)
Wesco (WSC)

The first observation is how dismal the returns have been for stocks this decade. Less than -3% a year with a near 50% drawdown is depressing indeed. (The drawdown figures are currently at a monthly resolution; this will be updated in a future AlphaClone release.)

BUFFETT
Annualized Return: 5.5%
Volatility: 13.2%
MaxDD: -27%
(Max DD is maximum peak to valley drawdown, measured monthly.)

S&P 500
Annualized Return: -3.9%
Volatility: 15.6%
MaxDD: -44.1%

Buffett returns over 5% a year, which doesn't sound that spectacular but it beats the market by more than 9% per year with volatility less than the market. $100,000 invested in the Buffett portfolio would be worth approximately $150,000 today vs. about $75,000 invested in the S&P500.

(There are plenty of clones with much better numbers, but I am using Buffett as an example as most are familiar with him and I don't want to look like I am cherry-picking a fund.)

(Click on the chart to enlarge)


Source: AlphaClone

About 85% of Buffett's portfolio is concentrated in his top ten holdings. Volatility was low, surprising given that the portfolio contained only 10 holdings. If you ran a mutual fund with these numbers you would probably be one of the best performing mangers in the United States over the time period.

A recent academic paper has examined the strategy for Buffett all the way back to 1976 and found results consistent with mine. From the abstract:

Contrary to popular belief, we find Berkshire Hathaway invests primarily in large-cap growth rather than "value" stocks. Over the period the portfolio beat the benchmarks in 27 out of 31 years, on average exceeding the S&P 500 Index by 11.14%. We find that Berkshire Hathaway's portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value. While increased volatility is normally associated with higher concentration we show the volatility of the portfolio is driven by large positive returns and not downside risk.

Another simple application is running a hedged portfolio. In this example, I simply use a 50% S&P500 hedge on the portfolio, updated quarterly. (I do not include short rebates which would improve the returns further.) This technique has the obvious effect of dampening volatility and drawdown significantly:

BUFFETT 50% HEDGED
Annualized Return: 7.4%
Volatility: 9.2%
MaxDD: -12.6%

Now that I have shown that the process can work for a single manager, how about a group of custom managers? In Part III we examine a custom "fund-of-funds" approach applied to the progeny of Julian Robertson's Tiger Management.

Comments

[TaxRECapGai...:]

He's going to buy CHK next. Mid-American, Pipelines from Enron, COP, there is a nat gas theme with BRK-A that's going to continue.

2008 Dec 19 03:03 AM

[ikkyu:]

[Initially published at World Beta]

Greeting Folks,

I am a huge fan of Mebane's stuff and this site has taught me a lot. Thus, I just want to go through an example to see if a pure alpha extraction of a Buffet port is going to work.

Here is how I break it down with today's numbers for a $100,000 port on prices and margin for today. Consider two options. The first might be buying SPY one year at-the-money options. Right now, they would cost about 15% of the port and that is only with a delta of 50 (i.e. an imperfect hedge). You could use emini S&P futures. You would need about 2 and a quarter contracts and your initial maintenance margin would be $13,923( at Interactive Brokers), or roughly 14% of the port, if you could have fractional contracts). You would be asked for more margin if the trade was going your way. You also lose about 1% a year for yours service and there are the trade transactions. I don's see how this is going to work. 3:1 leveraged ETF would require at least 33% of the port (and would work horribly).

Your example had a 50% hedge so that would require about 7.5% of the port value to hedge with a return of 7.4%? Whoops…. You would be at least minus 1% with your service fee. That is assuming your hedges went well (they aren't always so tidy).

I would take a good look at the alpha extraction sales pitch. It doesn't seem to add up to me. Am I missing something?

Cheers from Osaka,
john

2008 Dec 19 04:09 AM

[long_on_oil:]

You could buy what Buffet buys but the secret to Buffets returns is the sell and you would always be to late on that side. The average investor knows nothing about options so that is not an option. So, the best option is to just buy brk-b shares, and forget about looking at your monthly statement.
Buffets 2007 annual report had a section about the 100 year return of the market from 1900 thru 1999 and it was only 5% so if Buffet makes you 5.5% he is beating the market by 10% a year and that is damn good.
There are only a handful of investors that have a 50 year track record that can even come close to Buffets. I'll trust him with my little nest egg and I won't lose any sleep over it.

2008 Dec 19 08:47 AM

[Nick Gogerty:]

I really appreciate the quote from Graham. Nice find. Most "value" adherents are looking for something cheap and trapped in simple mathematical analysis. Charlie Munger gives some insights into business dynamics that are far more interesting in his book. rcm.amazon.com/e/cm?t=...

2008 Dec 19 11:07 AM

[auto44:]

Why pay a mutual fund to a fee when you can buy (brk-b)? As I recall Warren dosen't think value and growth are different things. Folks who pigeon hole investments often cause more confusion than not.

2008 Dec 19 11:21 AM

[John-Galt:]

This seems a bit sloppy to me. Did the comparison take into account the purchase delay in buying something after WB has actually filed a 13F?What about the losers he has bought and dumped ? What about the winners he no longer owns? What about the investments he makes that are just not available to the rest of us? What about the insurance company nature of his capital base? What about the wholely-owned businesses? What about the variances in capital allocation?

2008 Dec 19 11:48 AM

[notsosmart:]

what happened to acas?

2008 Dec 19 01:17 PM

[Glenn McSpa...:]

I've been thinking about doing something like this. Thanks for all this research....

2008 Dec 20 06:57 PM

[sr9web:]

Buffett is a greedy wanker.

When he buys stocks, he insists on getting good yield via juicy dividends.

But Berkshire stock pays ZERO dividends.

2008 Dec 21 01:20 AM

[jayceh:]

Last time i checked, if a company is making outsized returns versus the market, it is ideal for them to retain as much cash as possible without issuing dividends.
Buffett is simply forcing you to reinvest any "dividends" back into berkshire. He figures and has said so repeatedly, that as long as he is growin per-share value at a greater rate than the market, he will not pay out dividends.
Once berkshire has grown too big and its returns can no longer outpace the benchmark, dividends will begin.

sounds good to me.

2008 Dec 22 03:17 AM

[heartky:]

When you buy BRKB you are buying the operating companies as well as the investments. What percentage of BRKB's assets are represented by investments. How are the operating companies themselves doing?

2008 Dec 31 01:24 PM

[mkreisel:]

With so many other insurance firms in trouble, don't you guys think insurance premiums are going to firm up a little bit, especially those super-cat reinsurance stuffs?

2008 Dec 31 11:44 PM

[Financial P...:]

Just a note on something you said: "For Buffett's style of value investing to be successful, the efficient market theory must not be valid"

***

This is a common fallacy I see a lot. Usually, I see either:

1) the market is efficient, and by efficient they mean that all information is reflected in the stock price at any given time

or

2) the market is inefficient and by inefficient they mean that it is "irrational".

But I think these are false alternatives. The market is efficient *because* of the traders making rational evaluations about the value of companies. They are seeking to maximize profits - they don't always get it right, but their motives are rational, they want to make money.

The reason they're able to make money is that not all of the info is reflected in stocks (and an obvious conflict which demonstrates this is the illegality of insider trading), but even if insider trading were legal, it takes time for information to reach the market. Nothing happens instantaneously. When price discrepancies are found, or new information implies that a stock ought to be more valuable than what it is (based on the values of the participants trading in the market), then that represents a profit opportunity.

It's incredible if you think about it. Those stock pickers - despite their humility - are pretty smart.

Jan 13 03:50 PM