It feels weird to come to the defense of Warren Buffett. The chairman and CEO of Berkshire Hathaway (NYSE:BRK.B) is widely regarded as the most successful investor of all time - a title he deserves because no one matches his track record of outperforming the S&P 500 over a similar long period. He did so while attaining the best Sharpe ratio of any company or mutual fund. Even more amazing is that he did so while managing many billions of dollars.
Fellow contributor Robert Wagner, however, doesn't view Warren Buffett as such a great investor. In fact he states:
If success is measured by the number of friends and supporters, yes, Warren is a success. His performance is another matter.
What I really like about Wagner's article is that it's a refreshing sound. Otherwise I disagree with Wagner about his interpretation of the facts. Wagner summarizes his article as follows:
- Warren Buffett has underperformed the S&P 500 total return over 5 and 10 years.
- Warren Buffett's portfolio assumes much higher risk than a broadly diversified index.
- Warren Buffett's public persona doesn't match his portfolio construction.
I'd like to discuss these key points a little more in depth:
1. Warren Buffett underperformed the S&P 500 total return over 5 and 10 years. True or False?
I've examined Wagner puts it like this:
I recently wrote an article highlighting how Warren Buffett's portfolio was highly concentrated, completely void of any vision and underperformed the S&P 500 Index for 5 and 10 years.
This is partly true. In fact I'll include the graph of BRK.B against the S&P 500 over 10 years so you can examine the difference for yourself. However, a highly concentrated portfolio can't be void of any vision at the same time.
BRK.B Total Return Price data by YCharts
I don't disagree with Wagner's performance claim over the last 10 years, but I disagree with the author of the piece that it is a better gauge of Buffett's investment prowess than his historical results.
In the graph below, you'll be able to view Berkshire's performance over the maximum period YCharts is able to show. Book value stood at $19 a share when Buffett took over at Berkshire. Since, it has compounded at almost 20 percent annually through 2013. That compares with 9.8 percent for the benchmark.
BRK.A Total Return Price data by YCharts
Buffett has repeatedly warned Berkshire's shareholders that the company's huge capital base would inevitably slow % increases in per-share book value. For example, in the 2010 letter to shareholders he wrote:
Charlie and I hope that the per-share earnings of our non-insurance businesses continue to increase at a decent rate. But the job gets tougher as the numbers get larger.
Berkshire's net worth failed to rise as much as the Standard & Poor's 500 Index from the end of 2008 through 2013, the company's annual report showed. This is the only five-year period that happened since Buffett took control in 1965.
On an annual basis, Berkshire has failed to beat the index only 10 times during Buffett's tenure, and nine of those years occurred when the S&P 500's annual gain exceeded 15 percent. The index returned 32 percent last year.
Finally, I'd like to add that even though stocks' total return easily beats that of bonds, it's possible to cherry pick a period of 30 years where bonds beat stocks. Stocks' outperformance over bonds is pretty brutal (read Siegel on the subject).
If Buffett's edge over the S&P 500 isn't as great as that of stocks over bonds, it's possible to underperform for a great number of years while actually being a favorite to outperform every one of those years. Variance in investment results should not be underestimated.
2. Warren Buffett's portfolio assumes much higher risk than a broadly diversified index.
Warren Buffett often advices investors to buy a broadly diversified index, and I can't recall he ever called Berkshire a well diversified portfolio or an appropriate alternative to an investment fund. On the other hand, Buffett is well known for saying things like:
That was my lucky moment. During the next four hours, "Davy" gave me an education about both insurance and GEICO. It was the beginning of a wonderful friendship. Soon thereafter, I graduated from Columbia and became a stock salesman in Omaha. GEICO, of course, was my prime recommendation, which got me off to a great start with dozens of customers. GEICO also jump-started my net worth because, soon after meeting Davy, I made the stock 75% of my $9,800 investment portfolio. (Even so, I felt over-diversified.)
-Warren Buffett 2010 annual report
Buffett also wrote:
We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
-Berkshire Hathaway Owner's manual
Neither Buffett nor Munger claims to agree with modern portfolio theory or wide diversification specifically. Diversification isn't a priority in Omaha at all. Munger possibly even likes it less than Buffett. However, they are definitely aware of the Kelly Criterion and have incorporated some form of fractional Kelly betting in their investment strategy.
Another problem with comparing the risk of Berkshire to that of the S&P 500 is that Berkshire is a component of the S&P 500. Berkshire's risk (in any definition I can think of) is lower than that of the average company in the S&P 500. The inclusion of Berkshire actually decreases the risk of the index.
Wagner argues that Berkshire is more volatile and illustrates this by pointing out peaks and troughs in the stock price on the chart of Berkshire A Stock (NYSE:BRK.A) vs. the S&P 500.
Against that I'd like to draw attention to the paper Andrea Frazzini, David Kabiller and Lasse H. Pedersen published last year that examined the subject of Berkshire's risk taking in depth. The excerpt of the paper reads as follows:
Berkshire Hathaway has realized a Sharpe ratio of 0.76, higher than any other stock or mutual fund with a history of more than 30 years, and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors. Further, we estimate that Buffett's leverage is about 1.6-to-1 on average. Buffett's returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks. Decomposing Berkshires' portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett's returns are more due to stock selection than to his effect on management. These results have broad implications for market efficiency and the implementability of academic factors.
Berkshire may not be safer than the S&P 500 (although it has crushed the index over its existence), but it is safer on a risk/return basis than any other stock or mutual fund with a similar long history.
I'll yield that Berkshire is more risky compared to the S&P 500 but going for the safe bet comes at a great cost: Giving up the greatest outperformance risk can buy.
3. Warren Buffett's public persona doesn't match his portfolio construction.
The final critique on Buffett by Wagner:
My real problem isn't with Warren's mediocre performance, it is the fact that his actions don't seem to match his public persona.
He portrays himself as a champion of liberal causes, hero of the little man, and yet his major holdings are the evil "multi-national corporations," corporations that make high fructose soda that can cause obesity, corporations that represent "Big Oil," corporations that are extremely non-union and worst of all, that "evil" industry that caters to the "1%ers," the home of the "banksters," Warren invests heavily in Wall Street banks.
Warren Buffett is mindful of his reputation and consciously made the decision to stay away from investing in some industries like tobacco. Especially if he can make similar gains elsewhere, he'd rather avoid investing in vice, but he isn't committed to staying away from anything.
It's possible to perceive a conflict between Warren's public persona and his management of Berkshire. However, this mainly depends on how exactly you view Buffett's public persona. The more you read and listen to him (and pay less attention to what others say about him) the smaller this gap will be.
Even Buffett's investing style is often misunderstood. One of the most original books about it is "How to trade like Warren Buffett" by James Altucher. An unlikely title for a book about Buffett, but it is a highly original view of Buffett's investing.
Something that will help a lot with understanding Buffett is realizing his fiduciary duty to his investors comes first. He is committed to shielding their money and outperforming the market.
When he critiques the legislative branch, it reflects his opinion, but he will work to obtain the best results he can for his investors within the current system - even if he thinks it should be changed in some way. He isn't going to set examples with his investors' money.
It should also be noted that Buffett doesn't manage Berkshire Hathaway by himself. For example, Charlie Munger is a very important force within the company. Charlie is not as liberal as Buffett.
Again it's possible to perceive a disconnect between Buffett's public persona and Berkshire's portfolio. If you just read or listen to primary sources (like the Berkshire letters to shareholders), keep in mind that Buffett has adapted often and has been flexible throughout his career, there is no mismatch. For example: If Buffett says his favorite holding period is forever, it shouldn't be taken to mean he will never make a trade.
If there is one company that is a favorite to outperform the S&P 500 over long holding periods (some of Buffett's skill is priced in, so it's better to buy for the long term), it is Berkshire. Ironically, one of the reasons the stock price may not reflect Buffett's skill fully, and thus helped cause the 5-year underperformance to the S&P 500, is Buffett's age.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.