Money Managers and the Berkshire Hurdle

A month ago Fortune published an article about a hedge fund of funds group that made a bet with Warren Buffett that it could pick a group of funds that would outperform the S&P over the next ten years. I remember in particular the last line of the article, in which Ted Seides, one of the bettors, said the following:

Fortunately for us, we're betting against the S&P's performance, not Buffett's.

Wait a minute, say I. That statement might be true in terms of the specific bet, but it's certainly not true in real life. As I see it, every money manager who accepts outside investors' money, especially those who call themselves value investors, is essentially "betting" that he can beat the performance of Berkshire Hathaway. Imagine the following scenario: You're interviewing a potential hedge fund manager and he says the following:

1) "I'm a value investor. All my life I've idolized Warren Buffett.  I go to Omaha every year. He inspired me to start my own hedge fund. I own Berkshire shares myself."

2) "I will charge you 2% of assets and 20% of profits for the benefit of my investment prowess, which is a combination of my own ability and the principles I've learned from my idol, Warren Buffett."

So far so good. Some variation of the above can be heard all the time in Midtown Manhattan conference rooms. Now it's your turn. You should say the following in reply:

3) Your idol, Warren Buffett, is still alive and still working hard.

4) I can become partners with Buffett today, simply by buying a share of Berkshire Hathaway. If I did that I'd get the benefit of his ability and his principles firsthand, cutting out the middleman as it were.

5) Berkshire's stock price, $120,100 as we speak, certainly does not seem overvalued, and may in fact be significantly undervalued.

6) It does not cost 2 and 20 to become Buffett's partner. It costs maybe $10 to buy one A share, plus my share of Buffett's $100,000 salary: about 6.5 cents per A share per year.

7) Berkshire Hathaway is rated AAA and it's a "real" AAA. Chances are your hedge fund holds positions in sub-AAA names, so on a look-through basis it's less than AAA. Chances are it also borrows money on such terms that would make it less than AAA.

8) Given all this, doesn't it make more sense for me to buy Berkshire than to invest in your hedge fund?

If your potential money manager answers this question by saying "Fortunately, we're not betting against Buffett's performance," you should then say "You may not be, but I certainly am, relatively speaking, if I invest with you instead of him." 

My point is this: Your money manager should be able to articulate why he expects the high-cost investment option -- his hedge fund -- to outperform the readily available low-cost option. I'm not saying it's impossible to beat Berkshire, but your money manager should have the integrity to concede that that should be his goal, and you are entitled to know how he expects to do it.

Comments

[tvb:]

Hedge fund fees are, indeed, ridiculously high, but there's one flaw in your argument with respect to Berkshire: You don't take into account Berkshire's massive size relative to most, if not all, hedge funds. If Warren Buffet was running a small to medium-sized fund it would be different. However, the Berkshire entity has grown so massive, that they need to invest multiple billions in any one investment idea, just to make a dent in performance returns. I think anyone would agree that this creates prohibitive scale/liquidity/techni... issues for most potential investment ideas and reduces profit potential. Also, on what basis do you suggest that Berkshire's stock is not overly or fairly valued? Buffet's investment acumen is certainly no secret, so shouldn't his skills be already priced onto the stock? Berkshire is an extremely difficult stock to value, not least because it's hard to determine how you discount Buffet's advanced age when considering longer-term future performance. Berkshire is a great company, but as it's said: "a great company is not necessarily a great investment, but it's a good place to start looking". Disclosure: I am, in fact, long Berkshire.

2008 Aug 18 05:17 AM

[Umm, yeah:]

Good article. Good comment by tvb. Thanks!

2008 Aug 18 08:16 AM

[Nadav Manham:]

Thank you for your comments--I agree with you. The point of my post was not to argue that it's impossible for a hedge fund to beat Berkshire Hathaway. There are several good arguments why you can and you've just made some of them.

The point of my post was to make this issue part of hedge fund manager due diligence. I imagined myself interviewing a potential hedge fund manager who calls himself/herself a Buffett acolyte, as many do. I ask the magic question--"Why shouldn't I just invest in Berkshire instead of you"--and see what happens. Like the "Why are manhole covers round?" type questions they ask in Google interviews, the point of the question is really to see how the person thinks:

If the answer is some version of "We're not competing with Warren Buffett" then I make my snappy "Well I am, if I invest with you" comeback, and conclude in my head that this person is not thinking from the point of view of a principal--the guy with the money and all the options in the world as to where to put it. Also, it's likely that he/she has not internalized the fact that in order for the limited partner to beat Berkshire--i.e. after all fees and taxes and adjusting for risk--the GROSS returns of the hedge fund must beat Berkshire's by a very significant margin.

If the answer is "Berkshire is too big now to outperform" but then I find out my guy wants to be a $15bn hedge fund manager, or if I find out his fund is loaded with mega-cap names that negate this size advantage, then I would scratch my head a little.

If the answer is "Berkshire is overvalued" then I get to ask "Why do you think that?" As a self-proclaimed Buffett acolyte, my interviewee should be an expert on the subject.

If the answer does not include some discussion of risk, especially some acknowledgment of the fact that a 10% Berkshire return is "worth more," on a risk-adjusted basis, than the same 10% from a hedge fund that employs leverage itself and owns positions in highly-leveraged companies, then I've learned something important there.

2008 Aug 18 08:44 AM

[najdorf:]

The other thing about comparing BRK to a fund is that a lot of funds would be easier to get your initial investment out of if the manager retired or died. This might not be true of a hedge fund, but for a regular mutual fund, if your investment thesis is driven by managerial skill, you can sell out at NAV at the end of any day. If Warren Buffett leaves BRK, you can't sell out based on the value of the KO, WFC, AXP, etc. shares the company holds - you can only sell based on what other investors will pay you for a non-Buffett-managed BRK.

2008 Aug 18 08:46 AM

[TonyCinTX:]

I am long Berkshire as well.

Note that Buffett himself acknowledges TVB's point and has said BRK is so big it cannot achieve the returns it had in the early years.

The hedge fund manager's argument can be straight from Buffett himself: Warren has said he could earn 50% annually in the market if he were investing millions, but there is an upper limit because the companies that can deliver that kind of return are small and don't scale instantly.

But suppose we are talking about a $50M fund, if it earns 50% that is $25M, if the manager takes 20% and leaves investors $20M, that is 40% on the money. That beats the hell out of Buffett's average of 14%.

That would be the model argument for a hedge fund manager that wanted to claim he is the 40 year old clone of WB and wants us to pay him $5M a year.

2008 Aug 18 09:09 AM

[tvb:]

Good points Nadav and Najdorf. When you invest in a fund you pay the net asset value of the holdings and agree to forego a share of future performance returns through fees. With BRK, the market is theoretically valuing the assets/holdings plus or minus a premium/discount based on assumptions about the future performance returns on those assets. That cost/premium for BRK could translate into a cost much greater than a hedge funds 2/20 fees if the the market's growth assumptions for BRK are high enough (e.g say the share price requires a 40% annual return on assets/holdings just to justify the price). In other words, just because BRK shareholders don't pay a traditional fee for management's expected ALPHA generation, it doesn't mean they aren't paying an equal or greater fee/cost through a high share price premium to asset values.

2008 Aug 18 09:11 AM

[Rong:]

My financial acumen is likely well below the median of the other Berkshire shareholders, but silly me thinks Buffet’s longevity has long been factored into the stock price.

2008 Aug 18 03:08 PM

[whidbey:]

I like BRK because it is in the financial sector and might some day recover all its losses based on that fact. It might even dominate something and do very well (insurance). Until then I am stuck and not too happy with either my hedge funds or Warren. And who gives a damned about the comparative virtues of the non-performers? I am just stuck and trying to be big about it.

2008 Aug 18 04:35 PM

[najdorf:]

To say that BRK is in the financial sector is to over-simplify. First of all there's a distinction between insurance companies and banking companies. Secondly, a huge portion of BRK's book value comes from Buffett's stock picks, which of course include picks like KO (along with some big financial positions like WFC and AXP).

Secondly, you can't really blame Buffett for the low share price of any given moment. He can't control what investors are willing to pay for the company or for its stock holdings. He can only create value, which the price will reflect in the long run. He's the quintessential buy-and-hold investor, and if you don't fit into that profile then you shouldn't be a BRK shareholder. It's not the same as holding a mutual fund with 300% turnover, where you should blame the manager if he underperforms the relevant indices.

2008 Aug 18 10:34 PM

[mkreisel:]

BRK.A is not very attractive at moment:

1. We are in a bear market, and bear will get everyone in the end. BRK.A lost 50% in 1974, 35% in 1990, and 40% during the value stock bear market between 1998-2000. This stock is not immune from general market declines.

2. Insurance is in a cyclical decline. After several hurricane-free years, people get gaga again in the supercat business; on the auto side, there seems to be a major price war going on. I'm receiving "lowest price" solicitations from AIG, Allstate, Farmers, State Farm and etc almost on a daily basis. In a climate of rising inflation and higher claims down the road, declining insurance premiums is the last thing a P/C company needs.

3. Valuation for BRK.A is not that great either. It looks cheap compared to the bubblicious late 90s, but is at least 30% more expensive than the 1990 low. Even as late as 1988, BRK.A traded at 1.0 times book when it was a lot smaller, growth prospect a lot better, and Buffett a lot younger.

2008 Aug 23 07:36 PM