Being Good, Until One's Not

Includes: BRK.A, BRK.B, SPY
by: Salil Mehta


Berkshire Hathaway's recent annual report has some issues with it.

Sure the performance is great, but the performance summary commentary is misleading.

Still, if statistical mean-reversion has anything to say about market patterns, then Buffett should experience continued underperformance at the same good rate in the future.

From Berkshire Hathaway's (NYSE:BRK.A) recent 2013 Annual Report:

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong - as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%.

On one hand, Warren Buffett has had some incredible performance for 49 years. On the other hand, his probabilistic comments concerning performance falls short of expectations. Is a S&P gain exceeding 15% considered "strongly up"? If Buffett underperformed nearly 1/5 of the time, then we might think a "strongly up" market is a threshold only achieved only about 10 of the past 49 years. But in fact, a S&P rise over 15% is far more commonplace, occurring in 24 of the past 49 years (nearly half the years). So the quote above has the same absurd utility as a politician stating he or she doesn't always lie, but when he or she does it mostly happens during even years (e.g., 2008, 2010, 2012, etc.)

See the chart above for the annual frequency count of S&P performance, and the frequency count for Buffett's underperforming years. Now some can be thinking, among other things, that underperformance in those 24 years was only 9 times (so just 38% of the time).

The issue with this line of thinking is that it implies there is homogeneity in this underperformance relative to the S&P's >15% annual performance. Here too, the underlying statistics fall apart. Let's decompose this chart above and isolate Buffett's performance during the past 5 years. We see in the chart below that 4 of the 9 years that Buffett has underperformed, during "strongly up" years, were in just the past 5 years. And there were 4 "strongly up" years in the past 5, so Buffett didn't underperform 38% of the time then, but 100% of the time (4 of 4).

More broadly, nearly half of this "strongly up" deterioration, in Buffett's 49 year investment history, has happened in just the past 5 years (4 of 9). See the green triangle data, in the lower-left of the chart here. Certainly that should have been part of the quote above.

And, could this performance have something to do with the strong run in the S&P during the past five years? Once again this is false. We also show below the segmentation of the top chart, with two other five-year timeframes. In the charts below we see in 1995 through 1999, only 1 of 5 "strongly up" years did Buffett underperform (so down to 20%, from 100%). And further back in time, from 1984 through 1988, none of 3 "strongly up" years did Buffett underperform (so now down to 0% of these times).

So if we see anything, from the time frame decomposition, it is that Buffett's underpeformance has simply taken some lumps along with everyone else with such a lengthy investment career. His performance is great, but the quote above in the annual report is poor. An analyst should interpret the biased quote as misleading statistics.

Beyond this, if statistical mean-reversion has anything to say about market patterns, then Buffett should experience continued underperformance at the same good rate in the future. This would be true even if the annual up-streaks in the market dissolve back to a more normal, efficient market pattern.

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. I have no business relationship with any company whose stock is mentioned in this article.