First of all, this article is not intended to be negative towards Warren Buffett. At Netwall, we greatly respect and admire him and follow his investment philosophy to the best possible extent. Personally, having read almost all the books written about him and his own writings, I believe that "magic formula" that many people believe him to have, is not so magical after-all. I will attempt to shed some lights on these realities in this piece.
Now, two questions for this learned audience:
1. Is Warren Buffett the smartest guy in the world?
The answer is probably not.
2. Is Warren Buffett the hardest working guy in the world?
The answer is definitely not. (By his own admission in 2003, University of TN student address)
Compounding wealth is not easy and investing is not an exact science. If it were the case, all mathematicians would be the richest people on earth. It is some combination of art and science and this combo can vary from situation to situation. It can be more of a science (and less art) if you are evaluating investment options in hard asset company such as Realty Income (NYSE:O) and more of an art if you are evaluating companies such as Visa (NYSE:V) or Mastercard (NYSE:MA).
Einstein once said,
"Compound interest is the eighth wonder of the world. He, who understands it, earns it ... he who doesn't ... pays it."
Sir Isaac Newton was a famed scientist in history and he lost a lot of money in South Sea Bubble. After losing his shirt in the stock market, he said,
"I could precisely predict movement of stars and heavens but could not predict the madness of men".
So as you can already see, investing and compounding wealth had been a difficult subject, even for the smartest of all. So how can someone claim that investing is easy?
There are many biographies written about Warren Buffett and since authors have a monetary motive in publishing these books, they typically babble on and on praising Warren Buffett and trying to decipher his "mysterious" investment techniques. Well it can be argued that some of them have written books just for the love of the legend but most biographies just have good things to say about him. Nobody really wants to dig deeper into mistakes and struggles that he had to go through in order to become great. I think since many authors usually ask WB to bless their work before publishing it, they may have an incentive not to write anything negative if they want to see their writings published. I have only been able to find very few publications of extraordinary quality, which talk about WB's work in a rational fashion, shed some light on his mistakes, and most importantly the struggles that he had to endure in order to become a legend.
One such book that I would highly recommend to everyone is "BUFFETT: The Making of an American Capitalist" by "Roger Lowenstein". The best think I like about this book is that not only does it talk about how great WB's is; it also goes into actual details of his early life when he was a struggling businessman to make it as an investor. Lowenstein talks about his almost failed investments such as Buffalo Evening News (a Newspaper investment in 70's) and, are you ready…… "Berkshire Hathaway", the textile mill that almost buried Buffett and ironically later became the most successful company in the world. About early impressions of people who observed Buffett, he did not appear to be a larger than life man. Roger Lowenstein writes in his book:
"Buffet was not a hero, only a hope; not a myth, only a man. Despite his broad wit, he was strangely stunted. When he went to Paris, his only reaction was that he had no interest in sight-seeing and that food was better in Omaha. His talent sprang from his unrivaled independence of mind and ability to focus on his work and shut out the world, yet those same qualities exacted a toll………. Even at his California beachfront vacation home, Buffett would work every day for weeks and not go near the water."
His investment in "Buffalo Evening News" resulted in a monopoly lawsuit against him. A competing newspaper by the name of "Courier-Express" filed a complaint against WB for unfair business practices. Ultimately Buffett / Munger won the suit but not before appealing the first court's ruling, which was against them. That followed acquisition of "Berkshire Hathaway", a struggling textile mill, which barely produced a profit but was available on the cheap. WB later dubbed this a "Cigar-butt" approach to investing where you see this soggy used cigar-butt lying on the ground with only one puff left in it, but it's free and you take it.
My point of mentioning all this is to inform you that WB may now have become larger than life figure, but he has gone through all the struggles and disappointments that any businessman/investor has to go through before becoming great by learning the real essence of investing.
My favorite book on Warren Buffett
Magic of Compounding, More money more Magic:
Warren Buffett has gotten rich by compounding the most amount of money for the longest period of time at the highest possible rate. This is plain and simple aspect of WB's success and there is nothing "magical" about this. You see, "simple" and "easy" might seem similar phrases but they are two completely different things in practice. People do not understand this reality. Many things in life are simple (such as Warren Buffett's investment style) but they are not easy.
For making you understand a distinction between simple and easy, I can give you an example, which might be personal for you. Just think about your doctor's advice; i.e. eat an apple every day and exercise 30 minutes a day. Very simple, right? But I can assure you it is not easy. Tell me honestly, how many of you did eat an apple and exercise 30 minutes a day every day during the last 365 days? How about if I give you Christmas day off? Hmmm... not easy, huh!
This should illustrate that what seems simple on the surface is not actually easy to do. Same is the case with following investment disciplines. It is a well-known advice from the master (read Warren Buffett) to invest in businesses that you understand, who have sound managements and that are available at some discount to their true intrinsic value? Can you say honestly, that you have followed this investment advice in every single investment that you have ever made? I will leave the answer to you.
Warren Buffett has lived a frugal life style throughout his life. He used to draw $50,000 from Berkshire Hathaway in his early days to about $100,000 per year in not too distant past. His children went to public schools in Omaha. By the way he was already among the richest in Omaha when his kids were growing up, so keep that in mind. Compare this to the money managers of today, who immediately tend to have lavish life styles at the first hint of riches. They have to have mansions and yachts and need to spend lavishly to support their life style. I am not saying there is anything wrong with this if money is earned honestly, all I am saying is that extravagant spending today takes it away from your wealth, as I will demonstrate shortly. These are the reasons why some of the richest today in society will never attain the wealth equal to Warren Buffett's not because they are not smart, but because they under estimate the future value of present spending.
Before I give you some examples, I would like to share with you a book that I read 10 years that had a profound effect on my investing habits. The name of the book is "The Richest Man in Babylon" by "George Clason". I won't go into detail but in a nutshell, the book talks about the richest man in "Babylon" (the richest civilization that existed around 1894 BC) by the name of "Arcade". This gentleman was immensely rich while an average citizen had to struggle for existence. Remember, we are talking about the richest civilization in distant history. Funny, but "Babylon" reminded me of the US and "Arcade" reminded me of "Warren Buffett". The citizens of Babylonian age remind me of fellow Americans who can't stop complaining about their bills.
Anyway the point here is that Arcade made his money just the same way as Warren Buffett, only the day and age was different. In the book, there are many instances where Arcade gives investing advice to his audience and talks about virtues of compounding of money and how it can make you rich over a period of time. It is amazing that after centuries, the basics of accumulating wealth remain the same.
Fat paycheck & lavish spending will make you less rich (in the long run):
Now let's talk about really smart people in our society, many of whom are definitely smarter than Buffett (please don't be mad at me you Buffett fans out there) but I also sincerely believe that they will never be as rich as Warren Buffett. Let me clarify with an actual example:
Let's take an example of a very successful mythical Hedge fund tycoon by the name of "Mr. Smart". He is a Harvard graduate (remember WB was rejected) and has 200 IQ. Mr. Smart has consistently beaten S&P in the last 10 years. The best part (for Mr. Smart anyway) is that he regularly draws large paychecks from his firm every year with his last year's paycheck being at $200M. By many measures his investors believe that he deserves such a large paycheck as he has created much more value for them in the past years. As you might have already guessed, Mr. Smart will be an extremely rich man by the time he retires but I can tell you one thing with reasonable certainty: He won't be as rich as Warren Buffett. Here is why:
When you withdraw $200M dollars for yourself, it is safe to assume that you have a lavish style to support as well. Furthermore, with this paycheck comes your dues to your life time partner (I am not talking spouse here), the government. Although tax situations can be vastly different for different people, but let's assume that Mr. Smart is responsible for $60M in taxes (30% tax bracket). Now some of you might want to argue about tax amount, but let's keep it that way for simplicity since he does not have any losses to offset his paycheck (remember how smart Mr. Smart is). Now let's say that Mr. Smart still has 20 years to go in his career. After all, Warrant Buffett is still working at the age of 83. Let's calculate the Future value of this $60M which Mr. Smart has given to Uncle Sam, which could have been working for him for the next 20 years.
So Mr. Smart has "stolen" anywhere from $404M to a whopping $11.4B dollars from his future net worth. And this is only considering tax portion, what if he lets his whole paycheck ($200M) keep working for him for the next 20 years? Let's consider the future value of $200M compounded annually at different rates.
Ooops.... He could have attained Warren Buffett's wealth by just not drawing 1 years' worth of paycheck and letting it compound for 20 years at 30%. This might be an extreme example but clearly demonstrates the power of compound interest. This also shows how much future wealth is missed out by these humongous paychecks that these apparently smart people withdraw today. Perhaps Warren Buffett is rich by not drawing large paychecks but letting these compound quietly for the longest period of time since 99% of his net worth is still tied to Berkshire Hathaway (BRK.A, BRK.B).
So formula for being rich is not being the smartest but to realize the future potential of money and then letting it compound for years at best possible rates of return.
Before I end this discussion, I will give you an exercise, which I always give to my investing audience during live educational seminars we conduct for our clients.
Let me give you two options and please choose one without thinking too hard:
- I can either give you $1M right now, CASH ;
- -Or- I can give you only $1 today but promise to double it for the next 30 days. So on day 2 you would have $2; on day 3, you have $4; on day 4, you have $8; on day 5, you have $16; and so on. You got the idea.
Most people choose option 1 and of course this is the intuitive choice for many; nothing wrong with that.
Now let me show you how my promise will look like if you just had the patience to wait 30 days.
One dollar ($1) turns into a whopping $536,870,912 (about $537 Million Dollars), if doubled every day for 30 days. Just give it one more day and now we are talking $1,073,741,824 (Yes, this is more than $1 Billion Dollars). This shows that with passage of time, the compounding power of end sums grow exponentially.
Having trouble believing me? Pull out your financial calculator and punch the numbers yourself. Trust me, it astounded Albert Einstein too.
Have Conviction in Your Buys:
Great money managers have conviction in what they buy, which simply means that they have done their homework. If you have slightest of doubts in what you are about to invest in, stop and do some more due diligence. Here is an acid test for you to see if you have truly done your homework. If the stock that you just bought drops by 25% or more tomorrow, would you even buy more? If the answer is NO, then clearly either you have not done your homework or you don't have enough conviction in the company. Buffett bought IBM after having read its annual reports for 40 some years. Do you know someone in your investing circles, who has done such diligence before making a purchase? I sure don't.
During the market crash of 1973, the value of Berkshires portfolio had shrunk by almost 40%. WB's paper loss worsened significantly in 1974 and his net worth was shrunk by half. At that time, WB was talking about great future potential of his securities to his investors. The companies that were reporting profits were seeing their stocks crash. One such holding, Affiliated, reported a 40% earnings increase in 1973. Having gone public at $10 a share, the stock fell like a stone. The shares sank to 9, 8 & 7.5. When your pick drops by 25%, its only human nature to wonder if you have made a mistake. Lowenstein writes in "BUFFETT: The Making of an American Capitalist":
"On January 8, 1974, he [Buffett] bought more Affiliated - and more still on January 11 and January 16. He was back in the market on February 13, 14, 15, 19, 20, 21 and 22. He went on all year, like a thirsty man holding a bucket out in the rain. He bought Affiliated on 107 days, down to a low of 5.5 a share".
Now how many investors do you know of have similar conviction in their investments to buy more and yet more as these keep on falling. Bill Ackman bought JC Penny (NYSE:JCP) in 2010 at $25 and sold his entire stake in April 2013 at $12.90 taking a $500 million dollar loss. Did he not have a conviction in JC Penny when he bought the stake in the first place? Again I have nothing against Bill Ackman and he is a fine investor but many successful money managers of today's day and age perhaps would never reach Buffett's stature due to either lack of due diligence and then lack of conviction in their buys.
Warren Buffett has not become one of the richest men in the world by being the smartest or the hardest working but simply by being able to compound the largest sums of money for the longest periods of time at the highest rates of return.
As investors, we all can attempt this endeavor (perhaps our sums are not as large as his but logic is the same). This would require certain resilience and following Warren Buffett's "magic" formula which is to do your due diligence and invest in what you understand. And the most difficult part in the end is to have conviction and wait for the magic of compounding work for you over a period of time. As your money pile grows, the speed of compounding would also grow. As they show in cartoons, the size of a stone rolling downhill grows bigger and bigger as it comes down the hill; your money will grow in a similar fashion.
And if you are uneasy about investing your money yourself, don't be afraid to give it to professionals who can grow it for you at satisfactory rates.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.