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May 1, 2015

Parsing Mr. Buffett

by David Ensor

David EnsorNo doubt many readers will have noticed that this year’s annual Shareholder Letter from legendary investor Warren Buffett is a special edition, as it is now some 50 years since he took control of then-textile business, Berkshire Hathaway.

I strongly recommend that you read it in full; http://www.berkshirehathaway.com/letters/2014ltr.pdf

As an aside, if you can get hold of any of the letters Mr. Buffett wrote when he managed Buffett Partners Limited (BPL), read those too. The style and approach are basically the same now as they were then.

However, in this article, I wanted to highlight some of the attributes that have made Mr. Buffett (together with his partner, Charlie Munger) such an effective long-term investor—and I emphasize long term—and the ways you can learn from him.

Many books have been written about Buffett’s life and investment approach, by those who have far better knowledge of and access to Mr. Buffett, and I am not going to attempt to re-hash or paraphrase them. Rather, as a long time risk manager and investor-in-training, I shall try to distill what I see as the key attributes that have reinforced his demonstrable intelligence, because I believe they provide timeless advice and separate the signals from all the noise with which we are all surrounded.

Above all else, Mr. Buffett’s genius lies in the effective allocation and management of what I shall refer to as “his” capital. He does not try to second-guess the managers of the businesses he acquires, nor “get into the weeds” of day-to-day operations. Think of yourself as an investor who has a finite amount of precious capital on which you are willing to take some risk, and think about how you can and should allocate it to your investment portfolio.

Next, do not be a “follower of fashion” nor invest in businesses or sectors that you do not understand. No one can know or be an expert in everything. In other words, be comfortable that you understand what drives and affects a business’ returns and prospects; and recognize that “nothing lasts forever”—although some businesses clearly, as Mr. Buffett has demonstrated, have a defensible franchise (the famous “wide moat”) that justifies holding them “forever” (which I would define as your investment lifetime), unless and until it becomes clear that the reasons for which you made the investment no longer exist.

Be patient. Becoming rich quickly usually depends on the greater fool theory. Do not be that fool!

Be rational and dispassionate, not emotional, because emotion will almost certainly distract you and cloud your judgment. Be emotionally attached to your family, not to your investment portfolio!

Inaction can be, and often is, a virtue. Many of us feel that we have to be “doing something” with our investment portfolio to justify our ability to claim “bragging rights” amongst our peers. Mr. Buffett is demonstrably willing to wait and maintain enormous cash balances within BRK until he believes a suitable opportunity presents itself that will make a difference to BRK’s performance. We cannot all go “elephant hunting” with tens of billions of dollars, but we can and should wait until we believe we have found an opportunity or theme that will generate market-beating returns.

Following on from the last point: there is no shame in investing in an index ETF. Mr. Buffett himself has stated for the record that he has advised his executors to invest non-BRK investment funds 90/10 in a low-cost S&P index fund and cash. Very, very few active managers outperform the index over time (and it has to be a long time to be more than luck or chance!)

Compounding matters: incremental returns taken individually may not seem significant, but over the long term they matter hugely. It is a truism that for equities in developed markets, most returns actually come from reinvested dividends. Of course, BRK is a famous exception to that (at least for now) in never having paid a dividend, but that is because, over time, Mr. Buffett has been remarkably successful in compounding the book value of BRK versus the benchmark he uses of “the S&P 500 with Dividends included.” So, between 1965 and 2015, the S&P, on that basis, has returned 9.9% annually and 11,196% cumulatively—far, far better than so-called experts. However, BRK’s Book Value Per-Share over the same period has had an annual return of 19.4% (so + 9.5% per annum, which is impressive) and 751,113% (no, that is not a mis-print!) cumulatively: 67 times, the return of the S&P 500, including dividends… Read it and weep! Of course, many, if not most, individual stocks never remotely come close to such long-term returns.

You do not have to have access to management nor an “information edge” to be a successful investor. Certainly, the High-Frequency Traders made notorious in Michael Lewis’ book, The Flash Boys (which I recommend to you) have a technological edge over “normal” investors, but they are in a constant arms’ race with each other and it is highly improbable that they can endure. Similarly, most of the so-called experts in the investment world talk a good game, but their results do not bear close scrutiny (our illustrious editor being an honourable exception), because they are trying to sell you something and impress their client base, as well as their peers. Mr. Buffett is notorious for basing almost all his investment decisions on a review of available information. Only then will he address the qualities, motivations and incentives of management.

Be curious and well-rounded. Mr. Buffett may be highly intelligent and a very capable investor and allocator of capital, but he also strikes me as a very “normal” person, who enjoys a range of pursuits. He may move in exalted circles, but he appears to have no illusions about his own “genius.” The “folksiness” may be part of his public persona, but it would be surprising if it could have been maintained for over 50 years if it were not part of the man.

Be confident. By that I do not mean being arrogant, but rather that you should and must have the courage of your convictions; and be able to act decisively, without constantly second-guessing yourself. Of course, we all (including Mr. Buffett) make mistakes, but as long as the majority of our decisions are successful and we know when to cut our losses (the lack of emotional attachment, to which I referred), and our mistakes are limited in effect, the overall results will be positive.

Diversification can be over-rated. Much academic ink has been spilled on what is and should be the appropriate level of diversification for an investor: 10 positions? 20? 33? 100…? While BRK may by now own hundreds of individual businesses and investment positions, thematically it is organized into recognizable business groupings, and on a scale that one person (or a small team) can oversee and understand. As an individual investor, you will need to decide what level of diversification is appropriate for you in terms of your time and resources.

In this brief article, I cannot hope to do justice to parsing Mr. Buffet’s investment acumen. However, it should be evident from what I have written that there is no “magic” to being a prudent and successful investor. You simply have to be disciplined and focus on the actions and attributes that make the most difference for you.

(Full disclosure: the writer is a long-standing- and very modest!- investor in BRK.B shares)

David Ensor: Risk Management Consultant david.ensor@btinternet.com