Anyone who touches public market investing sings endless praise for Warren Buffett. But how many public market investors invest like Buffett — that is, actually employ the same strategy to generate superior returns? Remarkably few, it seems.
The Mutual Fund Observer recently profiled the Bretton Fund and interviewed its manager Stephen Dodson:
In imagining that firm and its discipline, [Dodson] was struck by a paradox: almost all investment professionals worshipped Warren Buffett, but almost none attempted to invest like him. Stephen’s estimate is that there are “a ton” of concentrated long-term value hedge funds, but fewer than 20 mutual funds (most visibly The Cook and Bynum Fund COBYX) that follow Buffett’s discipline: he invests in “a small number of good business he believes that he understands and that are trading at a significant discount to what they believe they’re worth.” He seemed particularly struck by his interviews of managers who run successful, conventional equity funds: 50-100 stocks and a portfolio sensitive to the sector-weightings in some index.
Stephen says:
I asked each of them, “How would you invest if it was only your money and you never had to report to outside shareholders but you needed to sort of protect and grow this capital at an attractive rate for the rest of your life, how would you invest. Would you invest in the same approach, 50-100 stocks across all sectors.” And they said, “absolutely not. I’d only invest in my 10-20 best ideas.”
The obvious question is why this is. There are various incentives that distort fund managers’ behavior, certainly. But my guess is that a large number of public market investors think they’re investing like Buffett, but they’re actually not disciplined enough to follow the value strategy all the way. It’s no wonder the average returns from actively managed mutual funds (versus index funds) are so disappointing.
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I should note that Steve is one of my closest friends. And not just because he’s made me money from my being an investor in the Bretton Fund.
Breaking with financial orthodoxy is difficult. Fund managers are generally expected to utilize an approach based on conventional risk management techniques and modern portfolio theory, which means diversify, diversify, diversify…
The Buffet approach looks smart if you make the right choices, but can be disastrous if you make the wrong ones, especially when handling money that isn’t your own. This is why higher risk approaches are reserved for hedge funds, whose investors can take on more risk than conventional mutual fund investors. Also, Buffet’s approach is more than just “investing in good companies”- he specifically seeks ‘franchises’- i.e. natural monopolies or near-monopolies – that deliver very regular returns. Relatively few companies meet all of his criteria. It’s much more than just a matter of discipline.
(Not that it’s impossible to apply rules similar to Buffet’s for other sorts of companies- he based much of his strategy on the work of San Francisco technology investor Phillip Fisher. While Buffet is famous for saying that he doesn’t understand technology or tech investing, one of his gurus made fortunes for clients by investing in companies like Dow and Motorola before their big runs.)
I’m also a huge fan of Stephen Dodson, but here’s an alternative Theory of Buffett for all to ponder:
– The financial markets have a huge number of equally sophisticated participants. Each one has a 50% chance of outperforming the market each year (and a 50% chance of underperforming).
– For each of these participants, the chance of outperforming the market for 20 consecutive years is 1 in 1 million.
– Once you outperform the market for 20 consecutive years, you suddenly have a “halo” effect that allows you to get above-market returns simply because people want to affiliate with you for brand reasons. (See GE during the financial crisis for example.)
The point being, perhaps there’s no deep source of Buffett’s differentiation that requires explanation? And maybe people aren’t following his example because (a) their ability to outperform the market is random anyway and (b) the sweetheart deals he now receives aren’t available to others.
A 1 in 1 million chance of outperforming the market for 20 consecutive years is roughly a snowball’s chance in hell (the odds of making as astute investments as Warren Buffett using other people’s money).
Nicholas MacDonald is right– Buffett’s “value investing” is more than just investing in good companies, and as much about seeking monopoly rents.
A long-term, focused approach to investing is certainly different from subjugation to robo-trading algorithms: don’t forget the Hathaway effect– Warren Buffett’s Berkshire Hathaway stock jumps when Anne Hathaway is in the news.;-)
Ben, you are right when you say many investors are not “disciplined enough to follow the value strategy all the way”.
As Nicholas mentioned above, discipline is only one element in the way Buffet invests. Perhaps there are other additional reasons for this disconnect between the way investors deploy outside capital versus their own money:
1) A desire for quick results. Most Investors want to earn money very quickly-they suffer from impatiency bias (Buffett has said “You can’t produce a baby in one month by getting nine women pregnant”). With hedge funds charging a 20% management fee, investors are incentivized to raise as much money as they can quickly as opposed to focusing on performance.
2) They suffer from “do-something syndrome”. The highly skilled Charlie Munger may say that most investors confuse activity (e.g. constantly checking prices, moving in and out of positions etc.) with results. Seth Klarman, one of the greatest value investors says “Few are willing and able to devote sufficient time and effort to become value investors”. He goes on saying “There are a number of reasons for this: among them the performance pressures faced by institutional investors, the compensation structure of Wall Street, and a frenzied atmosphere of the financial markets”. This can increase the “do-something syndrome” bias.
3) “Reputational awareness”. Investors could be aware that they don’t have the reputation to move markets the way Buffett does. Buffett’s reputation allows him to influence market prices heavily just through public announcements.
4) They may simply lack the natural gifts that Mr Buffet has when it comes to analysis and seeing the future. Therefore they resort to diversification. Ben you touch on this when you say that managers may “think they’re investing like Buffett”. Buffett is a genius but because of his humility and wonderful analogies he makes his style seem so simple and replicable. Buffett is a man who has an almost perfect memory for numbers and a knack for them (he can remember the prices of many individual goods within the companies he has invested in and can cube root numbers on licence plates instantly), he apprenticed directly under the father of value investing Benjamin Graham and he is uniquely skilled at influencing those around him (many founders would not sell their company to any other investor apart from Buffett e.g. Mrs B. of Nebraska Furniture Mart). Don’t forget this is a man (currently eighty-two years old) who has had more experience than most intelligent veteran investors (he bought his first stock at eleven and formed his partnership at twenty-six whilst starting small businesses in between). The required skill level to invest like Buffett is much larger than many smart investors believe.
Mutual funds are invested across so many investments because they have to be: mutual funds have to qualify as a “regulated investment companies” (RICs) under the internal revenue code–otherwise they get hit with an extra corporate-level tax–and to qualify as a RIC, you have to meet certain diversification standards that make it really hard to concentrate on 10-20 positions. If a mutual fund qualifies as a RIC, then it doesn’t pay taxes–only its shareholders do. But Berkshire Hathaway isn’t a RIC; it’s a normal “C” corp, which means that its shareholders, unlike normal mutual fund shareholders, bear an extra layer of tax paid by Berkshire Hathaway.
Hedge funds and private equity funds are organized as partnerships, and not as corporations, so they don’t have to qualify for RIC status to avoid fund-level tax. As a result, they are freer to–and typically do–take much more concentrated positions.