Sunday, June 01, 2014

Buffett and Ben: That’s As Good As It Gets—Redux—Part III

Considering the fact that there have probably been untold thousands of professional investors, analysts, wealth managers, stock brokers, financial advisors, gurus, hedge fund managers, etc., etc. associated with the financial industry over the last one hundred years, to be included in a top-ten list should be an extraordinarily singular accomplishment. While individual lists might vary, the following, based more or less on historical presence, would be one that would certainly qualify: Jesse Livermore, Thomas Rowe Price, Benjamin Graham (nee Grossbaum), Philip Fisher, Warren Buffett, John Templeton, John Bogle, George Soros, Carl Icahn, and Peter Lynch.

Within that iconic list, Warren Buffett is considered the best long-term investor of all, yet because of Berkshire Hathaway’s recent performance, questions have been raised as to whether his legendary reputation will persist. Throughout history, many legendary characters, any number of long held beliefs, and even more supposed truisms have been proven to be specious. In an article that appeared in this column over twelve years ago, I wrote, “This is a time when the ability to differentiate between myth and reality is critical.” This was then illustrated by the following story:

It’s somewhat like the time when two friends, a priest and a rabbi, traveling together to a convention on a plane, got into a discussion about some of the precepts of their respective religions. They agreed that many of the rules of religious law began as legends and myths from the ancient past, and in fact, some were even passed down from other primitive religions. The priest commented on the dictum that forbids Jews from eating pork, and he asked his friend, ‘Tell me Rabbi, have you ever eaten meat taken from a pig?’ ‘To be honest with you Father, on one occasion I did try a morsel of pork out of sheer curiosity.’ The priest inquired, ‘How did you like it?’ The Rabbi replied, ‘I must admit that it was quite tasty.’

The Rabbi then hesitatingly inquired, ‘Father, I know this is a sensitive issue, but we have been friends for many years, and I have often wondered whether despite the church’s teachings, you ever succumbed to the temptations of the female flesh, and participated in the sex act?’ The priest replied, ‘Since we are being so open with each other, I must admit that on just one occasion many years ago, I did surrender to that corporal desire.’ After a few minutes of silence the rabbi declared, ‘It’s better than pork, isn’t it?’ Now, that’s reality!”

Of course, one person’s reality is another person’s myth. So what’s the reality of Buffett’s recent “disappointing” performance as it applies to his reputational future? Comparing Berkshire Hathaway’s book value to the five-year performance (ending in 2013) of the S&P 500 Index with dividends reveals that for the first time since Berkshire’s inception in 1965, Berkshire underperformed that metric. Some observers pounced on that deficiency to exclaim that Warren Buffett was fast losing his right to claim the title of the Oracle of Omaha.

In the five-year period ending in 2013, the S&P 500 Index book value grew an astounding average of 45%, while Berkshire advanced a “mere” 38%, a 7% differential. On the other hand, evaluating the six-year period ending in 2013, Berkshire increased 31% compared to “just” 23% for the Index, again a 7% difference. But these numbers reflect another type of reality. During both the five-year and the six-year computations, just one year in each period had the greatest influence on the outcome. In the five-year segment, it was the 2013 performance of the S&P Index that escalated over 32%, the third highest level in 49 years. In that same period, Berkshire was up only 18%. However, during the six-year period, the 2008 S&P Index fell 37% (the worst ever), while Berkshire was down only 9.6%.

To fully understand Buffett’s basic investment strategy, one must accept the following underlying performance goal as expressed in a shareholder letter he wrote over 50 years ago in 1962: “I have consistently told partners that it is my expectation and hope (it’s always hard to tell which is which) that we will do relatively well compared to the general market in down or static markets, but that we may not look so good in advancing markets. In a strongly advancing market I expect to have real difficulties keeping with the general market.”

The performances experienced in the five year-blocks of time referenced above (partially) validate Buffett’s expectations expressed in his 1962 strategy letter, as well as many similar statements he has made over successive years. Berkshire Hathaway will do very well when the S&P Index does poorly; will do OK when the Index has an average year; but do quite poorly when the Index “strongly advances.”

Over the 49-year history of Berkshire’s performance vs. the S&P index, the Index either declined or gained less than 10% (a below average performance) 16 times. Berkshire did outperform in every one of those years, so Buffett’s prediction was right. However, the Index achieved a higher than 20% increase (a strong advance) 18 times. But here is what is ironic: (This also is where Mr. Buffett has made one of his few mistakes). On ten of those 18 occasions, rather than adhering to Mr. Buffett’s assumptions that Berkshire would underperform, Berkshire actually outperformed the Index.

However, some observers were disappointed that Buffett’s latest shareholder letter made no particular mention of his ”failure” to meet the five-year goal he had set for himself. Here is what Morningstar, the well-respected analysis organization said about this. ”I think we can put to rest any worries that Buffett was trying to pull a fast one. His ideal standard has long been to measure performance over a market cycle, as his letters from over 50 years ago show. The five-year period covering the 2008-13 trough-to-peak definitely counts as a ‘speculative explosion in a bull market.’ A peak-to-peak measurement period [like the six year period described above] is more sensible than arbitrary rolling periods.”

Morningstar seems to agree with Buffett’s methodology that when selecting an appropriate time frame for comparing book values. A trough-to-peak cycle takes precedent over the arbitrary 5-year cycle. On that basis, the five-year superior performance of the S&P index has much less significance. We won’t know for another year how 2014 will turn out, however, comparing current (May 22 nd) actual market price performance on a year-to-date basis, Berkshire is outperforming the S&P Index 12.4% to 7.3%.

There are other important factors to consider: 1) As a value stock, Berkshire is less risky than the S&P 500 Index, considered a growth vehicle, so in a severe market downturn, history has proven it (Berkshire) will lose substantially less. 2) All of the S&P Index numbers above assume that dividends earned by the S&P Index are retained and reinvested, benefiting from compounding. It is probable that most investors elect to take dividends to use as income. On that basis Berkshire outperformed even in the most recent five-year period. 3) Buffett is often criticized for not paying dividends from Berkshire’s huge cash hoard of $50 billion. He has consistently stated that he will never pay a dividend because he can make more productive use of those funds than can the average investor. Based on his performance, that point is difficult to argue against. 4) Unlike the S&P Index where dividends and capital gains are taxed, Berkshire distributes no dividends or capital gains resulting in zero tax implications. 5) While you can’t always trust analyst reports, four of the five analysts covering Berkshire currently rate the stock as a buy.

So, if you believe that Berkshire Hathaway will continue its long-term outperformance compared to the S&P Index, and thus basically use Warren Buffett as part of your portfolio management team, why consider Option #2 as described in last month’s article? That suggestion dealt with using the Vanguard S&P 500 Index Fund (VFINX), or the S&P Index Exchange Traded Fund (SPY) as a complement to, or even a substitute for Buffett and his company. What’s the argument in favor of the index strategy?

Four years ago, at the 2004 Berkshire Hathaway (NYSE: BRKA) (NYSE: BRKB) shareholders meeting, Buffett was asked by one investor if he should buy Berkshire, invest in an index fund, or hire a broker. His answer was typical, common sense Buffett: “We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund––where you don't put the money in at one time, but average in over 10 years––you'll do better than 90% of people who start investing at the same time.”

Buffett’s advocacy for index fund investing goes back much further than that 2004 meeting. It also surfaced again in his most recent 2013 shareholder letter. He wrote, “The goal of the non-professional should not be to pick winners––neither he nor his “helpers” can do that––but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”

However, in the first article of this series, I wrote, “Buffett describes a decision he made relating to his personal wealth that created shock waves throughout the investment professional community. More importantly however, you will read that decision provides the average investor with a free piece of invaluable advice by the best investor manager ever, advice that only the most honest money manager would admit to.” Next month’s article will reveal what was an “AHA!” moment, not only for investors, but also for the entire financial community.