Disspelling Warren Buffett

Here's an excerpt from Larry Swedroe about his thoughts regarding WB and BRK:

This is from my second book, What Wall Street Doesnt Want You to Know, published in 2000
Buffettology or Mythology?
I think it safe to say that if individual investors were asked to name the one money manager they would want to manage their assets, the overwhelming majority would choose Warren Buffett. Buffett clearly has earned his reputation by delivering superior returns over a very long time frame. Whenever I discuss the superior performance of passive investing over active management, the question that I am most asked is: “If that is true, how do you account for Warren Buffett (and/or Peter Lynch)?” In fact, I happened to be asked that question during a phone call on the morning of March 1, 2000. In responding, I try to be very careful because even questioning the possibility that Buffett was lucky is almost sacrilegious. The following is a summary of my usual response.

·First: it is certainly possible, if not likely, that given the length of his superior performance Buffett is fully deserving of his guru status.
·Second: we only know that Warren Buffett “won” after the fact. If skill is truly involved, with so many thousands of active managers trying to win, how come far fewer won than would be randomly expected? In mathematical terms, the following analogy is appropriate. If there were as many monkeys playing the game as there were active managers trying to outperform, how come we end up with more monkeys winning than active managers winning? In other words, the distribution of the performance of active managers falls to the left of what a random (bell curve) distribution looks like. Yes, some monkeys win, and some active managers win. But how do we know ahead of time which will be the winners? Just as important, how do we know that the past performance of the winning active managers is a predictor of future performance? Certainly, we can agree that the monkeys’ past performance would have no value as a predictor. In the case of active managers, all the evidence suggests that past performance is also a very poor predictor. Even Morningstar admits that their 4-star and 5-star funds underperform, after they are designated as superior performers. So how do we know for sure if Buffett was lucky or a true guru? As you will see, it may be harder to tell than you thought, and you will have to decide for yourself.
·Third: another possible explanation for Buffett’s superior performance may come from the fact that he is not like other money managers. Typically, Buffett does not just buy stock in a company and take a passive position. His more usual involvement is as an active investor. He often takes an influential management role, including a seat on the board of directors, in a company in which he invests. It is certainly possible that it is Buffett’s superior business skills that account for the superior performance of his investment portfolio. The recognition of his superior business management skills may also account for why Berkshire Hathaway’s stock (the vehicle investors have for investing the Buffett way) has often traded at a large premium to the underlying net asset value (NAV) of its portfolio. This would not be the case if Berkshire Hathaway were an open-ended mutual fund that would always trade at its NAV. Investors must believe that Buffett’s influence in the company will enhance their performance and investment returns.

At the end of this explanation I typically offer my own conclusion, which is that I am somewhat of an agnostic on the issue. Clearly you cannot ignore his superior track record. However, my own inclination is that the answer probably is some combination of all 3 possibilities. It is very hard to prove the guru or luck story. Mathematics might suggest luck, but logic might provide another answer. And I have learned you are not likely to ever convince people who have already come to a conclusion that they should change their mind. The best you can hope to do is to get them to consider another possibility.

After concluding my March 1 phone call, I remembered that whenever someone presents something that is stated as “generally accepted wisdom,” it pays to check the facts, or, as I like to say: “go to the videotape.” Out of pure curiosity I decided to check the performance of Berkshire Hathaway’s stock. I made the random decision to check its performance from the beginning of the 1990s right through the previous night’s close, February 29, 2000. That seemed to me to be a reasonable time frame for a couple of reasons. First, as I stated, you only “know” an active manager is great after he or she has delivered superior performance for some reasonable length of time. So we need to have some length of time to observe Berkshire’s performance before choosing Buffett as our standard-bearer. Second, I think that most people would consider that a decade is a sufficiently long time to consider (although I might suggest that the longer the better). Finally, the vast majority of money that is invested in the market today has come in since 1990. The result is that very few investment dollars benefited from any experience prior to 1990. (This is not to suggest in any way that returns prior to that should be ignored.)

Given the “generally accepted wisdom,” I fully expected that I would find that the performance of Berkshire’s stock would have far outperformed the S & P 500 Index (a good benchmark as most of Buffett’s investments have been large-cap stocks). Remember that we have chosen with hindsight not just a great investor but possibly the single greatest investor. The decade of the 1990s began with Berkshire’s stock at 8,675. It closed on February 29, 2000, at 44,000, an incredible gain of 407%. The compound growth rate was 17.3%. To my surprise, however, while that performance did allow the Buffett “faithful” to outperform the S & P 500 Index, it was just by 0.2% per annum. Certainly, 17.3% per annum returns were great and he did beat the Index, although not by much. Again, this slight outperformance comes from the one manager whom we know only with hindsight is considered by most to have been the single greatest investor. Most investors who placed their faith in other gurus fared far worse.

I tried some other time frames, admittedly performing a bit of intentional “data mining” (intentionally choosing specific data points to “prove” your point) in one case. It is important to note, however, that some investors in all likelihood actually experienced the returns shown in the following examples. We can certainly imagine the following scenario occurring. An individual investor comes into a large sum of money in June 1998 (through an inheritance, sale of a company, exercise of stock options, etc.). Lured by the sirens of superior performance, the investor decides to choose the active management approach. One logical candidate is Berkshire Hathaway, which has gone from 8,675 at the beginning of the decade to hit its all-time high of 80,900 (June 19, 1998). An investor unlikely (and unlucky) enough to invest on that particular date would have seen the value of his or her portfolio fall 46% between then and February 29, 2000. During the same period, the S & P 500 ran up from 1,101 to 1,366, an increase of 24%, not counting dividends. That would have been a very painful experience, possibly testing the individual’s faith in Buffett’s guru status. Some might begin to wonder if he had lost his “touch” or even question now was it luck in the first place. If you decided that you don’t want to invest with Buffett any longer, now what paradigm do you follow? Do you try again to find that great guru based on past performance, having just seen that “fail” miserably? Or do you switch to passive investing? If you decide to stay with Buffett and he continues to underperform, when do you know it is time to “throw in the towel?” What will your criteria be for making that decision? You can see the dilemma. Again, I admit, I created a carefully chosen example, but one probably experienced by some investors.

I went back for a somewhat longer and less biased look, again, covering a period that was probably experienced by many investors. If you look at the 4-year period 1996–1999, Berkshire rose from 32,100 to 56,100. Every dollar invested grew by about 75%. The only problem was that every dollar invested in the S & P 500 Index grew by about 155%. Again, I want to make clear that neither this example, nor the other two, prove the Buffettology or Mythology case. It does, however, at least in my mind, open the issue to questioning. Only time can provide the answer. Even then we may very well be left to speculate.