by Frederik Vanhaverbeke
In the latest of a series for Master Investor Magazine, Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
Volatility does not measure risk. … Risk comes from the nature of certain types of businesses, and from not knowing what you’re doing.
Warren Buffett needs little introduction. He is widely acclaimed as one of the best investors in the world. And his sharp quotes have become common knowledge (and wisdom) in the investment and business world.
The accolades for Warren Buffett’s achievements are definitely justified. His track record speaks volumes. Not only has he outperformed the market by a significant margin, but he has managed to do this over a very long period of time.
Between 1957 and 2014 (a period of 57 years!!), Buffett achieved an annual compound return of 22.3%. This is more than 12% higher than the S&P 500 (with dividends reinvested) over that same period. To put this in perspective, people who entrusted $1,000 to Buffett in 1957 would have about $100 million right now (compared to $250,000 for someone who put that $1,000 in the S&P 500 in 1957). In addition, although he occasionally underperformed the market in single years (sometimes by even 15% to 20%), Buffett’s outperformance over periods of 5 to 10 years has been consistently excellent, as we show in the figure below.
Figure: Annual outperformance of Warren Buffett versus the S&P 500 (with dividends reinvested) over periods of 1, 5 and 10 years.
So much has been said and written about the investment methods of Warren Buffett that it is impossible to summarize his methodology and investment philosophy in a short article. The interested reader will find all this material and more in my book Excess Returns: a comparative study of the methods of the world’s greatest investors. In this article, I will focus on Buffett’s investment career.
Interestingly, Buffett’s career didn’t take off smoothly. He started out as a regular teenager with a hunger for investment knowledge. He read every book on investing he could get his hands on. And he experimented with technical analysis. But time and again Buffett was dissatisfied with the results. His quest came to an end in the late 1940s when he got to know the investment ideas of Benjamin Graham. Graham’s investment approach was the revelation that Buffett had been looking for for years. Impressed by Graham’s teachings, Buffett’s dream was to join Benjamin Graham in his investment partnership. After some insistence Graham agreed.
Apart from his activities in Graham’s partnership, Buffett also invested his private money in the stock market in the 1950s. Although there are no records about the returns he earned over that period in his private account, based on some of his statements one can estimate that it was probably north of 50% a year. When Graham decided to wind down his investment partnership between 1955 and 1957, Buffett started a number of limited partnerships on his own.
Buffett’s partnerships of the 1950s and 1960s can be seen as modern-day hedge funds that try to beat the market with limited correlation to the general market. Buffett implemented such a strategy by meticulously managing his portfolios around three different types of stocks:
– Generals: these were undervalued stocks in which he took a minority position. Buffett was willing to hold on to generals as long as was needed (i.e., sometimes years) for the value to surface. Obviously, the generals had a strong positive correlation to the overall stock market. Notwithstanding, Buffett aimed for a weight of 5% to 10% in every general position as he argued that one should focus one’s investments on one’s (limited number of) best ideas. In 1964, he even put 40% of his portfolio in American Express – a very high conviction stock for Buffett after the Salad Oil Scandal.
– Work-outs are securities which offer returns that depend on corporate actions. These can be merger arbitrage positions, positions based on liquidations or spin-offs, etc. Given the higher predictability of the returns of work-outs, Buffett tried to increase the returns from work-outs through borrowing. Workouts also offered attractive diversification to his portfolio as they are much less correlated with the stock market than generals.
– Control situations: these were participations in companies that were sufficiently high to exert control or to influence the company’s policies. Here Buffett’s aim was to lobby for or impose value-enhancing changes in management, strategy, capital utilisation, etc. Although the correlation of such stocks with the stock market tends to be high around purchase, that correlation can drop quickly once the corporate changes take effect.
By the end of 1968, the investment partnerships had returned about 32% a year over the previous 12 years versus 10.7% for the S&P 500 with dividends reinvested. At that moment Buffett decided to call it quits. He felt uncomfortable about the high valuations of the stock market, and he couldn’t find enough bargains for his taste. He therefore wound down his partnerships, and liquidated all the positions except for one: Berkshire Hathaway. At that time Berkshire was an obscure textile company that Buffett had bought some years before due to its compelling valuation. Interesting to know, Buffett’s market call was prescient as the stock market went nowhere between 1968 and 1982.
As it turned out, Berkshire would not have survived if it were not for Buffett.
The textile business could not cope with the increasing competition and went into liquidation in the early 1980s. In the meantime, though, Buffett realized that he had made a mistake and decided to turn Berkshire Hathaway into an investment holding by taking participations in both private and publicly traded companies. As part of his acquisition spree, he bought insurance companies, which provided the float that added a boost to the returns that Buffet earned on Berkshire’s equity.
We all know the rest of the story. Throughout the 1970s and 1980s Berkshire steamed ahead under the stewardship of Warren Buffett and Charles Munger. We can see in the figure above, for instance, that Buffett beat the market by about 20% a year between 1972 and 1982, by more than 10% a year between 1982 and 1992, by almost 10% between 1992 and 2002, and by about 8% a year between 2002 and 2012. Thanks to the power of compounding, it is now one of the biggest and most creditworthy corporations in the world.
In my next article I move to the U.K., and take a look at Anthony Bolton.