iCubed
Sunday Times 13 March 2016
Warren Buffett, arguably most successful investor in history, released his annual letter to shareholders last week. It’s one of the most widely read dispatches in the business world. Though other letters have provided a more entertaining read, this one is rich in investment lessons, and is as likely to provide as good an education in investing as any academic syllabus.
Lesson #1 appears on the front page. It shows the year by year performance of Berkshire Hathaway shares relative to the company’s book value, and the performance of the S&P 500 with dividends included. It’s a remarkable fifty one year track record.
A quick tabulation will show that there were eleven down years including seventeen when Buffett’s return was below that of the market.
Thus, for some 34% of the time there were annual disappointments, including last year. But remember, over this period in aggregate the gain was 1,598,284% or 20.8% per annum, more than double that of the market (more on that later).
Two critical observations of the numbers: first, if one of the world’s best long-term investors can deliver disappointment one third of the time, we should not hold ourselves or those that invest on our behalf to a higher standard. This is very apt given recent market movements.
Secondly, it’s not the frequency with which you are right that counts, it’s by how much. Consider this; Buffett has managed to more than double the return delivered by the S&P500 from 1965-2015. The US stock market’s 9.7% p.a. over this 51 year period has delivered a tidy return on investment to investors equating to 112 times the original capital, turning $1,000 in to $112,000. Not bad, until you see what Buffett’s return has generated. Berkshire’s 20.8% p.a. return does not give you double the 112 times original investment. Through the magic of compounding it gives you more than 112 squared (i.e. 112 x 112!).
And this is lesson #2 from this year’s letter. Reportedly described as the most powerful force in the universe, compounding has helped propel Warren Buffett into the top table of richest people on earth and by a stretch, the most deserving of the accolade ‘world’s most successful investor’.
Buffett has turned $1,000 in to over $15 million. It is difficult to conceptualise these numbers, and 51 years is beyond the time frame of most readers, but it does highlight the power of compounding. As Buffett’s business partner Charlie Munger says, try not to get in its way!
It should be noted that the corporate structure of Berkshire and its investment in large insurance companies affords Buffett a large float from unpaid future claims that leverages the company’s own equity. Leverage adjusted, Buffett’s track record is still stellar.
Lesson #3 from Buffett is that investing is not easy, nor should it be. Buffett’s “motherhood and apple pie” style of communication belies a complex investment approach, something that is often forgotten by his followers. If you fancy yourself as a stock picker, the odds are firmly stacked against you.
An interesting report from JPMorgan sheds some light on these difficulties, and it makes for sober reading, even for investment professionals.
- Since 1980, two-thirds of all US stocks have underperformed the index. Good luck with those odds; a one in three chance of picking a stock that outperforms the index.
- The median stock returned 54 per cent less than the index.
- If you were investing over the last generation you might be forgiven for believing that it was difficult not to do well. The US stock market has risen twenty fold since 1980, yet the JP Morgan report shows that 40 per cent of US stocks have suffered large, permanent declines (defined as a drop of 70 per cent or more that was not recovered).
The reason the overall market did well is because of a handful of winners – some 7 per cent of stocks are extreme winners, driving the index. The odds of picking such stocks in advance are tiny.
Buffett is refreshingly honest in that he does not take credit for serendipitous gains and doesn’t hide from his mistakes. Part of the letter is devoted to a discussion of his shortcomings, and the serious mistakes he has made in capital allocation, one’s he admits he will undoubtedly continue to make, but hopes they will be in Berkshire’s smaller operations.
There are lots of things Buffett didn’t discuss notably the slump in commodity prices, the volatility in markets and Berkshire’s most recent share price returns.
Lesson #4 is therefore not to get caught up in the minutiae of every market detail. There is a danger of being too flippant here, as emotionally market returns and volatility have an impact on investor sentiment and actions. Buffett has an extraordinary brain and has perhaps a personality better suited to investing than most. But we must trust the process and the plan, or risk becoming the ‘patsy’ for those around the investment table.
Gary Connolly is Managing Director of iCubed, an investment consulting company providing investment support to financial advisers and chairman of the valueinstitiute.org. He can be contacted at gary@icubed.ie. iCubed Training, Research and Consulting, trading as iCubed, is regulated by the Central Bank of Ireland.