Investors just celebrated the golden anniversary of Warren Buffett’s tenure as chairman and CEO of Berkshire Hathaway. In addition to building Berskshire Hathaway from a tiny textile company into a huge conglomerate, Buffett has also spawned an entire industry of books and mutual funds dedicated to explaining and exploiting his methods.
However, only Buffett can take credit for generating an average annual return of 21.6 percent versus 9.9 percent for the S&P 500 for 50 years. Almost all the books and mutual funds have fallen far short of either unlocking Buffett’s secret formula or generating similar returns.
Many investors, including me, are fascinated by Buffett and his investment success. When it comes to investments, there are few things that I look forward to reading. Most investment reviews and research reports are dry and uninformative. Yet Buffett’s annual shareholder letter is anything but dry or uninformative.
Usually I have it downloaded and read within an hour of its publication. Like many readers, I enjoy Buffett’s folksy style, his willingness to point out at least some of his short-comings, and his simple investment advice. However, the best part of Buffett’s letters is the casual inconsistency. Buffett’s 2015 letter is a 38-page homage to active investing, and yet Buffett is an ardent advocate for passive investing.
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This week I want to explain why it’s impossible to replicate Buffett’s success, and why the world’s greatest investor is so passionate about passive investing. In preparing to write this column, I tried to count the number of books about Buffett on Amazon.com. After six pages, I abandoned the task. Suffice it to say there are dozens of books that promise to reveal Buffett’s investment strategies or explain how to apply his business acumen to your business. I’m not sure whether any of the authors made much money, but their publishers surely earned a few dollars because many of their publications are highly ranked on Amazon.com.
Neither books nor magazine articles can capture the essence of Buffett’s talent. As an investor, Buffett has been able to see changes in the investment landscape before most of us realize that change has occurred. By the time a book or article appears in print, or mutual funds attempt to replicate his methods, Buffett has already figured out that his existing investment strategy isn’t working as effectively as it once did, and that value is to be found elsewhere in the market. In the first 15 to 20 years of his stewardship of Berkshire Hathaway, Buffett was known as a classic Graham and Dodd investor. He bought boring/traditional businesses that were selling at substantial discounts to their book value. However, as the bull market of the 1980s heated up, those traditional businesses failed to grow fast enough, and their stock prices no longer reflected any kind of meaningful discount.
While many traditional value investors stuck to their old ways, Buffett had the foresight to look for companies with better growth prospects. As a result, he was forced to evaluate businesses where much of the value was embedded in intangible assets, such as brands, trademarks and patents, and the stocks were priced at a premium to book value. Buffett wound up buying stocks such as Coca-Cola, Capitol Cities and Gillette, and owning outright strong brands such as Geico. He also became adept at investing in property and casualty insurance companies and balancing those businesses against a collection of transportation, utility, industrial and consumer businesses.
As other companies (think of General Electric) and money managers emulated his strategy, Buffett was already moving in a new direction. He realized that his strongest brand was Warren Buffett. He could make deals and pay prices that weren’t available to anyone else because companies and financial institutions wanted to be identified with Buffett. Through his well-honed reputation, Buffett was able to buy companies a bit more cheaply and earn interest or dividends at higher rates than other investors. As a result, Buffett’s personal brand has created tremendous value for Berkshire Hathaway’s shareholders. For example, during the financial crisis, Buffett invested in Goldman Sachs through preferred stock at an interest rate that made other investors envious. Because none of us enjoys Buffett’s reputation, there’s no way for us to emulate this stage of his investment success.
Buffett would probably deny that it is his personal brand that is so valuable. Like any good manager, he’d rather give credit to Charlie Munger, Berskshire Hathaway’s 91-year-old vice chairman or one of dozens of other executives managing one of Berkshire Hathaway’s subsidiaries. However, it is Buffett that companies, bankers and financiers want to do business with. In my estimation, it is Buffett’s personal brand that represents an enormous business challenge for Berkshire Hathaway. While Buffett has acquired and mentored many fine business executives, it’s hard to imagine how he will transfer his personal brand to his eventual successor. One of those executives will probably be capable of managing Berkshire Hathaway’s vast collection of businesses. However, Buffett’s personal brand will probably exit Berkshire Hathaway when he eventually leaves the company.
Very often Buffett employs the very Wall Street tactics in his business that he attacks in his letter. He has called credit default swaps and other derivatives weapons of mass destruction. Nonetheless, many of Berkshire Hathaway’s subsidiaries rely on them, particularly its property and casualty and reinsurance businesses. In this year’s shareholder letter, Buffett made an eloquent case against investment bankers. He pointed out that bankers make their money by stimulating transactions rather than helping to create value in businesses. Even so, Buffett has invested on numerous occasions in the very investment banks that he criticizes.
In perhaps the most glaring contradiction, Buffett has disparaged the high fees and tactics of private equity. Yet his most recent mega-acquisitions have been done in partnership with a private equity firm. In 2013, Berkshire Hathaway joined forces with 3G Capital, a Brazilian private equity firm, to acquire Heinz for $23 billion. Just last month, Berkshire and 3G Capital teamed up again to buy Kraft in a $38 billion deal. While Buffett decries private equity’s financial engineering, Berkshire has earned billions of dollars in dividend and interest income built upon financial engineering. Although Buffett decries private equity’s tendency to fire employees and pare back portfolio companies, he’s content to have 3G Capital engage in those very practices in order to generate returns on his investments in Heinz and Kraft.
To be clear, 3G Capital is a very fine practitioner of the tactics and strategies of private equity. Buffett has chosen well in selecting a private equity partner. He has also struck a deal with 3G Capital that no other investor obtained. Berskshire Hathaway isn’t paying exorbitant fees to 3G Capital. Instead, it is getting to invest alongside 3G Capital on very advantageous terms. The relationship with 3G Capital allows Buffett to delegate the dirty work of firing people, so Buffett’s brand remains untouched.
Although Berkshire Hathaway is dependent on all financial tactics of active investors, Buffett regularly advises the average investor to use low-cost index funds. Recently, he advised a not-so-average investor, LeBron James, to stick to index funds. In his investment letter in 2014, he recommended that the trustee of his personal fortune utilize index funds. We all want to be like Warren Buffett. Who wouldn’t want to earn more than the market averages have to offer? However, Buffett recognizes that his abilities and his brand aren’t available to any of us. That’s why we should do as Buffett says and not what he does.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/