Berkshire Hathaway’s (NYSE: BRK.A) annual letter to shareholders was released yesterday: http://www.berkshirehathaway.com/letters/2016ltr.pdf
For followers of Warren Buffett and his company, his annual letter is always something to look forward to every year as it contains nuggets of wisdom about life, business, and investing. There is always something new to be learned whether you are a beginner or a seasoned investor.
For the uninitiated, since Buffett took control of Berkshire Hathaway in 1964, its share price has increased at an annual compounded rate of 20.8%. This means that $1 invested in 1964 would have turned into almost $20,000 in 2016. This is by far the most impressive public company record of creating long term shareholder wealth. Given Buffett’s generosity with dispensing investment advice, his annual letters are a must read for all investors.
As a long time follower of Buffett, his 2016 letter mostly contained topics which I am already familiar with. But they are worth repeating for newer followers who want to have a better understanding of how the company became what it is today and its guiding principles and future path.
One interesting thing I note is the inclusion of US Airlines in the marketable securities portfolio, with the two biggest airlines position being Southwest Airlines (NYSE: LUV) and Delta Airlines (NYSE: DAL). Though their combined value is not more than 5% of the overall portfolio, this is surprising because Buffett has famously eschewed investing in airlines in the past due to very poor industry economics leading to poor economic returns for almost all US airlines. He has been burnt more than once on investments in airlines. He even joked that a far sighted capitalist should have shot down the first manned flight at Kitty Hawk. Now that he has money in airlines again, this must mean that he thinks that there has been a favourable change in industry dynamics to warrant an investment.
Although it has already been mentioned before in his past letters, one thing that stood out for me in the 2016 letter is the bet that Buffett made roughly ten years ago. He bet that the average total 10-year returns (after fees and expenses) of any five selected hedge funds will not beat the average returns obtained by investing in a low cost index fund in the same period of time.
In my opinion, the brilliance is not in Buffett making the bet itself, but it is in the reasoning process that led to the conclusion of his point. He reasoned as follows: Investors in the stock market are either passive investors (buy and hold investors who buys index funds) or active investors (people to try to outperform the stock market averages by timing and/or stock selection).
By definition, passive investors as a group earn the average stock market return. The sum of the returns of passive and active investors equal to the total stock market returns (before fees). Therefore, active investors as a group must also earn average stock market returns.
Even if all the geniuses in the world tried to outperform the stock market, at least some of them are destined to fail because they are competing against each other and their collective results will be no better than the market averages. This is a universal truth and a powerful result.
What this means for investors in hedge funds is that given the high fees levied on investors (usually 2% fixed fee plus 20% of profits) on top of the usual trading fees associated with buying and selling shares, they are even more likely to achieve a result which is poorer than the market average.
The running tally after 9 years? Index fund: 85.4%, Hedge funds: 22%. Unless something unexpected happens in 2017, Buffett will win the bet against hedge funds.
Therefore, we may conclude that for a “know nothing” investor, their best bet is investing in a low cost index fund. But wait, there is a caveat. As a general principle of investing, the price you pay is the single most important determinant of your investment returns. If the idea of buying index funds becomes so mainstream and popular that everyone starts buying into them, their price may be bid up to astronomical levels. Index funds, after all, consist of individual stocks which make up the stock index, and individual stocks may become overvalued from time to time. Should this happen, I think it would not be wise to invest in an index fund.
Talking about investing in index funds reminds me of the idea of the Efficient Market Hypothesis (EMH), which is the staple topic of any finance/investing course in business school. The core tenet of the EMH is that stock prices fully reflect all publicly available information, so trying to outperform the stock market by timing and/or stock selection is futile. Therefore, you can do no better than buying an index fund.
While the EMH made perfect sense to me back when I was in business school, over time I came to realise that in reality, the EMH is nothing but a nice academic construct. In theory, theory is the same as practice. In practice, it is not. Buffett puts it best when he said something to the extent of teaching the EMH to business students is like teaching beginning chess or bridge players that thinking about strategy adds no value whatsoever.
Before we move on, I do realise that refuting the conclusion of the EMH looks like going against Buffett’s advice in his annual letter as well as his bet against hedge funds. But then, Buffett, with his long term outperformance over the stock market, is living proof that the EMH is wrong. So, what gives?
The answer lies in an article written in 1984 by Buffett titled “The Superinvestors of Graham-and-Doddsville”. Given that there are many investors in the stock market, does the fact that a some of them outperform the market over a number of years proof that the EMH is wrong?
Imagine that we substitute our investors with a group of 10,000 coin tossing monkeys. After 10 consecutive tosses, we can expect around 10 monkeys (10,000*0.5^10) to have tosssed 10 heads in a row. If we liken tossing heads to investor outperformance in any given year, then the fact that some investors outperform over long periods of time can be explained purely by chance.
However (and this is the crux of the argument), Buffett argued, what if all of the 10 monkeys who outperformed all belonged to a certain zoo in Omaha, with similar traits and characteristics? Then, further investigation is warranted. In the article, nine investment fund managers with different individual investing styles were featured. The managers had two things in common – they outperformed the market by significant amounts over time, and they were alumni of the Benjamin Graham value investing school, as was Buffett.
To me, that was irrefutable proof that the EMH was wrong, and that it was worth devoting your time in studying value investing if you want to outperform the market. Since then, I learned that there are many different valid ways that investors have employed to outperform the market in the long term.
One of the ways, which has gained more popularity in recent times, is that of quantitative trading. This is a very short term, trading of stocks by modeling their behavior quantitatively, which is the total opposite of value investing in some ways. An example of a successful “quant” is James Simons, who started his trading career in his fourties and managed to amass an USD 18b fortune in thirty something years, thanks to annualised returns in excess of 50%. Alas, the requirements of this strategy are very rigorous – Simons was a mathematical genius who obtained his Phd at age 23 and had multiple important contributions in the field of Math and Science.
For mere mortals like me, I can only try to study everything I can about value investing and hope that I have the skill to outperform the market. After all, I am also subject to the same law that dictates that only a small group of active investors are destined to outperform the averages.
Only time will tell.
C is for Compounding 