If you dive into any of Warren Buffett’s many shareholder letters (and you absolutely should – they are a master class of communication style as well as an awesome throwback to the late-90’s early-internet-chic design style) the apparent lessons to take away is that the route to investment success is to buy a small number of great companies and hold them forever, love compounding, embrace frugality and keep it all simple. And maybe take a few cheap shots at the investment industry along the way, or at least generally ignore it.
That’s fine, as far as it goes and not the worst first go at an investment philosophy let’s be honest. “Lessons from Buffett” blogs and books are basically an entire genre at this point. I have always wondered though whether a different angle might reveal an alternative set of lessons:
Lesson 1: Leverage plus a strong style bias and a concentrated portfolio will lead to extreme investment outcomes.
AQR have done the work to really break down the drivers behind Buffett’s success in this classic 2018 piece here (you should read the piece, it’s really very good). The key here is that the combination of a strong style bias (quality, low vol) and a concentrated portfolio will lead to extreme outcomes through time – far from the inevitable obvious safe bet Buffett would have you believe. Berkshire Hathaway has had a volatility of ~24%, much higher than the broader stock market and has suffered 40%+ drawdowns on multiple occasions.
These performance measures reflect Buffett’s impressive returns but also the fact that Berkshire Hathaway has been associated with some risk. Berkshire has had a number of down years and drawdown periods. For example, from 30 June 1998 to 29 February 2000, Berkshire lost 44% of its market value while the overall stock market was gaining 32%. Many fund managers might have had trouble surviving a shortfall of 76%, but Buffett’s impeccable reputation and unique structure as a corporation allowed him to stay the course and rebound as the internet bubble burst.
Buffett’s Alpha Andrea FrazziniDavid G. KabillerLasse H. Pedersen
Sure you might say, volatility isn’t risk, but tell that to the folks that (understandably) sold out after an underperformance of 76%.
Buffett is one of the succesful ones but you need to view that through the lens of survivorship bias, many folks pursuing a similar strategy would have found themselves sacked or without clients which brings us on to the second, perhaps most important lesson:
Lesson 2: Have permanent capital that you personally have control over.
An underappreciated part of Buffett’s success? Berkshire Hathaway is structured in a way that relatively few other managers have tried to replicate. If Warren had been a regular fund manager with an open-ended mutual fund his long and large periods of underperformance (see chart) would almost certainly have seen him get sacked, or even if he ran his own firm to lose the majority of his clients.
Lesson 3: leverage matters a lot, the terms of the leverage matter more
Buffet loves to tut tut at folks being reckless with borrowing and derivatives and leverage and so forth but the truth is subtler. As the AQR piece showed a large chunk of Buffet’s returns are attributable to the leverage gained through his access to the insurance float provided by the wholly owned position in GEICO as well as the extremely cheap debt Berkshire is able to issue. The leverage levels are somewhere between 1.4 and 1.7 to 1. But this leverage is different to a futures contract or a margin loan and that does matter. It’s unlikely to be withdrawn and it is available on very favourable terms (low interest rates, long term, non-recourse). He isn’t going to get margin called on it at the wrong time necessitating him to firesale the portfolio.
You can see the impact of this leverage through the AQR quant work as they calculate the public stock portfolio has had an excess return (1980-2017) of 12% p.a. and the private portfolio 9% p.a. whereas Berkshire Hathaway did 18% p.a.
Lesson 4: Combine private and publicly held securities … OR SHOULD YOU??
From AQR’s piece:
Empirically, we found that Berkshire owned 65% private companies, on average, from 1980 to 2017, the remaining 35% being invested in public stocks. Berkshire’s reliance on private companies has been increasing steadily over time—from less than 20% in the early 1980s to more than 78% in 2017.
Buffett’s public and private portfolios have exceeded the overall stock market in terms of average excess return, risk, and Sharpe ratio. The public stocks have a higher Sharpe ratio than the private stocks, suggesting that Buffett’s skill comes mostly from his ability to pick stocks, not necessarily his added value as a manager (but keep in mind that our imputed returns may be subject to noise).
AQR: Buffet’s Alpha – Andrea FrazziniDavid G. KabillerLasse H. Pedersen
What’s the lesson here on public/private markets investing – to mix the two or not? I have debated this a lot and am undecided either way really. It’s certainly up there as one of the biggest differentiating features of Berkshire compared to almost all other investment vehicles (where mixing public and private tends to be quite problematic and something of a no-no especially in open ended funds).
Buffet is often at pains to point out the huge volatility of their listed investments as compared to the stability of the earnings from their privately held assets, and the quant analysis shows there is diversification there. But as AQR also show the performance of the private portfolio has been less stellar than the public piece, with a more normal looking sharpe ratio of 0.45 and an unlevered annual excess return of ~9% p.a. (compared to 0.7 and 12% p.a. for the public stock portfolio).
A key point to note here is that Buffett pays almost no fees to managers, platforms etc in making his private investments. Investors, even large ones cannot achieve this. An important insight (I think) is that if you take the estimated unlevered performance of the Berkshire private markets porfolio: 9% p.a. and subtract a typical institutional total fee load across manager fees, platform and structure of 2%p.a. you’re left with a a 7% p.a. return which is in line with the broad stock markets. So applying the usual fee rates to even the world’s best business-picker you end up with pretty average outcomes. Private markets can be pretty good, but there’s no investment so good that you can pile big fees on it and remains great.
Lesson 5: Build a brand, communicate your philosophy relentlessly if you want to run big active risk for the long term
Exhibit A on brand Buffett (if anyone’s got the number of the agency that designed those slides please send it my way immediately) –
but it’s the non-brand brand that is fundamental to Buffet’s carefully crafted brand here, if that makes sense. Buffett’s cult-like following is actually important to his success because it makes folks sticky, they buy-into a deeper concept of what Berkshire Hathaway is and does (and will do) that allows them to keep on holding it through the inevitable periods of 76% underperformance and this is essential! Folks have almost aligned their identity with Buffet which is pretty rare among asset managers I’d say. His comms and style are an essential part of this. I think very few investors and managers grasp the need for this, and fewer still do it well.
For a deeper dive on Buffett from an expert check out this great podcast with Buffett-watcher Yun Li.
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