Tuesday, July 22, 2008

The secret of Warren Buffett’s success

Years ago I was asked what kept us from being Warren Buffett. My reply was "how Buffett picked stocks was fairly well-known. The problem was the inability of managers to tolerate excessive tracking error." This was quant-speak for "portfolio managers spent too much time building benchmark hugging portfolios for business reasons".

There has been much written about how Warren Buffett picks stock. Jeff Matthews had a great series of posts on this topic:

It's not just about picking stocks
One of the effects of Buffett’s approach is that he won’t buy companies whose businesses he doesn’t understand or he deems “too difficult to run”. As a result, the portfolio will contain very few companies in certain industries, such as Technology. As any good quant can tell you, a lot of return risk can be explained by industry weightings and such a lopsided portfolio will have returns that are very different from the S&P 500.

I have written before that running a portfolio is a lot more than picking stocks, which people have focused on for Buffett. It’s also about benchmarking, portfolio construction and trading.

Warren has a plan - and sticks to it
Could the secret of Warren Buffett’s success be the way he benchmarks himself? Indeed there is some evidence of that as this study shows that despite Berkshire's vaunted investment results, its Sharpe ratio is only 0.64.

In many cases, Berkshire Hathaway buys the whole company and seems to only consider the value of that cash flow stream at purchase time. Buffett et al seems to care less about the value of the company in the marketplace after its purchase. After all, the value of Berkshire Hathaway’s unlisted subsidiaries are not reported anywhere nor can they reported since there is no publicly listed value for these companies. After BRK acquires them, they only get valued by the market based of their aggregate cash flows, asset values, etc.

Could Berkshire's investment policy be just a form of Economic Value Added (EVA), as popularized by Stern Stewart & Co? Under the EVA analytical framework, your objective in running a company is to make sure the returns on your investments are above the cost of your funding. Since Berkshire buys and doesn't sell, its investment policy seems to be consistent with the concepts of EVA: buy cheaply and never mind what the market thinks in the interim because you are managing through the economic cycle.

You can build your own Berkshire Hathaway
You may argue that “Warren Buffett has the means to buy the whole company, but I don’t. I don’t have the luxury of doing the same thing.”

It can be done. I once worked with a taxable family trust that held an equity portfolio with many positions with very low cost basis (and therefore large capital gains liability if the position were to be sold). The objective of the trust was to provide its current beneficiaries with an income stream while preserving the inflation adjusted value of the capital for future generations.

The trustees decided to focus the portfolio on holding dividend paying stocks with good growth prospects. They created a synthetic benchmark based on the dividend growth metrics to measure the portfolio’s performance. Returns were measured on an after-tax basis. The hurdle rate for selling a stock with an embedded capital gain therefore was higher than normal because of the higher after-tax cost of replacing the dividend stream.

As the portfolio manager for one of the trust’s portfolios, I found myself in the unusual situation of apologizing every time the market went up, even if the portfolio had outperformed: “Sorry, we made money for you this quarter (but that means that we can’t re-balance the portfolio and sell anything without taking the capital gains hit)”. Conversely, market declines were welcome because it afforded an opportunity to harvest some capital losses so that the portfolio could be re-balanced on a tax-efficient basis.

Know yourself, be disciplined and march to your own drumbeat
The story of this trust is an example of an investor knowing his objectives and sticking to them. In this case, the trust knew its objective and created its own benchmark. The trustees focused on dividends and their growth rates (just as Berkshire Hathaway focuses on cash flows and their growth). What the market pays for those investments in the interim was mostly noise that could be ignored.

If you know yourself and can be disciplined in the same way, you can do the same.

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