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Last Updated: February 26, 2012 • Posted in Individual Gurus
Does Warren Buffett consistently keep Berkshire Hathaway in market-beating form? If so, how does he do it? In his annual letters to stockholders, he includes company performance and benchmark data and describes in general terms how he goes about investing. He sometimes shares his thoughts on the current state of and prospects for the U.S. equity market. Using annual performance data from his 2015 letter to Berkshire Hathaway shareholders for 1965 through 2015 (51 years) and the investing approach/outlooks described in his letters of 1977 through 2015, we find that:
The following chart relates annual Berkshire Hathaway stock return to same-year S&P 500 Index total return during 1965 through 2015. The alpha from the best-fit regression line is about 14%, and the beta is 102%. In other words, Berkshire Hathaway has beaten the market over 50 years, but it does not diversify the market. Per the letter, Berkshire Hathaway market value per share has grown at an annualized rate of 20.8% over this period, compared to 9.7% for the S&P 500 Index with dividends reinvested.
Is there any trend in Berkshire Hathaway alpha over the sample period?
The next chart shows differences between Berkshire Hathaway and same-year S&P 500 Index total annual returns during 1965 through 2015, along with a best-fit linear trend line. Results indicate that Berkshire Hathaway alpha is trending downward, suggesting mean reversion in firm valuation. Over the last 10 (5) years, Berkshire Hathaway has outperformed (underperformed) the S&P 500 Index by an average 1.3% (-1.3%) per year.
How does Warren Buffett achieve these results for Berkshire Hathaway?
The following excerpts from Warren Buffett’s letters to Berkshire Hathaway shareholders distill his approach to investing (in reverse chronology):
2015: “For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. America’s social security promises will be honored and perhaps made more generous. And, yes, America’s kids will live far better than their parents did.”
2014: “Financial staying power requires a company to maintain three strengths under all circumstances: (1) a large and reliable stream of earnings; (2) massive liquid assets and (3) no significant near-term cash requirements.”
2013: “You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick ‘no.’ Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake. If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it. …Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays. Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: ‘You don’t know how easy this game is until you get into that broadcasting booth.’) …Owners of stocks, however, too often let the capricious and often irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits – and, worse yet, important to consider acting upon their comments. …In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners…but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal. That’s the ‘what’ of investing for the non-professional. The ‘when’ is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. …The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the ‘know-nothing’ investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.”
2012: “American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favor… Since the basic game is so favorable, …it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.”
2011: “The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. …Investment possibilities are both many and varied. There are three major categories…
…Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as ‘safe.’ In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. …Under today’s conditions…I do not like currency-based investments.
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. …The major asset in this category is gold… I’m confident, however, that the $9.6 trillion current valuation of pile A [gold] will compound over the century at a rate far inferior to that achieved by pile B [productive assets].
My own preference…is our third category: investment in productive assets, whether businesses, farms, or real estate. …I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three… More important, it will be by far the safest.”
2010: “…the American system for unleashing that potential…remains alive and effective…America’s best days lie ahead. …In addition to evaluating the attractions of one business against a host of others, we also measure businesses against opportunities available in marketable securities, a comparison most managements don’t make. Often, businesses are priced ridiculously high against what can likely be earned from investments in stocks or bonds. At such moments, we buy securities and bide our time. …What students should be learning is how to value a business. That’s what investing is all about. …By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well.”
2009: “[We] avoid businesses whose futures we can’t evaluate…”
2008: “In 75% of [the last 44] years, the S&P stocks recorded a gain. I would guess that a roughly similar percentage of years will be positive in the next 44.”
2007: “…people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.”
2006: “When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.”
2005: “…’frictional’ costs…are now being incurred in amounts that will cause shareholders to earn far less than they historically have. Today, in fact, the…frictional costs of all sorts may well amount to 20% of the earnings of American business.”
2004: “Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to…piggyback Corporate America in a diversified, low-expense…index fund that they never touched… Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful. I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked. “…we yearn to buy more fractional interests similar to those we now own or – better still – more large businesses outright. We will do either, however, only when purchases can be made at prices that offer us the prospect of a reasonable return on our investment.”
2003: “…I made a big mistake in not selling several of our larger holdings during The Great Bubble.”
2002: “Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. Unless, however, we see a very high probability of at least 10% pre-tax returns…we will sit on the sidelines.”
2001: “American business will do fine over time but think that today’s equity prices presage only moderate returns for investors. The market outperformed business for a very long period, and that phenomenon had to end.”
2000: “…a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. …many in Wall Street…will sell investors anything they will buy…speculation is most dangerous when it looks easiest. We try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge… We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Really juicy results…can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point.”
1999: “…we have no insights into which participants in the tech field possess a truly durable competitive advantage. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter… Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality…equity investors currently seem wildly optimistic in their expectations about future returns… If investor expectations become more realistic – and they almost certainly will – the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.”
1998: “At yearend, we held more than $15 billion in cash equivalents…it’s better to have the money burning a hole in Berkshire’s pocket than resting comfortably in someone else’s.”
1997: “…we have found few new opportunities…it may be some time before we find opportunities that get us truly excited. We made net sales during the year… Today’s price levels, though, have materially eroded the ‘margin of safety’ that Ben Graham identified as the cornerstone of intelligent investing.”
1996: “We continue to make more money when snoring than when active… Inactivity strikes us as intelligent behavior… The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved. When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio…we favor businesses and industries unlikely to experience major change…operations that…are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. Most investors…will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. What an investor needs is the ability to correctly evaluate selected businesses… You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you need…only two well-taught courses – How to Value a Business, and How to Think About Market Prices. Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”
1995: “We continue in our Rip Van Winkle mode…”
1994: “We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess?”
1993: “…a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it…by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy… the true investor welcomes volatility…the greater the opportunities available…[A] situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry… By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
1992: “…the return over the next decade from an investment in the S&P index will be far less than that of the past decade…stocks cannot forever overperform their underlying businesses… Our equity-investing strategy remains little changed from what it was fifteen years ago…The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase…the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return…insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying.”
1991: “John Maynard Keynes…says it all: ‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence…’ Typically, our most egregious mistakes fall in the omission, rather than the commission, category.”
1990: “Lethargy bordering on sloth remains the cornerstone of our investment style… The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling.”
1989: “In a finite world, high growth rates must self-destruct.”
1988: “We continue to concentrate our investments in a very few companies that we try to understand well. Naturally the disservice done students and gullible investment professionals who have swallowed [Efficient Market Theory] has been an extraordinary service to us… In any sort of a contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline.”
1987: “We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts. Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities…investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.”
1986: “…we had no new ideas in the marketable equities field, an area in which once, only a few years ago, we could readily employ large sums in outstanding businesses at very reasonable prices. So our main capital allocation moves in 1986 were to pay off debt and stockpile funds. Under current stock market conditions, we have little hope of finding equities to buy…occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful…little fear is visible in Wall Street. Instead, euphoria prevails…because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the companies they own.”
1985: “[The] stock market…offers very little opportunity compared to the markets that prevailed throughout much of the 1964-1984 period…stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued. Our 1985 results include unusually large earnings from the sale of securities. We are enormously indebted to those academics [who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value – and even thought, itself – were of no importance in investment activities]… what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?”
1984: “The companies in which we have our largest investments have all engaged in significant stock repurhases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding… It’s been over ten years since it has been as difficult as now to find equity investments that meet both our qualitative standards and our quantitative standards of value versus price. We try to avoid compromise of these standards, although we find doing nothing the most difficult task of all. With our financial strength we can own large blocks of a few securities that we have thought hard about and bought at attractive prices… Over time our policy of concentration should produce superior results…we believe that present fiscal policy – featuring a huge deficit – is both extremely dangerous and difficult to reverse.”
1983: “…we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are.”
1982: “We need a moderately-priced stock market… The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
1981: “While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.”
1980: “…we buy many minority portions of already well-run businesses (at prices far below our share of the total value of the entire business) that do not need management change, re-direction of cash flow, or sale.”
1979: “We currently believe that equity markets in 1980 are likely to evolve in a manner that will result in an underperformance by our portfolio for the first time in recent years. We very much like the companies in which we have major investments, and plan no changes to try to attune ourselves to the markets of a specific year. In the last several years our net fixed dollar commitments have been limited to the purchase of convertible bonds. We believe that the conversion options obtained, in effect, give that portion of the bond portfolio a far shorter average life than implied by the maturity terms of the issues (i.e., at an appropriate time of our choosing, we can terminate the bond contract by conversion into stock).”
1978: “We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. We continue to find…small portions of really outstanding businesses that are available, through the auction pricing mechanism of security markets, at prices dramatically cheaper than the valuations inferior businesses command on negotiated sales. We are not concerned with whether the market quickly revalues upward securities that we believe are selling at bargain prices. In fact, we prefer just the opposite since, in most years, we expect to have funds available to be a net buyer of securities. And consistent attractive purchasing is likely to prove to be of more eventual benefit to us than any selling opportunities provided by a short-term run up in stock prices to levels at which we are unwilling to continue buying. Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.”
1977: “We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price… “Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies. Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained indirectly through stock ownership.”
In summary, Warren Buffett’s approach is to buy deep value in a few companies he understands well, and then hold until the value is no longer there. If there is nothing to buy, he sits on cash. The approach appears to work, but outperformance is fading.
See “Warren Buffett’s Track Record: Luck or Skill?” for a formal study of Warren Buffett’s track record, finding that “Warren Buffett is an investor with superior stock-picking skill that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.” See also “Why Don’t We All Just Do What Warren Buffett Does?”.
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