Warren Buffett: the world’s richest index hugger

good morning. The stock market has been strong for the past three days, and it seems that the theory that “the labor market is definitely cooling down and inflation is certain to occur” has taken root. As I said in yesterday’s letter, I’m a little skeptical, but I’m still a journalist. If you are not a journalist and have comments, please send them to [email protected].

Does Buffett matter?

Eric Pratt, along with valued collaborators Eva Hsiao, Patrick Maturin, Ian Smith, and Miles McCormick, has created an excellent series about Berkshire Hathaway’s future without Warren Buffett. Read it! It’s full of surprises and realizations.

One of the key questions in Eric’s series is, “Who can follow what Buffett accomplished at Berkshire?” But this question, while a good one, raises another question for me. “From a purely financial perspective, why does it matter what happens to Berkshire after Mr. Buffett?”

The important thing to always remember when talking about Berkshire today is:

Over 21 years, the S&P and Berkshire’s return performance has been nearly identical. On an annual basis, there is a 5 basis point difference in performance between the two companies (S&P has a pointlessly small advantage). Sure, going back further, Berkshire has crushed the index, but it’s hard to see the relevance today given how much the company has changed. Twenty years is plenty of time to evaluate your investment strategy. After all, this is the average person’s effective investment horizon (the time from when they can invest a large amount until they retire). The results are really showing. Berkshire produces exactly the same returns as the U.S. large-cap index (and this is true over 5 and 10 years as well).

And, as I argued back in February, we almost certainly know why. Berkshire is such a large, diversified conglomerate that it would be strange if it did anything other than outperform the index. During his years of strong performance, Buffett’s market capitalization was less than $100 billion, a fraction of the S&P. It now stands at $900 billion, or about 2% of the index.

There is one obvious answer to this question, but it is problematic. Berkshire’s volatility (beta) is lower than the market (approximately 0.7 to 0.8 when market volatility is 1). So anyone who believes beta is a good measure of risk could theoretically leverage their investment in Berkshire to earn better long-term returns than the S&P. The problem is, Warren Buffett is not one of those people. Buffett has rightly said that for true long-term investors, volatility is a good thing, not a risk, because it provides an opportunity to buy and sell at favorable prices. By that logic, and since Berkshire is an active buyer of its own stock, Buffett should wish Berkshire’s beta was higher. This is no joke. He really should. I think maybe he is.

Buffett says the real risk is the risk of permanent loss. And in this sense, Berkshire is probably a little less risky than S&P, he said. But it’s clear (to me anyway) what exactly he means by this, given that S&P is a diversified index where growing companies automatically enter and shrinking companies automatically exit. isn’t it. Where is the risk of permanent loss in that?

Some might argue that during a crisis, Berkshire’s stock price declines by less than the index, so investors are less likely to panic and sell at the wrong time. Of course, this is the best and most common way to create permanent investment losses (as far as I know, Buffett hasn’t made this argument, but he probably does. It’s pretty Buffett-ish. is not it).

But judging by the experience of the Great Financial Crisis, this is not particularly true. From 2007 to 2008, Berkshire’s high-to-low price drawdown was slightly smaller than the S&P. Yes, in his four years (March 2007 to March 2011) centered around the market bottom, Berkshire outperformed by a huge total of 15 points. Importantly, however, this significant safety period did not improve long-term returns. During the decade centered around the global financial crisis, Berkshire underperformed by about 50 basis points a year.

There’s another problem with the argument that Berkshire produces superior volatility-adjusted returns. Buffett may be more or less responsible for the company’s low volatility. Mr. Buffett exudes a magical aura of wisdom and stability over stock prices. Mr. Buffett is arguably the greatest spokesperson in financial history. (Try this thought experiment: Imagine a conglomerate that controls the same corporate empire as Berkshire, including particularly unpopular industries such as energy, insurance, and banking.) Can you imagine enjoying the same amount of goodwill among the public as Berkshire, if the company were run by anyone other than ol’ Uncle Warren? (I personally don’t). After Buffett, it wouldn’t be at all surprising to see Berkshire’s beta rise.

However, there is one interesting card remaining in the Berkshire Bull deck: Valuation. If the S&P is catching up with Berkshire because Berkshire’s stock has become more expensive relative to its fundamentals, there is reason to think mean reversion will cause Berkshire to outperform over time. In that case, the appearance of index and performance parity is something of an illusion, perhaps created by the irrational rise in popularity of Big Tech stocks (other than Apple, of course). But when it comes to price and earnings valuations, this is not the case. The p/e difference between the two varies, but not by much.

However, Buffett does not like to think of value in terms of earnings per share, as the numbers fluctuate widely from year to year depending on gains and losses from investments and insurance businesses. He prefers, or used to prefer, book value per share. Over the past 21 years, book value per share has increased at 11 percent a year for Berkshire, compared to 6 percent a year for S&P. Why doesn’t this translate into better performance than Berkshire? That’s because the S&P’s price-to-book multiple has been rising rapidly, while Berkshire’s has been very stable.

However, the problem with this debate is the composition of the industry. In recent years, S&P has shifted to high-price/book, high-margin industries, such as technology. Berkshire continues to focus on low-value/book, low-margin energy, industrials, and financials. To make the case that Berkshire’s stock is undervalued relative to the index, you’d have to dig deep into the changing composition of both industries (haven’t you?).

We might change the question again from “Who cares what happens after Buffett?” “Without destroying Berkshire’s identity and spirit, what can Buffett’s successor do to make Berkshire something other than an index hugger?” I’ll think about that some more tomorrow.

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