Be a Buffett, don't back the benchmark
Warren Buffett’s latest letter to Berkshire Hathaway shareholders is the usual mixture of folksy charm and investment wisdom.
Warren Buffett’s latest letter to Berkshire Hathaway shareholders is the usual mixture of folksy charm and investment wisdom.
9:15PM GMT 03 Mar 2012
33 CommentsThe part that grabbed the headlines this year was a comparison of equity investing against bonds and gold, which unsurprisingly came down on the side of shares. Having achieved a 19.8pc annual growth rate from stocks over 47 years, it is not hard to see why they should be Buffett’s first love.
For me, there was a more interesting lesson in this year’s letter. It was a thought prompted by its first page on which Buffett compares his performance year by year since 1965 against the S&P 500 index. Last year, the 4.6pc rise in the value of Berkshire Hathaway’s book value compared with 2.1pc growth in the main US benchmark.
It was the 39th year out of 47 in which he has beaten the market, a fantastically consistent performance. But then, as Buffett says, “if our gain over time outstrips the performance of the S&P 500, we have earned our paychecks. If it doesn’t, we are overpaid at any price.”
So once a year, and cumulatively over the half century he has run Berkshire Hathaway, Buffett compares his progress against the S&P 500. It is a convenient benchmark to see if he is earning his corn and, in that regard, he is no different from any other fund manager.
In another important way, however, Buffett is quite different from the majority of professional investors. This is because, although he cares about his overall performance compared with the benchmark, he is indifferent to how his portfolio of investments compares with the make-up of the S&P 500. He is, to use the jargon, unconstrained by the benchmark.
Buffett’s approach is simply to buy companies that he believes are undervalued compared with their intrinsic value and hold them for the very long term. If you think that most investors do something similar you may be disappointed. That is because the fund management industry has increasingly lashed itself to the mast of stock market indices. Its buy and sell decisions are to a greater or lesser extent determined not by the intrinsic merits of individual shares but by their weighting within a relevant price-derived benchmark.
It is an approach which more thoughtful investors believe may not necessarily be in the best interests of their customers. It has led to funds having heavy concentrations in small numbers of very large companies or in particular sectors that dominate and, as such, it may be seen as a significant contributor to the stock market’s booms and busts.
Investment approaches that measure their performance against price-related indices almost by definition encourage the purchase of overvalued shares that have been pushed above fair value. This is a particular problem with passive funds like index trackers but, to the extent that actively-managed funds have become “closet trackers”, it means they too risk being sucked in at the top of the market, contributing to moments of madness like the dot.com bubble a decade or so ago.
What is increasingly happening in the institutional investment world in response to these concerns is a move to alternative indices that try to take the price of a share out of the equation. These new indices focus on different measures such as a company’s sales, the value of its assets, even the size of its workforce. Alternatively, they simply measure themselves against an equally-weighted benchmark, one with a similar exposure to every company in an index. In both cases, there is evidence that these approaches outperform market value-based indices in the long run.
So why doesn’t everyone simply invest according to this new “fundamental” approach? The main reason is that the alternative methods have a tendency to solve one problem but create a new one. For example, equally weighting all the companies in an index gives a fund a relatively greater exposure to small companies. There will be times when this is an advantage and times when it leads to under-performance.
As a consequence of this, some active fund managers are testing a move back towards the unconstrained Buffett approach, freeing up their investors to back their best ideas regardless of a benchmark. Some might say that is what they are paid to do.
Tom Stevenson is an investment director at Fidelity Worldwide Investment. The views expressed are his own.
He tweets at @tomstevenson63.
He tweets at @tomstevenson63.
