How smart has America’s smartest investor been?

University of Berkshire Hathaway: 30 Years of Lessons Learned from Warren Buffett & Charlie Munger at the Annual Shareholders Meeting (Pecaut and Wren 2017) is interesting for students of probability. We celebrate Warren Buffett as America’s smartest investor. But how much of that is survivorship bias? In November 2008 it looked as though Berkshire Hathaway might default on its debt (see “Betting Against Buffett” (Forbes): “Spreads on insurance against a debt default by Warren Buffett’s triple-A-rated Berkshire Hathaway are trading about on par with that of the embattled General Electric and worse than Goldman Sachs and Citigroup.”)

If the company was risky enough to nearly go broke in 2008, but didn’t, of course it should have done pretty well since then.

The authors, themselves money managers, start with some history:

Berkshire Hathaway was originally a New England textile company. It was a deeply discounted stock, with a book value of $19. Its net working capital was over $11 a share. Buffett bought shares at around $7–$8 per share. Buffett was buying shares at a discount to net cash and near-cash items. The decline of the textile industry was underway. Berkshire Hathaway was consolidating and selling assets. Then, with the cash, it was buying in its stock—which was intelligent because the stock was so cheap. In 1963, Berkshire did a massive buy-in of almost a third of its shares. The owners of Berkshire Hathaway saw Buffett’s position and didn’t want him in their little fiefdom. They called Buffett, offering to pay him $11.50 a share. He agreed. He’d make about a 40% profit in a short period. When the letter came for the offer, however, it was less than the agreed-on amount—but only by pennies. Nevertheless, their dishonesty upset Buffett. They were trying to chisel him out of 12.5 cents per share. So Buffett went the other way and started buying increasingly more shares of Berkshire until he took control. He then booted out the guy who had tried to chisel him out. In 1964, Warren Buffett took control of that small New England textile firm, and it became his new base for making investments. At the time, the move made no sense. Buffett had bought a business in decline that he didn’t know how to run. He later joked that he should have taken the money. That would have been the smarter thing to do. As it turned out, this textile company was an ideal vehicle for making investments. With Berkshire Hathaway’s stock, Buffett had a publicly traded corporation with captive capital. The benefits of this corporate structure for managing money are significant.

In 1967, Buffett bought an insurance company, National Indemnity. Insurance has been a core operation at Berkshire Hathaway ever since. He loves the insurance business. With its float characteristics, it creates a powerful platform for compounding wealth.

Insurance companies collect premiums, of which a significant portion goes into reserves to pay future claims. This reserve (the “float”) earns money for Berkshire, leveraging the company’s return on capital. If you can operate in a way where that float is generated at a low cost and you can grow it over time, you have built a wealth-compounding machine. As Munger once put it, “Basically, we’re a hedgehog that knows one big thing. If you generate float at 3% per annum and buy businesses that earn 13% per annum with the proceeds of that float, we have figured out that’s a pretty good position to be in.”

For every $1 of equity at Berkshire, over time there has been roughly another 50 cents or so in float. By investing $1.50 for every $1 of capital over the years, Berkshire has leveraged its returns. A significant portion of Berkshire’s long-term outperformance can be attributed to Buffett and Munger’s ability to execute on this brilliant insight. That’s not something you or I can go out and do.

So maybe you could have gotten some of Berkshire Hathaway’s performance, especially after the firm had gotten big, simply by leveraging the S&P 500? A 10-year chart shows that BRK.A and the S&P 500 have performed almost identically (i.e., you wouldn’t even need leverage to match BRK.A with the S&P 500). Actually the S&P 500 has paid dividends over the years, not reflected (I don’t think) in the pure index price. So the slightly better performance of Berkshire Hathaway (no dividend) would disappear if you factored in the dividends that the S&P 500 has paid.

Over a 20-year period, BRK.A looks a lot better, with a return of nearly 500% versus 170%. But a leveraged S&P 500 would also have done much better than the straight S&P 500. Maybe the argument is that using insurance float instead of borrowed money is a less risky way to use leverage?

As I did, Buffett lived through the traumatic inflation of the Jimmy Carter years. The authors record Buffett warning investors at every meeting that, due to the U.S. government’s deficit spending, significant inflation was just around the corner.

[1986] Buffett says it’s a political phenomena, not an economic one. As long as politicians lack self-restraint, they will print a lot of money at some point. Though it is probably two years or more down the road, Buffett sees “substantial inflation” and “rates we’ve never seen before.”

[1987] Like John Templeton, Buffett believes significant inflation is inevitable due to our government’s quick-fix attitude. “The availability of a printing press as a short-term band aid is very tempting . . . Inflation is a narcotic.”

[1993] While amazed at how low inflation has stayed, Buffett said that, at some point, inflation will return. “It’s just in remission.” Munger agreed, noting in his characteristically upbeat way that “the failure rate of all great civilizations is 100%.”

[2004] With perhaps the most significant statement of the meeting, Buffett asserted that inflation is heating up in the U.S. This explains Berkshire’s shift from bonds to cash.

[2006] Buffett noted that the CPI (Consumer Price Index) is not a particularly good measure of inflation. First, “core” inflation excludes food and energy. “Not much is more core!” Buffett exclaimed. Second, since CPI uses a rent equivalent factor for living costs, it hasn’t captured the rising cost of housing. In sum, the CPI understates inflation. Munger noted that inflation is where you look. [i.e., when your predictions don’t come true, declare measurement failure!]

[2009] Buffett guaranteed that the dollar will buy less over time, and that is happening with all other currencies as well. All major nations are electing to run major deficits in the face of the economic crisis. Buffett was emphatic: “You can bet on inflation.”

At nearly every meeting Buffett talks about how it is nearly impossible to lose by investing in Coca Cola due to its valuable brand. From the 1999 meeting:

Dismissing concerns about Coca-Cola’s prospects with the strength of the dollar, Buffett said what really matters is share of market and share of mind. Coca-Cola’s market share is marvelous, and its share of mind is overwhelmingly favorable with a ubiquity of good feeling. The keys to analyzing Coca-Cola’s economic progress are l) unit cases sold (more is better), and 2) number of shares outstanding (the fewer the better). While it’s true case growth slowed over the last four quarters, Buffett believes that is temporary and unimportant to a 10-year projection. (Munger interjected that 10–15 year projections can tune out a lot of noise.) Buffett concluded that it’s hard to think of a better business in the world. There may be companies that could grow faster, but none as solid.

What’s happened since 1999? Maybe Buffett was right… Coke is up 32 percent. But on the other hand, the S&P 500 is up 105 percent (double your money in only 20 years). See this comparison chart.

Buffett and Munger predicted the Collapse of 2008:

Buffett continued that when things go bad, all kinds of things correlate that you wouldn’t think of. Buffett said this is deadly. If you are not aware of these correlations, you have an unrecognized concentration of risk. When telecom debt collapsed, for example, people found that all of it was correlated.7 Munger warned that derivatives have the same sort of danger and that the accounting for them exacerbates the problem.8

Buffett added that, while participants claim derivatives help spread risk, he believes that they have actually intensified risk since a few large players do much of the business.10 Buffett cautioned that the counter-party risk in the system has been little examined despite the warnings of past mishaps. Munger stated that he would be amazed if he lives another five years and doesn’t see a significant blow up.

Buffett warned that when there is trouble, everything correlates. Thus, in managing catastrophic losses, one must think through the ripple effects. California, for example, has had 25 6.0 earthquakes in the last 100 years. Such a quake in a populated area would have enormous consequences. At Berkshire, not only would it hit the insurance operations, but it would correlate with the businesses of See’s Candy, GEICO, Wells Fargo and other Berkshire subsidiaries.

As with many Wall Street prophets, however, he was apparently able to predict the collapse but not the date. The above quotes are from the 2003 and 2005 meetings.

From the 2007 meeting:

As one example of what can happen under forced sales, Buffett reviewed October 19, 1987: The infamous Black Monday when the Dow Jones Average dropped 23% in a single day. It was driven by portfolio insurance, which was a joke. It was a bunch of stop/loss orders, but done automatically, and the concept was heavily marketed. People paid a lot of money for people to teach them how to put in a stop/loss order. When a lot of institutions do this, the effect is like pouring gas on a fire. They created a doomsday machine that kept selling and selling. You can have the same thing today because you have fund operators with billions of dollars—in aggregate, trillions of dollars—who will all respond to the same stimulus. It’s a crowded trade, but they don’t know it. And it’s not formal. They will sell for the same reasons. Someday, you will get a very chaotic situation.

Buffett shared that when he and Charlie were at Salomon, they talked about five or six sigma events, but that doesn’t mean anything when you’re talking about real markets and human behavior. Look at what happened in 1998 and in 2002. You’ll see it when people try to beat the markets day by day.

We have expressed great concerns about the subprime mortgage meltdown. However, Buffett does not see that this will be “a huge anchor on the economy.” Especially if unemployment and interest rates do not go up, Buffett believes it unlikely this factor alone will trigger anything major in the general economy. … Buffett concluded that it will be at least a couple of years before real estate recovers. The people who were counting on flipping the homes are going to get flipped, but in a different way.

From the May 3, 2008 meeting (four months before the Collapse):

Buffett opined that “a chief risk officer is an employee that makes you feel good while you do dumb things.”

He talked about CDOs (collateralized debt obligations), which were aggregations of tranches of thousands of different mortgage claims. They were so complicated that there could be 15,000 pages to read to understand all the mortgages and tranches involved. As if that wasn’t complicated enough, there are also CDOs squared, which might be a security that comprises 50 CDOs. At 15,000 pages per CDO, one would have to read some 750,000 pages to understand one CDO squared.

When asked about CDS (credit default swaps), a $60 trillion national market, Buffett felt the CDS market was not a big risk to tumble into chaos.

At the first meeting after the collapse, May 2, 2009, Buffett talked up Wells Fargo. How has it done? Up about 170 percent… against the S&P 500, which is up more than 220 percent (chart).

So… there are a lot of great stories in this book, certainly better than the story “Back in 1990 I bought the S&P 500 with 2:1 leverage. But it looks as though Buffett had a couple of decades of tremendous success and then a couple of decades of S&P-style returns. It is unclear that what he did can be replicated, even by Buffett himself.

Readers: What do you think? It isn’t far to demand that Buffett be right about everything, but is it possible that the reverence in which he is held is largely due to early-stage luck, leverage in a generally rising market, and survivorship bias?

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