Being Warren Buffett
By Christopher Farrell
Once, parents looked fondly at their youngster and harbored hopes that their child would grow up to be a professor, a concert pianist, a professional athlete, or maybe even a chief executive. Now, in a nation where more than half of all households own equities, many parents utter a daily mantra that their child will become the next Warren Buffett, the legendary investor.
Just how good is the Sage from Omaha? The price of his holding company, Berkshire Hathaway, has increased from $18 a share in the spring of 1965 to $71,000 a share by the end of 2000 -- for an annualized return that is more than double the performance of the main market benchmark, the Standard & Poor's 500-stock index.
"CONTROL YOUR EXCITEMENT."
Of course, it's not just Buffett's investing acumen and billionaire status that have turned him into a stock market icon. No, he's the Will Rogers of investing, gleefully puncturing Wall Street's many pretensions. What other corporate chairman would have written these lines in his letter to shareholders in his 2000 annual report? "But I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation, and paint. Try to control your excitement." (You can read Buffett's letters to Berkshire shareholders from 1977 to 2000 at www.berkshirehathaway.com.)
Still, what most people want to know is, what are the lessons for individual investors? Buffett's investment philosophy is well-known, as he has long preached the virtues of buy and hold, independent thinking, and the financial benefits of a simple framework. Wall Street brokers and strategists are also fond of mentioning Buffett as proof that it's possible for investors to beat the market. But a recent academic paper, "Buffett in Hindsight and Foresight," by Meir Statman, professor of finance at Santa Clara University, and Jonathan Scheid of Assante Asset Management, suggests the lessons are far more sobering.
For instance, the price of a share is approximately equal to what investors judge is the discounted value of the company's future cash flows. Statman points out that when Buffett took control of Berkshire Hathaway on May 10, 1965, the stock sold for $18 a share. That price is a "value in foresight," and represents the sum of investor wisdom about Berkshire Hathaway's prospects, says Statman. But the "value in hindsight" is vastly different.
Knowing what we now know about Berkshire Hathaway, the stock was worth $1,383 on May 10, 1965. In other words, investors would have had to put $1,383 in the S&P 500 that day to earn the same $71,000 that Berkshire was worth on Dec. 31, 2000.
This isn't just an exercise in ancient history. The value in foresight of Berkshire Hathaway was $8,675 at the end of 1989, but the value in hindsight was $14,671. "We might find out 10 years from today that $71,000 was a bargain price for Berkshire Hathaway shares," says Statman. "Or that it was a bubble price. But hindsight is not foresight."
The distinction is crucial for investors. Numerous academic studies have documented that investors pour money into the best-performing mutual fund for the past quarter or an outstanding stock for the past 12 months only to watch their fund lag the following quarter or the stock tread water for the next year. In other words, hindsight is not foresight.
Put it this way: Who among the thousands upon thousands of men and women just starting their professional careers managing mutual funds, hedge funds, venture-capital pools, or some other investment vehicle, will be the next Buffett? The odds are that a few will consistently beat the market and that if you invest with them you'll pocket a handsome sum of money. But how can you confidently spot such ability?
Somehow there's more to Buffett than his innate abilities. He's a financial genius, the Michael Jordan of the investing game. And he's an avowed disciple of the value approach pioneered by his mentor, Benjamin Graham. But the value methods of investing are well-known. You can read up on them in just about any introductory text on investing.
Yet Buffett leaves other Graham/Buffett acolytes far behind. For instance, the well-known Sequoia Fund returned 16.1% annually from 1971 to 2000, vs. 28.3% for Berkshire Hathaway (even though the Berkshire Hathaway made up 35.6% of Sequoia's assets as of Dec. 31). The Vontobol U.S. Value Fund returned 17.5% annually, compared with 26.7% for Berkshire from 1991 though 2000 (and it doesn't own any Berkshire stock), according to Statman.
Indeed, despite Buffett's wonderful anecdotes and genuine insights into buying and selling stocks, there's a critical element to what he does that even he can't explain. At times, he almost sounds like the Will Rogers who said, "Buy stocks that are going up. After they've done that, sell them. If they aren't going to go up, don't have bought them."
Nobel laureate Paul Samuelson noted that John Maynard Keynes once came up with a similar insight: "Really, you should buy one stock at any one time. The best one going. And when it's no longer that, replace it by the new best." Somehow, that's what Buffett does. Yet it's a trick few of us can emulate. In the end, Buffett has talent and perseverance but he also turns out to have been in the right place at the right time.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online
Edited by Beth Belton