Archives for September 2016

Okay, so you probably aren’t reading a book titled Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor if you are perfectly happy owning solely index funds forever. While the shared concepts with low-cost, passive investing still apply, here are things to consider if you want to do some of your own picking and choosing between individual stocks and bonds.

Given how much energy an 86-year-old Buffett seems to have, it must have been very interesting to invest with him as a hungry young man. On the other hand, reading through the partnership letters also shows how mature he was in his late 20s and early 30s.

Be honest with yourself. Pick a yardstick ahead of time. You need to pick a proper benchmark against which to measure your performance, not just having positive or negative years. Back in 1966, it was the Dow over the last 3 years. Note that it wasn’t just an index, but also a timeframe of at least 3-5 years.

If you’re going to invest a portion of your portfolio on your own, always keep track of your performance. You need to be honest about your results and whether they beat the rest of your portfolio, or even a simple target-date fund.

Investing modest amounts is an advantage. Use it. Warren Buffett had a lot more flexibility with a smaller asset base. There are many deals out there that on a percentage basis are attractive, but if you have to deploy billions, it won’t even move the needle. For example, there might a 12-month CD that earns you 8% APY, but only on $10,000. If you only have $20,000 to invest, putting a big chunk of your portfolio in a risk-free 8% would be much smarter than stocks over the next year. However, if you have $100 million to invest, such a deal would be a rounding error. Some other transactions like odd-lot tenders are also ideal for smaller investors.

Worry about risk and return, not about the name of the product. It doesn’t matter if it’s a laundromat, rental unit, shares of a public company, or bonds. When Buffett was winding down his partnership, municipal bonds were yielding 6.5% on a tax-free basis. In his mind, it was a better investment to buy the municipal bonds rather than stocks given the near-term prospects. So that’s what he recommended.

Ignore the crowd. Think rationally and independently. If you’re going to “beat the market”, then you have to think differently than the market. You’re looking for some area where the market price is much lower than the intrinsic value. By definition, that means a lot of people will be disagreeing with your opinion.

Develop your best ideas, and then bet big on it. Buffett is not a big fan of owning 100+ stocks in the name of diversification. If you have your 5-10 best ideas, why also invest in the other 90 that are worse? If you’re going to actively manage your portfolio, you must have the conviction to bet big on your opinions.

Self-confidence is required, as you will have periods of bad performance. For me, keeping my conviction during times of underperformance is the primary reason most of my portfolio is indexed. Here a stat from the book credited to Joel Greenblatt: Of the top 25% of managers who had outperformed the market over the decade: 97% spent at least 3 years in the bottom half of performance and 47% spent at least 3 years in the bottom 10%.

If you are hiring an outside manager, look at integrity first. Buffett on the types of managers he seeks for Berkshire:

We look for three things: intelligence, energy, and integrity. If they don’t have the latter, then you should hope they don’t have the first two either. If someone doesn’t have integrity, then you want them to be dumb and lazy.

As a side example, here is how Buffett organized his own fee structure for the partnership. If the fund did not accumulate anything past a 6% annual gain every year, he would not take any fees at all. Above the 6% annual rate, he would take 25% of gains as his fee. While some hedge funds also employ a “high water mark” system, they usually still have some form of flat fee that they take, no matter way. If Buffett didn’t reach his 6%, he got nothing. In addition, he had nearly all his own net worth in the partnership as well. He “ate his own cooking”.

If you get in a debate about owning index funds, Warren Buffett will likely be invoked as an example of successful stock-picking. A recent book called Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor covers a period when Buffett was arguably at his peak of active stock trading. However, even during this time, Buffett’s rules and wisdom still shared a lot in common with low-cost index investing.

From 1956 to 1970, Buffett managed a relatively modest amount of money through the Buffett Partnership Limited (BPL), mostly from family and close friends. Already a good teacher, he wrote his partners a series of transparent, frank, and educational letters. While he does write a lot about his outperformance goals and successful trades, but here are examples of how you can be both a Buffett fan and an index fund fan.

You are buying fractional ownership of a real business. Too often, stock trading is treating like playing a game with numbers that zip up and down. Even if you just buy index funds, you should always realize that you are still buying a piece of a business and all its future earnings. These businesses employ hard-working people and provide tangible value and useful services to customers.

In the long-term, the market is efficient. Value investing tries to take advantage of times when the quoted prices of shares vary from “intrinsic value”. Market quotes will vary in the short-term, and you can’t predict them. You can only choose whether to buy, sell, or do nothing. However, value investing also relies on the price eventually returning towards intrinsic value in the long run.

If you buy index funds, you do not spend your time and energy determining intrinsic value. However, you also believe that the markets will work themselves out over the long run.

In the short-term, be ready for big drops in prices. Even though index funds give up the search for intrinsic value, all stockholders are subject to the same short-term swings. From a 1965 BPL letter:

If a 20% or 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments. In the words of the poet Harry Truman – “If you can’t stand the heat, stay out of the kitchen.” It is preferable, of course, to consider the problem before you enter the “kitchen”.

Beating a diversified index of companies is hard. From a 1962 BPL letter. Buffett made these observations more than a decade before a single person owned an index fund… because they didn’t exist yet.

The Dow as an investment competitor is no pushover and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.

You may feel I have established an unduly short yardstick in that it perhaps appears quite simple to do better than an unmanaged index of 30 leading common stocks. Actually, this index has generally proven to be a reasonably tough competitor.

Consider after-tax results. Buffett offers good advice in that you should always keep track of your portfolio on an after-tax basis. If you are creating a lot of short-term capital gains, your outperformance has to be rather significant in order to counteract the additional tax drag. This doesn’t mean that Buffett never traded – he did a lot of transaction in the partnership years – but he also had many years of awesome returns.

Today, some people criticize Berkshire for not distributing a dividend, but in fact Berkshire does a great job deferring taxes so that the growth can keep compounding and keep your after-tax returns higher. If cash is needed, a Berkshire shareholder can always sell some shares.

A market-cap-weighted index fund usually has very low turnover and thus minimized tax drag. An actively-trading mutual fund that has the same pre-tax performance numbers as a passive mutual fund will often have lower after-tax performance.

More assets makes it much more difficult to create outperformance. More assets doesn’t always translate into lower returns, but as Buffett states you must have enough ideas to put that money to good use. From a 1964 letter:

Our idea inventory has always seemed 10% ahead of our bank account. If that should change, you can count on hearing from me.

Buffett stopped accepting new partners when asset levels reached $43 million. He decided to unwind the partnership completely in 1969, for a variety of reasons. He eventually found a better way to align his interests by all becoming shareholders of Berkshire Hathaway (and only taking a small salary as CEO).

A mutual fund with high performance will naturally attract a lot of assets. The good ones will stop accepting funds if the asset levels outrun their supply of great ideas. The bad ones will keep accepting funds because it means higher management fees. However, with Vanguard index funds the problem goes the other way. As the asset levels rise, the costs go down and the performance is unaffected. Here’s an interesting profile of the little-known manager of the Vanguard Total Market Index Fund, which now holds nearly a trillion dollars in assets.