How Warren Buffett Really Invests

In future issues of this Unconventional Wisdom newsletter we will be undertaking a detailed analysis into the investment strategies of the most successful investors in the world. The aim of this recurring piece will be to identify what makes the endowment, sovereign wealth and pension funds from around the world so successful, and what our readers and clients can glean from their experiences. As a pre-cursor to this series of articles, we thought an interesting starting point would be to understand how the most quoted person in the world, Mr Warren Buffet, the ‘Oracle of Omaha’ really invests.

It’s difficult to pass through a day without hearing a Warren Buffet quote taken out of context. Seemingly every financial advice, accountant, fund managers, index manager of investor in Australian quotes the Oracle from time to time. Many businesses actually list Warren as the source of their investment inspiration. I’m sure you have seen them before, they may be a one-man investment firm, that lists their investment philosophy around Buffet quotations like:

  • ‘Always invest for the long-term’
  • ‘Never invest in a business you cannot understand’
  • ‘Buy and business, don’t rent stocks’
  • ‘Most people get interested in stocks when everyone else is, the time to get interested is when no one else is. You can’t buy what’s popular and do well’
  • ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price’
  • ‘Forecasts may tell you a great deal about the forecaster, they tell you nothing about the future’

Yet, as it always tends to be in the financial planning, stock broking and investment management industry, the same advisers that publish these quotes, tend to recommend the exact opposite of the values they espouse. For one, they rely solely on economic forecasts and broker research reports to make decisions, whether that is in sticking to a strategic asset allocation or recommending the new stock with a buy. If you ask most stockbrokers or investment advisers, they seemingly always think it’s a good time to buy and its never time to sell. Whilst they constantly stress the importance of investing for the long-term, as soon as markets become volatile, the long-term goes out the window, particularly if you call asking them what they would recommend. Most worryingly, Australian investors tend to chase the most popular companies after they have already gone up. One only needs to review the broker reports on the likes of Newcrest or BHP Billiton over the last decade, or look closely at the excessive multiples, even by US terms, that are afforded to up and coming technology businesses.

So how does Buffet really invest?

For those people willing to take the time to research and consider how Warren Buffett really invests, the approach is markedly different to the perception of a buy-and-hold, fundamental investor. We have summarised Buffet’s investment strategy down to five key factors.

Opportunistic

This would likely be Warren Buffet’s most successful investing trait. Buffet’s substantial balance, investing gravitas and influence over markets is such that he is afforded opportunities very few people have access to. Buffet’s Berkshire Hathway made four key investments in the dark days of the GFC following the collapse of Lehman Brothers. The investment in Goldman Sachs was likely the most successful. It came at a time when confidence in the sector had disappeared and share prices were in free-fall. Buffet negotiated with Goldman Sachs to provide capital of $5bn under a preference share and warrant agreement that afforded him interest payments of 10%, dividends and the ability to convert his shares at a discount to the market price in a few years’ time.  Berkshire Hathaway provided this offer to a series of businesses when they were on their knees, resulting in outsized returns with markedly lower risk.

Private Investments

Whilst it may not appear so from reading updates on Berkshire Hathaway’s annual meeting, Buffet actually prefers to take control of businesses and move them off publicly listed sharemarkets. Berkshire’s common equity holdings represent just $170bn of the $702bn under management in December 2017. The entire team share his views that the most successful companies are run for their customers, not solely for their shareholders; importantly they know that this can take time. The only way to afford companies an appropriate amount of time is to ensure they are not burdened with the stress of daily market volatility, broker research reports and profit projections. Most of Buffet’s successful investments have been off market, including the famous Geico insurance business, the US railroads and utility networks.

Buffet has been quoted as saying ‘I am a better investor because I am a businessman, and a better businessman because I am an investor’. If this could be said for the majority of advisers, brokers and planner in Australia, we believe their clients would be getting much better results than they have. There has simply been too little interest effort applied to what is in the best interests of clients, which is the key to a successful business, as opposed to selling products for commission.

Aggressive & Involved

Many believe Buffet is somewhat of a passive, fundamental value-oriented investor, however, his actions indicate it’s the opposite. Buffet is inherently an aggressive investor. His firm seeks acquisition and expansion opportunities for his businesses, negotiates and mergers and acquisitions with other portfolio and external companies and is willing to back his views with substantial amounts of capital. When Buffet allocates capital to a business, the ASX’s Insurance Australia Group is one such example, he does whatever he can to ensure it will be successful, offering resources, additional capital, network and management opportunities.

Patient 

One of Buffet’s greatest traits is no doubt his patience and trust in his management team. Every investment is viewed as a business ‘not as a ticker symbol to be bought or sold based on their ‘chart’ patterns or analyst ‘target’ prices’. The result is that Buffet is willing to wait 5, 10 or 15 years for businesses to provide returns on his capital. He focuses on identifying the strengths and requirements of each business and putting together the best management team possible together. Most importantly, he is trusting enough to let these people run the businesses themselves, and affords them the time, flexibility and capital they need to achieve excellent results.

Control

A quick review of Berkshire’s balance sheet shows that most of their capital is invested into businesses they control, of in which they have a substantial stake and a chair at the boardroom table. Among his direct US shareholdings, the ownership of American Express, Moody’s and Phillips, all exceed 13% of the issue capital, and the ‘smallest’ is the 3% ownership of Apple Inc. making it the third largest investor behind index managers Vanguard and Blackrock. Berkshire does not seek to be a passive investor, they want control of each business and the ability to install their own management team and guarantee success.

This is only a short analysis of Buffet’s investment strategy, if you are interested in learning how you can apply some of these concepts to your portfolio don’t hesitate to get in touch.

 

Managed Funds Vs Listed Investment Companies – (LIC)

We have republished a recent research report from Zenith Research, a leading investment research firm in Australia. It is an interesting and well written paper that strengthens the belief that the default way investors should access pooled investments is through wholesale managed funds.  Our interpretation of the research is that, including an extra variable in the investing process, especially one that can substantially change the success of the investment, is not worth the extra risk.  The simple fact that the share price of an individual LIC can trade at a premium to NTA or at a Discount to NTA (noting that a managed fund will always trade at NTA) just increases the chances of an investor being less successful over the duration.

Investing is hard enough, without applying this factor to the outcome.

The research does highlight that the same variable can potentially add extra returns to an investment if, a very same investment strategy is implemented, however nothing is guaranteed.  In reverse, if the underlying fund underperforms, the problem is most likely amplified by the fact that the market over the long term will further price such an underperformance by discounting its share price to a NTA, further deteriorating the return. The paper does argue that over the long term the risk of underperformance is reduced. However the chance that an investor will hold it over the long term, is a hard to imagine.

This is one investment area that Unconventional Wisdom prefers, the Conventional; Wholesale Managed funds are superior investment vehicles than Listed Investment Companies. Enjoy the read and happy to hear your thoughts.

LIC discounts– can you get more than you pay for?

Despite the strong growth recorded across the Listed Investment Company (LIC) market, share prices trading away from their Net Tangible Assets (NTA) is a factor that continues to act as a barrier to entry for many investors. Owing to this dynamic, many investors have preferred to gain exposure to unlisted managed funds to avoid divergent return outcomes caused by market sentiment and trading patterns.

Amidst this dynamic, Zenith has analysed the market to examine what investor returns have been generated through investing in LICs (and Listed Investment Trusts) at a range of premiums or discounts to NTA. These results provide a framework for how investors can implement transactions over the short and long-term.

Logically, the propensity for LICs to trade away from their underlying NTA should provide opportunities for returns arbitrage and potentially higher yields. But this raises a number of questions:

  • At what level is a discount to NTA a good buying opportunity?
  • Is this a persistent phenomenon?
  • Does this effect decay over time?

Zenith believes that to a certain extent, these questions are broadly answerable. We have conducted a study of LICs using historical data on 51 vehicles (not limited to those rated by Zenith), with the following attributes as at 30 April 2018;

  • Market capitalisation of over $100 million to remove the ‘sub-scale’ effect
  • Minimum three-year trading history to ensure that lack of dividends for new LICs was not over represented as a factor

We measured the outcomes for each LIC by aggregating them into brackets based on their prevailing premiums or discounts to their pre-tax NTA. We then assumed purchasing each at their corresponding market price and measured the outcome in terms of the actual Total Stock Return (TSR – share price movement and dividends reinvested). TSR’s have then been averaged on a simple basis rather than using a market capitalisation weighted approach. We ran this analysis for 12-month periods over each year for five years with the following results.

These results show that purchasing at a discount is, on average, a valid strategy. Buying at an average discount of 15% to 20% to Pre-Tax NTA delivered an average 12-month TSR of 18.2% over each of the one-year periods tested between 2014 to 2018. Purchases at progressively lower discounts, and then escalating premiums, resulted in poorer results. While this is a somewhat intuitive result, interestingly, the worst result was not buying at the highest premium bracket (15% to 20%), but rather the second highest (10% to 15%). This scenario generated an average TSR of -1.4% for the year, versus 0.4% at the highest premium. Zenith believes that this is a result of including those LICs which frequently trade at high premiums for prolonged periods. Examples here included Djerriwarrh Investments Limited, Mirrabooka Investments Limited, WAM Capital Limited, WAM Research Limited and Platinum Capital Limited. As we measured performance over five consecutive years, this does suggest some level of persistence in this phenomenon over time. However, Zenith recognises that this is likely to decay in markets where strong market demand causes widespread narrowing on discounts and increases in premiums, as was observed in the sample group (and more broadly), between 2012 and 2014 (see following chart).

Thirdly, we asked the question, does the effect of arbitraging price to NTA decay over time? Based on our assessment, the answer is yes. To do this, we examined what happens if the holding time exceeds 12-months. Using data ending 30 April 2018, the following results were derived.

Interestingly, holding for longer timeframes delivers a very different outcome. There is a strong propensity for the effect to be relatively short-lived, with six to 12 months appearing to be the optimal timeframe (measured at six months, similar outcomes were observed but at weaker levels than at 12 months). Over longer timeframes, Zenith believes that other factors such as portfolio performance and market sentiment begin to override the discount effect and as such it results in much stronger return profiles.

While not illustrated here, we also ran scenarios over different time horizons i.e. data measuring TSR over 1, 2 and 3 years ending in each year over five years between 2014 to 2018. The results consistently showed that the effect of buying at a discount decayed materially past a 12-month holding period.

Zenith believes that this bears out our view that while movements in share price relative to NTA may throw up advantageous opportunities to enter or exit positions in LICs, other drivers influence long-term outcomes. This is important, as it addresses a widespread view held by the market that LICs are unattractive versus managed funds because of their ability to trade away from their NTA.

That said, Zenith does maintain that there is material danger in buying LICs at strong premiums. Our results around the performance of longer-term holdings indicated that notwithstanding the potential to generate reasonable returns when buying LICs at a premium, these premiums are also at greater risk of dissipating where market sentiment moderates.

Ultimately, while relative pricing on the secondary market is an important aspect, it should not eclipse the longer-term performance that can be achieved. On choosing quality LICs, if an appropriate investment horizon is adhered to, shareholder outcomes should not differ materially from that of the portfolio over the longer term.

While this data is encouraging, it should also be obvious that when treated on a case by case basis, individual LICs may not be so accommodating as to provide such arbitrage opportunities. Portfolio performance aspects aside, those LICs exhibiting negative features such as suboptimal scale, egregious fee terms, poor shareholder engagement practices or lacking sufficient transparency, will frequently find the market applying negative feedback loops, making share price discounts difficult to overcome. Similarly, LICs with strong market support may trade at irrationally high premiums for prolonged periods of time.

To finalise, Zenith rated LICs achieved the following returns on a TSR and portfolio basis for the year ended 30 April 2018. This highlights the short-term impact market sentiment can have in terms of the dispersion between portfolio and shareholder outcomes. While there is a large dispersion of positive and negative outcomes, Zenith believes that longer term outcomes should be the focus when purchasing.   

Challenging the traditional asset allocation model

The ‘balanced’ portfolio has become an institution in the financial world. Equities and bonds are the main ingredients and the ‘mix’ determines the categories of balanced funds commonly used. Here we discuss this approach, and look at another option.

The traditional model

Words like ‘conservative’ or ‘capital preservation’ signal a low weighting to equities, around 20% to 30%, while ‘balanced’ usually means 40% to 60% in equities, and ‘aggressive’ or ‘growth’, can be as high as 90% in equities. The equity component is the main determinant of the return and volatility of ‘balanced’ portfolios. Property is another asset class often used, but generally speaking this will consist of listed property companies, and I would argue listed property companies are just a part of the equity market. Cash is of course another asset class, but for the purpose of this article, I will assume cash is part of the bond allocation. Equities provide high long-term returns, but are volatile. Losses in equity markets can be severe, leaving investors in the red for years on end. Bonds provide more predictable returns because they (the returns) mostly come from regular interest payments called ‘coupons’. These payments remain the same throughout the life of most bonds. Lower risk bond prices fluctuate based on interest rates, but the fluctuations are much lower than equities. Investment grade corporate bond volatility is around 2% p.a. versus 12% to 15% for equity markets.

Traditionally advisors and institutions manage portfolio risk by their bond/cash weightings. The more conservative the investor, usually based on age and circumstances, the lower the allocation to equities.

The logic behind this approach is based on the fundamental principle of diversification. Diversification depends on an asset’s behaviour in certain market conditions, particularly when losses are involved. When you have an asset that is losing money, something that provides ‘diversification’ will be making money or at least losing far less, and this pattern is strong, that is, you can rely on this inverse relationship.

Among other things, the chart below shows the Schiller P/E, a measure of how expensive equities are, and the US 10-year yield inverted, showing bond market valuations.

Over the last 100 years, bonds have been a great diversifier. The exception is the period 1960 to 1980 when ‘real’ bond prices fell -26.2 %, and equities rose just 74.3%, or 2.7% p.a. These were the inflation years, and while equities rose, they became increasingly cheap.

What is particularly interesting for us, is that in most people’s ‘investing lifetime’ (post 1980), we have been in a golden age for bond/equity portfolios. By the early 1980’s both were extremely cheap. Since then, bonds have not only steadily appreciated in value but have also spiked in value in all three major equity market downturns, 1987, 2000 and 2008, providing an excellent ‘hedge’.

The question is, how will a bond-equity mix work going forward, when both are expensive?

Not since the 1920’s have we seen both asset classes so stretched. I believe investors who remain wed to the ‘balanced portfolio’ approach of bonds and equities may have to accept a long period of considerably lower returns than what they are used to, even lower than those experienced in the inflation years mentioned above. 

Three scenarios

Let’s imagine three scenarios for a ‘balanced’ portfolio going forward.

  • Scenario one, a crisis which disrupts global growth causing interest rates to fall and bonds to rise. Equities would fall but bonds would increase in value and soften the blow – another chapter in the bull market for the ‘balanced portfolio’ but you would still lose money. Also, most bond portfolios are set up for rising interest rates so are weighted towards shorter maturities. This ensures smaller losses if interest rates rise, but also limits gains when interest rates fall.
  • Scenario two, the status quo with continued steady to strong economic growth leading to ‘normalisation’ of interest rates globally. Bonds underperform, with losses in capital value partially offsetting the already very low coupons. As the ‘discount rate’ rises, equity valuations face a headwind and valuations become more difficult to justify. Both bonds and equities underperform and the diversification benefit is limited.
  • Or thirdly, we see inflation rise more quickly than expected, sending interest rates sharply higher, which would probably lead to a correction in equity markets. Both bonds and equities lose money.

Unfortunately, many investors who have only ever been in a world where this strategy has worked, believe it will always work, and many have built business models which depend on it.

Another option? 

So what options do investors have in a world where both bond and equity markets are expensive? The answer is simple and is based on the same principle which popularised the ‘asset allocation’ model, the principle of diversification.

If you are prepared to look beyond traditional equities and equity funds, you will find a world of ‘alternative’ investments.

Within this universe of ‘alternatives’ are strategies which can be relied upon to respond differently to a given development in the environment. Dr Chris Gerczy, Associate professor of finance at Wharton School writes:

“Investors need to rethink their overall approach to portfolio construction and start thinking in terms of risk diversification and getting exposure to as many different and non-correlated types of risk they can-building a portfolio based on risk exposures, not just ‘asset classes’.

Many of the funds we invest in can be broadly categorised as ‘equities’, only the strategy adopted by the manager produces returns which bear little resemblance to equity market returns. Some strategies we invest in tend to make more money when equity markets fall than when they rise. Others will lose far less than the market, leading to meaningful long-term outperformance.

Unlike most traditional equity funds, alternatives depend very much on the skill of the manager rather than the market for their return. Manager selection is of course critical.

Just as you ought to conduct in depth research when selecting companies and bonds, so you should apply the same rigour when selecting alternative managers. You can manage this risk by diversifying across multiple strategies and managers, just as you manage company risk by diversifying across multiple shares and bonds.

This approach is not new. In McKinsey’s 2015 report, “The Trillion Dollar Convergence” they write, “Institutions are beginning to abandon traditional asset class definitions and embrace risk-based methodologies, a trend that repositions alternatives from a niche allocation to a central part of the portfolio.”

In a December 2014 Natixis survey of institutional investors they report:

“The challenge of generating alpha is leading institutional investors to implement alternative investments and non-correlated asset classes to their portfolio strategies.”

You don’t need to be a wealthy investor to access great alternative funds. Australia has a large number of very talented and skillful managers offering funds which focus on ‘risk’ rather than replicating the market, and which provide a compelling alternative, pun intended, to a traditional ‘balanced portfolio’.

Written by Mark Houghton from King Tide Asset Management. King Tide Asset Management (“King Tide”) is a specialist, independent investment management company and the manager of the “King Tide NZ/Australian Long/Short Equity Fund”.