Buffett-style investing - a discussion

C

Cutten

I thought I'd start a thread to discuss the pros and cons of Buffett-style investing. Most people are familiar with it, but I'll just recap the main elements of his approach:

1) Buy a stock looking at it as a fractional ownership of a business, not for reasons such as what the price has done, volume, technicals, sentiment etc.

2) Only buy a business you understand. You should have a high degree of confidence that the business will be around in 10 years and be operating just as good or better than it is now.

3) Buy excellent businesses/stocks which have very good economics and long-term prospects, usually based on some kind of "moat" (e.g. strong brand, lowest costs, patents, high quality product & service etc) which protects them from competition and allows above-average returns on capital. If you buy a good business, then unless you paid a very expensive price, in the long-run you should do well.

4) Buy businesses run by competent, honest management who are focused on shareholder value

5) Prefer great businesses at reasonable prices, rather than average or poor businesses at low prices

6) Ideally hold the stock for as long as possible, don't sell just because the price has gone up. Ignore market fluctuations except if an extremely attractive price is being offered for your stock.

7) Don't diversify. Your 10th best idea will not be as good as your best idea. Concentrate your bets on less than 10 main positions, overweighting your favourite position.

8) Have an extreme focus on risk control, by purchasing at attractive prices, and concentrating only on the highest quality, most predictable businesses. Aim to never make a permanent capital loss (as opposed to short-term quotational loss) on any investment.

9) Only focus on what is important and knowable. Do not waste time on unimportant things, or trying to figure out things that are essentially impossible (in his view) to predict. Thus, ignore forecasts for the economy, interest rates and so on when making your business investments. If it makes sense now, go ahead and don't let fears of the future put you off.

Let me know if I've missed any points.

The way I see Buffett as different to most investors is his focus on predictability, and business quality. Value investors often buy average businesses at what they think is an attractive price. Buffett seems to pass up *many* average businesses even at attractive prices. And unlike growth investors, he will stay away from businesses that have a high level of operational risk or uncertainty (e.g. a lot of technology or internet companies).
 
Now onto the pros and cons of Buffett's investing style.

PROS:

1) High returns: he has achieved a very good long-run return on equity in the mid 20s % compound. Considering the last 10-15 years he has been restricted to only a small number of mega-cap companies, and is now pretty darn old, that's impressive. His returns in his younger days, with a smaller fund, were extremely high. This suggests following this approach could provide a great return over the long-term.

2) Simplicity: although one would not expect people to easily replicate his results, the approach does have the merit of being simple to understand.

3) Good long-term risk control. Despite a couple of large drawdowns during severe bear markets, Buffett has not had a long losing streak.

4) Consistency. Buffett for most of his career outperformed the S&P the vast majority of the time.

CONS:

1) Volatility of returns: during severe bear markets, Buffett has had one or two nasty drawdowns. 1973-74 being the worst. Many do not have the psychological fortitude to sit through such large drawdowns and keep investing.

2) Economics not the same as for most passive investors: Buffett had access for the latter half of his career to an insurance company float and corporate earnings. This gave him a steady, predictable income which he could use to scoop up bargains during bear markets. Many investors may be in a different position, having low income relative to their investment capital. Thus the only real way they can profit in a bear is to reinvest dividends - which in recent years have not been very big.

3) Degrading performance: Buffett has not done as well in the last decade or so. This can be partly put down to the huge size, limiting their pool of investments. Buffett did extremely well when he had less capital to invest (40%+ returns). He is also very old now, which must have some impact. And the S&P has languished since 2000, which has had an effect. Still, he has not been cranking out 25-30% per annum over the last decade.

4) Questionable exit strategy: several times Buffett has held onto businesses even when they were clearly overvalued. The most egregious example was Coca Cola and Gillette in 1998, when they sold for over 40-50 times earnings despite only growing earnings in the low teens. As seen by the subsequent stock performance, and by Buffett's own admission, his decision to continuing owning the stock at that price was a bad mistake.

5) Lack of focus on growth. A great business that cannot grow the top or bottom-line very quickly e.g. due to a saturated or mature market is not not a great stock (unless selling at a big discount ofc). Coca Cola was a great business in 1998 but its markets had become mature and its stock performance has sucked since then. A business that grows sales and profits at 5% is not going to doing all that well as a stock, even if it has great margins and return on capital. So I would adjust here and look for businesses that still have good long-term growth prospects.

I think the pros are quite compelling. If you are going to invest on your own account and not index, then the Buffett approach has a lot going for it.

Reviewing the cons, I would address them as follows:

1) Volatility. Here you can solve the problem easily - just invest less of your capital. Buffett is happy being 80-100% long, and will ride out the occasional 25-50% drawdown. If your risk tolerance for short-term price fluctuations is lower, then just invest less. A portfolio with 50% long in Buffett-style stocks would probably have a drawdown of 10-20% in a typical bear market. If that's still too high, go down to 40 or 30%.

2) Lack of income to reinvest at cheap prices - again, being less than fully invested in stocks helps this problem; as does having an outside source of income. A typical 60% stocks 40% bonds/REITS portfolio would have decent income on the 40% portion to reinvest during a bear market.

3) Degrading performance. With smaller accounts the Buffett approach works much better, so I wouldn't be too concerned about this. Most will not have the problem of being "too big" to consider the majority of companies.

4) Exit strategy. Here I think some of Buffett's pronouncements are wrong. At a high enough price, you should be prepared to sell any business, no matter how good. The 1998 Coca Cola and Gillette debacle was a perfect illustration, and Buffett accepted this was a big mistake. So I would say you have to sell once the business clearly becomes egregiously overvalued - so expensive that not even the business "growing in to" the stock valuation is feasible in any reasonable length of time. If you have a 13% grower and it goes for 50 times earnings, sell and redeploy elsewhere.

5) Lack of focus on growth. Here I'd just try to focus more on this factor than Buffett has done in the last decade or so (admittedly not many large businesses are high growth, by definition).
 
Quote from Cutten:

4) Questionable exit strategy: several times Buffett has held onto businesses even when they were clearly overvalued. The most egregious example was Coca Cola and Gillette in 1998, when they sold for over 40-50 times earnings despite only growing earnings in the low teens. As seen by the subsequent stock performance, and by Buffett's own admission, his decision to continuing owning the stock at that price was a bad mistake.
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Don't forget that when you're up multiple 1000% on a stock, the cap gains taxes are a MAJOR consideration in selling. Own $1 of dividend paying coke stock or sell and buy $0.75 of something else. The tax deferal has been incredibly valuable.
 
The monish pabrai way seems to be better to smaller investors(less than $1b).
He's the buffett follower but doesnt use buffett method, he admitely buys shitty business simply because they are too cheap, then he takes the profit.

I think a even better way is to mix macro calls on the monish 'valuation arbritage', they shy away from making macro calls because they dont think it's possible but then pabrai goes long Delta Financial a levered mortgage lender and buys all the way to $0 and bankruptcy because he thought their underwriting was so good, had he understood negative equity and likely path of unemployment he might have dodged that one because the underwriting would be of little difference

He was also long CCRT compucredit, had he been aware we were in a credit bubble he maybe could have avoided this
 
Quote from Daal:

The monish pabrai way seems to be better to smaller investors(less than $1b).
He's the buffett follower but doesnt use buffett method, he admitely buys shitty business simply because they are too cheap, then he takes the profit.

I think a even better way is to mix macro calls on the monish 'valuation arbritage', they shy away from making macro calls because they dont think it's possible but then pabrai goes long Delta Financial a levered mortgage lender and buys all the way to $0 and bankruptcy because he thought their underwriting was so good, had he understood negative equity and likely path of unemployment he might have dodged that one because the underwriting would be of little difference

He was also long CCRT compucredit, had he been aware we were in a credit bubble he maybe could have avoided this
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I think Pabrai's recent problems are a *classic* illustration of the wisdom of Buffett's approach. Let's look at some Buffett "rules" that would have kept him out of having such a drawdown:

2) Only buy a business you understand. You should have a high degree of confidence that the business will be around in 10 years and be operating just as good or better than it is now.

5) Prefer great businesses at reasonable prices, rather than average or poor businesses at low prices

8) Have an extreme focus on risk control, by purchasing at attractive prices, and concentrating only on the highest quality, most predictable businesses. Aim to never make a permanent capital loss (as opposed to short-term quotational loss) on any investment.

I agree with you that *if* you can make macro calls, this is a useful addition. The problem of course is that most people cannot consistently make accurate macro calls. A second problem is that often the stock does not react the way you think to a macro event. For example in 1990, what if you had held off buying Microsoft or Intel or Coca Cola because of the macro environment. What if you had sold your Dell in 1998 because of the macro environment. If you can make macro calls AND correctly time the market's reaction to them, then this is a skill you can use advantageously - but for most people that's a pipe dream. I think the logical consequence of using macro calls is to be a trader, not a buy & hold investor. Given the volatility of the macro environment, it is impossible to hold ANY stock for 5-10 years+.

I think the notion of simply assessing the economic risks of the business, and waiting for an attractive price, is essential to any investment. I'm not sure I would class the meltdown of those 2 Pabrai picks as a macro event. You did not need to predict interest rates, the direction of the dollar, or GDP growth to dodge that bullett. I'm not sure how Buffett would class it and don't really care, to me it was a given that seeing what kind of business lenders were writing in the last 3-4 years would be an essential part of any analysis of those stocks. IMO judging the economics of stocks is not macro trading, and if it is then it should still definitely be incorporated into any investment analysis.

IMO Pabrai's problem was not that "we're going into a credit crunch", but rather that the two stocks he invested in were writing unsound business, and using imprudent levels of debt. He did not need to predict the general direction of the housing crisis in order to find this out. Let's imagine that there was no reckless lending, no housing bubble, and the rest of the lending sector followed prudent business practices, but these two businesses lent recklessly with too much leverage - would they then have been a sound investment? If not, then it is not the sectoral problems that did them it, but their specific actions in lending unsoundly.
 
Mr. Buffett does stop a loss (he closes the business). I remember reading that Warren Buffett closed Berkshire after about 20 years of losses and there was also a shoe company that was closed.

I suspect Warren Buffett holds a portfolio of stocks and the big winnners offset the losses. By investing long term Mr. Buffett defers taxes and experiences some big winnners such as Amercan Express.

I do not know how Warren Buffett can stomach the volatility as it is really intense sometimes.

I choose to stop losses and sleep at night.
 
pabrai was making a macro call by being long credit through levered equities. if he had a macro view of unemployment going up, credit contraction, recession and more bankruptcies he would have thought it would be prudent to avoid it. the problem is as I see it is that he bought into the value investing religion of only looking at the business. now it could be true that most people cant make the macro calls and forecast market reactions but the same can be said about earnings potential and how the market will value the company. we will have to look for great R/R to make it up our tendency to be wrong
 
Quote from Hook N. Sinker:

OK here is a thought. Would Warren Buffett buy Fannie Mae or Freddie Mac now?
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Probably not. Buffett bought FRE in the 80-90's but sold them all in 2001. At the time he sold out, he said the systematic risk became too high.

Actually, Bill Miller is now the biggest share holder of FRE, which just shows that not all value investors are created equal.
 
I think the biggest hurdle to do-it-at-home buffett wannabees is patience.

Buffett's purchases in publicly traded stocks number like a handful a year?

Most people can't spend 99 days in analysis and then do a trade on the 100th day when all the stars align.

Even Buffett occupied his early days with merger arb on the side to increase returns on idle cash.
 
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