Good morning. The stock market has had a nice little three-day run, and it feels like the “labour market is definitely cooling and inflation is sure to follow” narrative has taken hold. I’m a bit sceptical, as I noted in yesterday’s letter, but then I’m a journalist. If any non-journalists have thoughts, please send them along: robert.armstrong@ft.com.
Does Buffett matter?
Eric Platt, along with worthy collaborators Eva Xiao, Patrick Mathurin, Ian Smith and Myles McCormick, have produced a tremendous series about the future of Berkshire Hathaway without Warren Buffett. Read it! It is full of surprises and insights.
One of the driving questions of Eric’s series is “who can possibly follow what Buffett has achieved at Berkshire?” But this question — a good one — raises a different one for me. “Why does it matter, from a purely financial point of view, what happens to Berkshire after Buffett?”
The critical thing to remember, whenever we talk about the Berkshire of today, is this:
Over 21 years, the return performance of the S&P and Berkshire are all but identical. On an annual basis, their performance is five basis points apart (the S&P has the meaninglessly tiny advantage). Yes, if you go back further, Berkshire crushes the index, but it is hard to see the relevance of that today, given how much the company has changed. Twenty years is plenty of time to assess an investment strategy. It is, after all, as long as the average person’s effective investing horizon (the time from when they have substantial sums to invest to the time they retire). The results are really and truly in. Berkshire produces returns exactly like those of the large cap US index (this is true over five and 10 years, too).
And we know almost to a certainty why this is, as I argued back in February: because Berkshire is such a large and diversified conglomerate, it would be odd if it did anything but hug the index. In the years when Buffett outperformed, it had a market cap of $100bn or less, and represented a smaller fraction of the S&P. Now it is $900bn and about 2 per cent of the index.
There is one obvious answer to this point, but it is problematic. Berkshire has a lower volatility (beta) than the market (somewhere around .7 to .8, where the market volatility is 1). So, in theory you could leverage an investment in Berkshire and make better long-term returns than the S&P, if you are one of those people who thinks beta is a good measure of risk. The problem is that Warren Buffett is not one of those people. Buffett says — rightly — that for true long-term investors, volatility is a good thing, not a risk, because it provides opportunities to buy and sell at favourable prices. By that logic, and because Berkshire is an active buyer of its own shares, Buffett should wish that Berkshire’s beta was higher. This is not a joke; he really should. Maybe he does.
Real risk is the risk of permanent loss, Buffett says. And he has said that in this sense, Berkshire is probably a little less risky than the S&P. But it is not clear (to me anyway) what exactly he means by this, given that the S&P is a diversified index that growing companies automatically enter and shrinking companies automatically leave. Where is the risk of permanent loss in that?
One might argue that in times of crisis, Berkshire falls by less than the index, and that therefore it is less likely that its investors will panic and sell at the wrong time. That, of course, is the best and most common way of creating permanent investment losses (to my knowledge Buffett has not made this argument, but he may well have; it sounds pretty Buffetty).
Judging by the experience of the great financial crisis, however, this is not particularly true. Berkshire’s peak-to-trough price drawdown in 2007-2008 was only slightly smaller than the S&P’s. Yes, in the four-year period with the market bottom at its centre point (March 2007 to March 2011), Berkshire outperformed by a meaty 15 percentage points in total. But, crucially, this significant period of safety did not improve long-term returns. In the 10-year period with the global financial crisis at its centre, Berkshire underperformed by about 50 basis points a year.
There is another problem with the argument that Berkshire produces superior volatility-adjusted returns. The company may have low volatility in small or large part because of Buffett, who creates a magic aura of wisdom and stability around the stock. Buffett is easily the greatest public relations man in the history of finance. (Do this thought experiment: picture a conglomerate controlling the same empire of companies as Berkshire, including in notably unpopular industries such as energy, insurance and banking; can you imagine the company enjoying the same amount of good will among investors and the public as Berkshire, if the company was run by anyone other than ol’ Uncle Warren? I myself cannot). After Buffett, it would not be at all surprising to see Berkshire’s beta rise.
There is one interesting card left in the Berkshire bulls’ deck, however: valuation. If it is the case that the S&P has kept up with Berkshire because it has become more expensive relative to fundamentals, then there is reason to think that mean reversion will drive extended outperformance by Berkshire. In that case, the appearance of performance parity with the index is a sort of illusion, perhaps created by rising irrational popularity of Big Tech stocks (other than Apple, or course). On a price/earnings valuation, though, that is not what has happened. The p/e differential between the two moves around, but not all that much:
Buffett does not like to think about value in terms of earnings per share, however, because gains and losses from investments and the insurance business make those numbers so volatile year to year. He prefers, or anyway once preferred, book value per share. And over the past 21 years, book value per share has compounded at 11 per cent per year at Berkshire, compared with 6 per cent for the S&P. Why has this not translated to outperformance by Berkshire? Because the S&P’s price/book value ratio has risen sharply while Berkshire’s has been quite stable:
The problem with this argument, however, is industry mix. In recent years, the S&P has shifted towards high price/book, high profit margin industries, such as tech. Berkshire has kept much of its focus on low price/book, low margin energy, industrials and finance. To argue that Berkshire’s equity has become undervalued relative to the index would require a deep dive into the shifting industrial mix of both (maybe a reader has done one?).
We might transform the question again, from “who cares what happens after Buffett?” to “what can Buffett’s successors do to make Berkshire something other than an index hugger, without destroying its identity and ethos?” A few more thoughts on that tomorrow.
One good look
Met gala round-up!
