Just How Wise is the Sage of Omaha?
Does Value Investing Still Beat the Market?
Say you have a million people stand in a row and flip coins a million times. Each time they get heads, you give them a dollar. Each time they flip tails, you take a dollar from them.
On average your total payout should be zero*: the tails should cancel out the heads. But that doesn't mean everyone ends up with nothing more than what they started with. Some people will be horrific losers, mortgaging the house to cover what they owe you. Others will be rich. And at least one will have a run so phenomenal that you'll think it can't be luck. He must have some sort of secret skill--the Warren Buffett of coin flippers.
In fact, this is a question that people have been asking about the Warren Buffett of financial markets. After all, someone has to be the outlier in the distribution: how do we know that it is skill, rather than luck, which has landed Warren Buffett in his current enviable position? For years, people have been arguing about whether Buffett actually beats the markets through sheer financial acument, or whether he's simply the guy at the far right-hand side of the probability distribution--a coin flipper who looks, through accident of fate, like a stock-picking genius.
It's the sort of argument you're never going to resolve, like "great taste, or less filing", or "who would win a cartoon character tournament?" He-Man has the power of Grayskull, and Lion-O has the Sword of Thundera, and there's something to be said for both sides. But it's a lot of fun to argue about.
Buffett himself once weighed in on the debate, in a speech at Columbia:
I would argue, however, that there are some important differences in the examples I am going to present. For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he's feeding them, whether they had special exercises, what books they read, and who knows what else. That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.
Scientific inquiry naturally follows such a pattern. If you were trying to analyze possible causes of a rare type of cancer -- with, say, 1,500 cases a year in the United States -- and you found that 400 of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables. You know it's not random chance that 400 come from a small area. You would not necessarily know the causal factors, but you would know where to search.
I submit to you that there are ways of defining an origin other than geography. In addition to geographical origins, there can be what I call an intellectual origin. I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville. A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.
Conditions could exist that would make even that concentration unimportant. Perhaps 100 people were simply imitating the coin-flipping call of some terribly persuasive personality. When he called heads, 100 followers automatically called that coin the same way. If the leader was part of the 215 left at the end, the fact that 100 came from the same intellectual origin would mean nothing. You would simply be identifying one case as a hundred cases. Similarly, let's assume that you lived in a strongly patriarchal society and every family in the United States conveniently consisted of ten members. Further assume that the patriarchal culture was so strong that, when the 225 million people went out the first day, every member of the family identified with the father's call. Now, at the end of the 20-day period, you would have 215 winners, and you would find that they came from only 21.5 families. Some naive types might say that this indicates an enormous hereditary factor as an explanation of successful coin-flipping. But, of course, it would have no significance at all because it would simply mean that you didn't have 215 individual winners, but rather 21.5 randomly distributed families who were winners.
In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham. But the children who left the house of this intellectual patriarch have called their "flips" in very different ways. They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by the fact that they are all calling flips identically because a leader is signaling the calls for them to make. The patriarch has merely set forth the intellectual theory for making coin-calling decisions, but each student has decided on his own manner of applying the theory.
Ben Graham, for those who have not been following along at home, is the Ur-Value-Investor, the intellectual progentior of Warren Buffet and a number of other successful financiers. He believed in buying stocks on the cheap and holding them for the long term, and following some variant of his strategy has made a number of his followers very rich.
The community of value investors is now very large, and Buffett himself has a huge following with a slightly cultish tinge; every year at Berkshire Hathaway's annual meeting, people descend on Omaha not just to hear him speak, but to eat his favorite meal at his favorite restaurant (an indifferent steakhouse), shop at his favorite stores (owned by Berkshire Hathaway, mostly), and otherwise emulate Warren Buffett a little more closely. They're not crazy, mind you--they don't think eating the same steak as Warren Buffett will actually make them better investors. But they are fanatical masters of very small details about Warren Buffett's life, and the collective wisdom of Ben Graham. And why not? Warren Buffett has made himself a pile of money with basic, sound investing principles. Who wouldn't want to beat the market like Warren does?
Anyone, of course, but it's not clear that this is possible. In a post a few days ago, Felix Salmon raised an interesting question: even if Warren Buffett is right, and Graham's disciples really did have the goods, what has he done for them lately?
I’d love this to be true, but at heart I’m deeply skeptical that any strategy can consistently outperform, over decades. Buffett famously avers a distaste for being judged on Berkshire Hathaway’s stock-market returns, preferring to use its book value as a measure, but the fact is that Berkshire has underperformed the S&P 500 for the past 1 year, 2 years, 3 years, and 5 years. At some point, Berkshire still outperforms, but I’m not sure where that point is: I’m having difficulty finding a suitable total-return index so that I can be sure that I’m including the effect of reinvesting the dividends which the S&P 500 pays out but Berkshire does not.
To put it another way, the Buffett legend rests in large part on the hypothetical returns that you would have received if you bought Berkshire Shares decades ago, which very few people actually did. Buffett is a hugely successful investor, and there are a handful of early investors whom he also made extremely wealthy. But even Buffett himself has been saying for years that his future returns won’t be as good as his past ones.
All strategies eventually run out of steam. Some have longer legs than others: the fundamentals-based investing philosophy of Buffett, which he inherited from Ben Graham, worked for decades, while the clever excess returns that academics find hidden in the market tend to disappear as soon as they’re published. And in the world of quantitative investing, even unpublished strategies have ever-shortening shelf-lives.
In some sense, this is not fair: value investing is supposed to be a long term strategy, which means that there may be quite long stretches when your portfolio is underperforming a frothy market. On the other hand, we're now in decade three of a rather frothy market. Which is why I went to the Berkshire Hathaway annual meeting a few years ago, and came away convinced that whether or not Graham and Buffett had ever really been able to outthink the market, their strategy that no longer works as well as it used to.
Graham's big investment coups came in the early 1930s, when the market was so depressed it was literally possible to buy some stocks for less than you'd get if you just shut the place down and sold off the assets. Buffett similarly made a lot of money in the prolonged bear market if the 1970s. And except for a brief period in late 2008 and early 2009, the market has simply never dipped low enough for investors to make those kinds of profits. To be sure, 2009 was a great year for value investors, but you cannot build an entire financial career off of a single nine-month period.
Over the last few decades, what economists call the "equity premium"--essentially, the price discount that investors demand to hold stocks rather than bonds, to account for the extra risk--has declined. It used to be very high because, well, people thought of stocks as something risky and daring. Now practically everyone knows that you're supposed to stuff your 401(k) full of stock funds. As a result, prices have been bid up, and the equity premium has shrunk dramatically. What that means for you, the investor, is that stocks no longer offer such high returns; you can no longer count on getting an eight percent annual return just for buying and holding a stock index fund.
What that means for the value investor, amateur or professional, is that there are no longer so many great, underpriced bargains out there. Especially since the tech boom, which has brought a wealth of new tools to even the amateur investor's desktop. Value investors used to have to laboriously hunt through prospectuses, calculating metrics by hand. Now there are computer programs that can search on any metric you set and deliver hundreds of potential targets for every screening program you run.
In economic theory, this sort of improved information transmission quickly eliminates the "arbitrage opportunities", the fancy jargon term for "free money that other investors have overlooked". And so it was in real life, the value investors told me; the classic kinds of opportunities outline by Graham, where you almost literally cannot lose, simply no longer exist. And the best pricing opportunities tend to be in very small stocks that are thinly traded, which creates two problems: first, that you may be forced to take a loss if you have to sell quickly, simply because there aren't good buyers in the market that day; and second, that you cannot invest very much money; exploiting these opportunities is a strategy that's open only to relatively small funds.
Self-described value investors are increasingly taking more risk than Graham or Buffett did: buying in situations where a total loss is possible, taking on leverage, selling short. You can see what modern value investing looks like in an article I wrote last year about two value investors duking it out over a Florida real estate company: one long, one short, both in a position to take a large loss.
This is the core problem with Buffet's argument. Even if you think that investing is not like coin flipping, because there are correlations--some types of investors do well, some don't--that doesn't mean that those investors are especially smart or visionary, or that other investors can replicate their success. At any given time, some classes of assets are outperforming others. The people who are invested in those assets do well. But that doesn't mean that, say, tech fund managers in 1998 had the "right" strategy; they just had one that worked then. Someone trying to follow their lead in 2001 would have been very sorry indeed.
Warren Buffet's acolytes will probably not be that sorry, because even the newer, riskier value investing is a fundamentally conservative strategy that does expose them to fewer losses than the average investor. But they may not get very rich, either.
* Okay, so actually, coins have a very slight tendency to land on heads, so technically, you won't be exactly even. It's a model, for crying out loud.