Friday, June 4, 2010

Don't Mimic Buffett

Warren Buffett's words and actions attract the attention of the masses and sway world markets. He cannot even hint at what he is considering buying as investors would flock to the stock and push up the price. Every quarter the revised holdings of Berkshire Hathaway are anticipated by thousands. Normally, any new positions receive a boost just from his endorsement alone. People tend to believe that if they follow Warren Buffett's investment moves and buy into stocks when he does, then they will be able to share in his impressive returns.

What people tend to forget is that the pond of investments from which Buffett can fish from is significantly smaller than that of the average investor. Berkshire Hathaway is one of the largest corporations in the world with tens of billions of dollars to deploy. It therefore is limited to investing exclusively in large cap stocks in order to maintain a decent return on its capital. Buffett simply does not have the time or resources to swallow up and keep track of thousands of little companies to recreate the fantastic returns he enjoyed decades ago.

Most of us are in a completely different situation than Buffett, so why do we insist on copying his every move? We are not constrained by such large sums of money (lucky us) and therefore have a massive universe of stocks to choose from. Buffett said the following in 2007: "Were I working with a very small sum...I'd be doing almost entirely different things than I do...You can earn very high returns with small amounts of money." As he stated in 1998, he advises to instead "look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market" when dealing with small sums of money. With this strategy, he guaranteed that he could compound $1 million at 50% per year.

There is a paper written by Gerald Martin and John Puthenpurackal called "Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway" in which they study 261 of Berkshire investments from 1980 to 2003. Now, Berkshire was already somewhat large during this period, but nowhere near its current size. During this period, Martin and Puthenpurackal identified 59 of these 261 stocks as arbitrage investments with an average holding period of under six months compared to an overall average of about 32 months. These arbitrage opportunities produced an astounding average annualized return of 81%, dwarfing the overall average of 39%. I would guess that if you looked at his investment activity from the 1950's and 1960's when he had a considerably smaller sum to invest, the returns from arbitrage investments would have been even more impressive.

While I believe that the growth of the investment management industry and the ubiquity of information that we have at our fingertips has shrunken the number of arbitrage opportunities and other "market wrinkles," I by no means think that they are gone. In addition, we don't have to leaf through thousands of pages of Moody's manuals to find an opportunity like Buffett did; there are many free online stock screeners that can help us hone in more easily, and there are many more publicly traded companies nowadays to choose from.

Now, I must give a small dose of reality, and another reason why we should not mimic Buffett's moves: we are not Warren Buffett. As I wrote earlier about him, Buffett is a genius and probably knows more about investing than anybody on the planet. As such, it would be unwise to dive into arbitrage or deep value opportunities without having a firm knowledge of the target's financial situation and business.

Lastly, I have to say that while I don't think copying his specific investments is wise, I do believe we should absolutely emulate Warren Buffett's investing principles. The vast majority of his investments throughout his career have been long-term stakes in well run, highly profitable companies trading at a discount to their intrinsic value. These opportunities are more plentiful and ultimately more profitable for the average investor.

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