Berkshire, Buffett, and the Haters

The Berkshire Hathaway annual meeting takes place his weekend in Omaha. In honor of the so-called “Woodstock of capitalism,” I thought I’d take a few minutes to reflect on the careers of Warren Buffett and Charlie Munger and their influence on American business.

This short clip below is conversational; Buffett discusses how his investing philosophy changed (with Munger’s help) from simply buying cheap business to buying quality businesses at a reasonable price.

In this second clip, Munger describes the simplicity of his investing philosophy. He also pokes fun at those who obfuscate their strategies to give the appearance that they are indispensable.

Of course, even a simple investing philosophy is hard to use successfully. Having a simple set of principles does not relieve you from the burden of execution. But Munger explains that at Berkshire, there is no algorithmic trading or supercomputing going on,  just thoughtful analysis and discipline.

And the Haters

Renowned as Buffett and Munger are, they still get a helping of criticism, including some from other investors. This is a real tweet from a professional hedge fund manager:


I can’t help but be amused by this kind of thing. This tweet argues that Buffet’s use of leverage (insurance “float”) is the only reason for his success.

If Buffett isn’t an exceptional investor, you might ask, where did he get the money to buy insurance companies in the first place? If it’s that simple, why don’t all investors just do the same thing?

While it’s true that insurance float provides Berkshire Hathaway with a great investing tool, $400 billion businesses don’t just pop out of nowhere. You can’t build that kind of company with a simple trick. He was a successful investor long before he could buy insurance companies.

This type of criticism is like a guy playing pickup basketball trying to tell you that Michael Jordan wasn’t a great player, he just had great teammates, or coaches, or shoes.

Sure, plenty of factors helped Buffett and Munger along the way, but until you invest your way to a $400 billion business, let’s show some respect where respect is due.

Way to go, Warren and Charlie.


Recommended reading:

Occam’s Razor, Hanlon’s Razor, and Tinfoil Hats

Recently, the Farnam Street Blog (Shane Parrish’s excellent site) published primers on two related mental tools: Occam’s razor and Hanlon’s razor.

Occam’s razor is the more well-known principle: if you have two competing explanations for something, the simpler one is more likely correct.

Hanlon’s razor, which is a play on Occam’s razor, states: never attribute to malice that which can be more easily explained by neglect or stupidity.

I enjoyed Farnam Street’s exploration of both of these ideas, and was reminded of a pernicious force that can be effectively countered using these two mental models: conspiracy theories.

You probably see them on social media, or in the comments section of your favorite newspaper online. Are dark, powerful organizations collaborating to topple the global economy? Is a worldwide cabal of scientists working together to push phony climate theories in order to get funding? Is gold the only real store of value? Is everything rigged against me?

Thanks to Occam and Hanlon, we know the answer. Probably not.

Richard Feynman on Knowing vs. Understanding

Richard Feynman was one of the most brilliant thinkers of the 20th century. His specialty was physics, but he had an amazing ability to clarify a problem, cut through unnecessary detail, and explain complex concepts. His techniques for problem-solving are valuable to anyone, in any field.

 

This is a short clip of Feynman explaining how we should think about competing theories, and why understanding the philosophical basis for a problem is more important than having a black box model that can spit out an answer. The parallels to investing couldn’t be clearer.

To anyone interested in learning more about Feynman, I strongly suggest the autobiographical book Surely You’re Joking, Mister Feynman as well as Genius by James Gleik.

Bad Incentives and Portfolio Managers as Salesmen

This is part one in a series about how active management could be better. This is my perspective alone. Of course, the dynamics I describe do not apply to all managers. In a prior piece, I explained how active managers could theoretically outperform their benchmarks; now we arrive at the question: why don’t they?

Part One: Bad Incentives and Portfolio Managers as Salesmen

Incentives are powerful. They unconsciously motivate everything we do. Even with the best intentions, the wrong incentives will keep pushing us to do the wrong thing. “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it,” says Charlie Munger.

Across vast swaths of the money management business, the incentives are broken, causing a vicious cycle that erodes returns. I will describe how this dynamic plays out.

There is a giant pool of portfolio managers (PMs) trying to build a track record. In such a large field of PMs, some will have periods of strong performance. Some perform well due to talent, others due to luck.

For a PM who shows good short-term performance, the incentive is to sell based on that performance. It’s hard to resist because the PM gets most of his income from a percentage fee on assets. The more the PM wants that new vacation house, the less he cares about his strategy’s fit for prospective clients. The prime directive is to grow AUM and ask questions later. He might employ a sales team whose bonus is tied to short-term inflows. Because the sales team has no long-term incentive, they will be eager to please. With these incentives, every prospective client seems like a perfect fit for the strategy.

Second prize is a set of steak knives.
Due to the laws of probability, the strategy does not outperform forever. Now that the PM has built a sizable AUM, his incentives shift to retaining assets. When performance lags, there is enormous pressure from clients to defend every quarterly return. The PM may say “some periods of underperformance should be expected in this strategy,” but that’s not how he pitched it when times were good. Clients are upset. The PM becomes myopic, short-term focused. There is pressure to hug the benchmark. It becomes harder and harder to stick to the strategy that gave him success in the first place.

It doesn’t help that many large clients want active managers to hug the benchmark. Many prefer closet indexers. Many consultants rank PMs using “optimization formulas” that heavily penalize managers for deviating from their benchmark. In my opinion, this is an area where the industry has lost its mind. If you don’t want deviation from the benchmark, don’t hire active managers—buy an index fund. If you just want less deviation from the benchmark, allocate less to active management!

Most equity managers don’t believe they can outperform every single year, much less every month. Not everyone is Renaissance Technologies. Most PMs have long-term investment strategies; they expect to have good years and bad years.

But misaligned incentives create a bad dynamic: when performance is good, the incentive is to sell fast, grow AUM, and ask questions later. This creates a poorly-fitted client base of impatient investors with unrealistic expectations. When performance lags, PMs feel pressure to become defensive or hug the benchmark, forgetting what brought them success in the first place.

What can be done about the problem of incentives?

Underlying almost every problem with active management is an uncomfortable fact: there is still more of it than we need. Too many PMs try to grow AUM without making sure clients are a good fit. Too many clients hire active managers without understanding the strategy. They develop unrealistic expectations and don’t stick with the strategy long-term. For many investors, indexing is a better approach. Encouraging more investors to use index funds will improve active management.

The other problem affecting PMs and their clients is a culture of impatience and desire to get rich. For most of us, active management shouldn’t be about getting rich quickly; it should be about getting rich eventually. Active managers should charge lower base fees (fees based on a percentage of AUM). When possible, they should use long-term performance fees and invest more of their own personal savings in their strategies. Aligning these incentives places the PM’s primary focus on long-term returns, not month-to-month AUM.

Finally, active managers need to focus on setting the right expectations and building trust. Some PMs have been model citizens in this regard. Seth Klarman’s Baupost Group has gone so far as returning money to investors when it doesn’t see enough good investment opportunities. If clients understand an investment strategy and trust it for the long term, the manager won’t need to do backflips every time quarterly performance lags a bit.

Changing these incentives would certainly benefit clients, whose fortunes are on the line. For many PMs, this could mean less money. But the system would be fair—the best active managers could thrive just by implementing their strategy. If they skillfully invest a sizable chunk of their own money, they will earn great returns for themselves. With great returns, they can attract a well-fitted client base and build a solid foundation of trust. It may take a bit longer, but everyone will be better off in the end.

Pulling Teeth: The FANG Year and Financial Memes

After reading Michael Batnick’s excellent posts about the distribution of stock market returns (read The Skew and The Other Side), I was inspired to look back at the market of 2015.

Perhaps you’ve heard about 2015, the fabled year when the four “FANG” stocks (Facebook, Amazon, Netflix, and Google) accounted for all of the gains (!) of the S&P 500. Many articles and blog posts were written about this phenomenon in 2015, and the “FANG year” became something of a meme in financial discourse. The S&P 500 returned only +1.4%, but the four FANG stocks returned +34%, +118%, +134%, and +46%, respectively. They accounted for the all of the gains (!) of the S&P. Crazy, right?

Will Deener of the Dallas Morning News wrote, “One of the hallmarks of a healthy bull market is that a broad swath of stocks and sectors move higher in tandem. Currently, that is not the case, with both the S&P 500 and Nasdaq being propped up by only four stocks.”

Only four stocks!

Many people surmised that investors who missed out on the FANG stocks must have had a dismal year. If you picked a random stock from the S&P 500, you would almost certainly not pick a FANG stock, so you must have had a terrible year, right?

Let’s look at the numbers. If you had thrown darts at a board to pick one random stock out of the S&P 500 and held it for the entire year, what were your chances of picking one that outperformed the index?

47.19%.

Yes, 47% of stocks in the S&P 500 outperformed the index that year. So slightly less than half. But still, almost half. You would have had a 47% chance to outperform the S&P 500 just by picking any stock at random and holding it for the year.

What were your chances of selecting a stock that had a positive return?

50.37%. You would have had better-than-even odds of a positive return by picking any stock at random that year.

Let’s look at the distribution of returns in the S&P 500 in a histogram:


The above chart shows the number of stocks that had a 2015 total return at various minimum ranges. The best performing stock (Netflix) returned +134.38%, and the worst (Chesapeake Energy) returned -76.76%. How did the rest do?

  • 50% of stocks returned at least +0.13%.
  • 40% of stocks returned at least +3.83%.
  • 30% of stocks returned at least +10.09%.

So in the infamous “FANG year,” when supposedly all of the gains (!) in the S&P 500 went to just four stocks, 30% of stocks in the index actually returned over +10%.

So what’s going on here? Why was this meme so misleading?

The S&P 500 is market cap-weighted (companies are weighted by their market value). A stock’s weight times its return equals its contribution. Bigger companies have a larger weight, so they can have a larger impact on the index’s return. In 2015, some of the best-performing stocks also happened to have some of the heaviest weights in the index. So it’s true that if you owned the S&P 500 index except for those four stocks, your +1.4% gain would be gone. These four stocks had a combined contribution of almost +2%.

In any given year, the index includes positive contributors and negative contributors. If you took all the stocks with gains in 2015, their combined contribution was +8.9%. This is the gross contribution, or what most people would consider all of the gains. If you took all of the stocks with losses, their combined contribution was -7.4%. This is all of the losses.

When you put the gains and losses together, it was a fairly flat year for the market. The net of all gains in the S&P 500 was just +1.4%. But wait, commentators said, the contribution of the four FANG stocks was more than +1.4%. So voilà, just those four stocks accounted for all of the gains (!).

Naturally, when gains and losses net close to zero it becomes easy to pick out a small group of stocks whose contributions add up to the net market return. What’s more, the FANG stocks weren’t even the top four contributors that year. Amazon was number one, but Microsoft was number two and G.E. was number four. Saying only the FANG stocks mattered in 2015 is like saying the only reason a football team won 28-21 is one particular touchdown. Every point counts.

All this FANG talk gave many people the false impression that only four stocks had any gains at all that year. But there were plenty of other stocks with huge returns that year. NVIDIA returned +67%. Hormel foods returned +54%. Starbucks returned +48%. Kroger returned +32%.

Nevertheless, the “FANG year” meme had spread across financial media like World War Z. ‪It’s a fun idea, but not all that meaningful.