Just what has made Berkshire Hathaway so successful?
Warren Buffett is retiring – words many investors thought they might never hear. One of the most famous investors of all time, and surely one of the most successful, Buffett announced his decision at the Berkshire Hathaway annual shareholder meeting at the beginning of May. At 94, Buffett has admitted he is beginning to feel his age and will step down completely at the end of the year.
His journey with Berkshire Hathaway began in the early-to-mid 1960s, as he took over what was then an ailing textiles business. Buffett restructured the business, and turned it into an investment conglomerate, buying both listed and unlisted companies. His investment returns since have been tremendous, returning nearly 20% a year, nearly double the S&P 500’s return (a not-too-shabby 10.4% a year over that period). Below we look a little closer at the factors behind Buffett’s success, drawing on the work by US investment house AQR.
Source: AQR
Another way to consider Buffett’s performance is to set it alongside other American stocks with a similarly long track record. We have seen how impressive Berkshire’s performance has been, but it has been particularly strong on a risk-adjusted basis. The chart below shows the Sharpe ratio of the stocks, which adjusts stock returns for their volatility. Berkshire is an obvious outlier in these terms, far outperforming its peers on a risk adjusted basis:
Source: AQR. The annualised Sharpe ratio of US common stocks with at least 40 years track record to 2017
Buffett is known for his charm, his lucid shareholder letters, and his ability to come up with a simple, pithy quote. This is not true, however, of his investment approach which was a lot more involved. At the heart of his investment empire is a large and complex insurance and reinsurance business which provided Buffett with cheap loans. Insurance companies typically receive their cash up front from their customers and then, over the course of the year, pay out their insured liabilities as they arise.
This insurance “float” is then lent onto to Buffett to invest. It is estimated that these loans provided funding to Buffett at 3% below the Federal Funds rate or the official US base rate. Berkshire Hathaway had other strategies to raise cash, but most of its borrowings came from the insurance float. Since 1964, it is estimated that Berkshire Hathaway was levered by 1.7 times suggesting that a large part of its extra return over the S&P 500 came from its ability to borrow very cheaply and gear up.
The ability to hold onto positions through periods of volatility is particularly important for an investor that is geared and has undoubtedly contributed to Berkshire’s success. For instance, Berkshire lost 44% between June 1998 and early 2000, while the stock market was up 32%. Very few geared investors or geared professional fund managers could have survived underperformance of 76% because their lenders would simply have demanded their money back. Buffett, though, controlled his lenders – the insurance companies – and was able to overcome his underperformance and roar back in the early noughties.
Allowing for the borrowing, Berkshire Hathaway still did well versus the S&P 500. AQR found that the company tended to buy cheaply, which was something Buffett himself repeatedly emphasized. AQR also found that he also tended to buy “quality” companies – that is, companies with high returns on equity, with growing profits and low borrowings. A classic example of Berkshire buying a quality company cheaply is the 1988 purchase of Coca-Cola. In the aftermath of the 1987 market crash, Buffett saw beyond the beaten-up stock price and bought what he deemed to be a great company with enduring competitive advantages. Up to the end of 2020, the investment returned him 1,550%.
In a similar vein to buying quality stocks, AQR also found that Buffett preferred to buy stocks with low volatility, with the man himself once opining that “the great [investment] moves are usually greeted by yawns”. Stock-market researchers have found that investors tend to overpay for volatile stocks, perhaps because they focus too intently on the upside, ignoring the potential downside. Buffett, however, did the opposite and tended to buy boring, low-volatility companies. In Berkshire Hathaway’s portfolio there are a number of examples of this, including BNSF Railway and Northern Natural, which owns natural gas pipelines. Buffett’s investing nous is stamped all over the portfolio, even as he began to wind down as he entered his 90s. His successor, Greg Abel, will pick up the mantle, and has been a crucial part of the team for decades. He has the full backing, and continued investment, of the retiring Buffet. We are long-time holders of Berkshire here at Callanish, and we retain confidence in the continued success of the company with Abel at the helm.
There is an old maxim about time in the market rather than timing the market and this is particularly true for Buffett who has an amazing 60-year track record. However, if you were not lucky enough to have invested with him for 60 years, and very few were, and if you had just invested in the S&P 500 over the same 60 years, you would still have turned your $10,000 into $3,905,400. Yes, there are exceptional investors like Buffett, but great returns are also available to those who just invest for the very long term, and ignore the market falls that happen from time to time.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
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