Thursday, August 25, 2011

Buffett on Mediocre to Disastrous Returns: Berkshire Shareholder Letter Highlights (BRKa)

From Warren Buffett's 2004 Berkshire Hathaway (BRKa) shareholder letter:

If you examine the 35 years since the 1960s ended, you will find that an investor's return, including dividends, from owning the S&P has averaged 11.2% annually (well above what we expect future returns to be). But if you look for years with returns anywhere close to that 11.2% – say, between 8% and 14% – you will find only one before 2004. In other words, last year's "normal" return is anything but.

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

For an example of this, consider what Joel Greenblatt said in this Forbes interview:

...in the decade of the 2000s, that ten year period, the top performing mutual fund was up 18% a year. The average investor in that fund lost 11% a year.

Why is that? It's because every time the fund underperformed, people left. Every time the market went down, people left. Every time it outperformed, people piled in right after the outperformance. Right after the market went up, people piled in. So with all the investor's market decisions, the average investor – the average dollar weighted investor in that fund over the last decade, the best fund – ended up losing 11% a year.

Whether investing in quality stocks or mutual funds a key thing is to keep the expenses low and to consistently be buy at a discount to intrinsic value. Shares of a good business (or basket of stocks via a fund) selling comfortably below intrinsic value is more likely to happen during periods of fear and uncertainty.

When it feels uncomfortable to buy it is often (not always) the best time to buy.

The last ten years or so was a tough period for stocks* but that's not because American business performed poorly. The problem was one of extreme valuation. Many good businesses spent the decade "catching up" to their year 2000 valuation. It was one of those times to be fearful since so many others were being greedy.

It seemed strangely similar to the way Garrison Keillor describes Lake Wobegon:

Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average. - Garrison Keillor

Well around the year 2000, far too many participants were acting as though the stock market was a place where every stock was above average.

Today, if not at the other extreme, it's close enough to be building long-term positions in quality businesses or funds while keeping the frictional costs low. The market as a whole may not be particularly cheap but many individual securities are more than reasonably valued.

The key thing is to avoid the buy high, sell low trap that Greenblatt describes in the Forbes interview. It is that behavior that frequently damages returns.

Of course, most do not think they are susceptible to that kind of thing but study after study shows otherwise.

Awareness of that susceptibility is a step toward developing a trained response to the episodes where the market goes from depressed to euphoric extremes.

Adam

Long position in BRKb

* There were quite a few professional money managers who avoided the many bubble stocks and navigated that difficult period just fine producing excellent returns.
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