Friday, November 29, 2013

Buffett: How to Minimize Investment Returns

At the beginning of the "How to Minimize Investment Returns" section found in the 2005 Berkshire Hathaway (BRKa) shareholder letter, Warren Buffett mentions that the Dow increased from 65.73 to 11,497.12 during the 20th century.*

He then says:

"This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments."

The reason is straightforward enough as Buffett goes on to point out. He says the "fundamental truth" is that owners, in aggregate, can only earn what the businesses, in aggregate, earn over time. 

Naturally, individual participants attempt to gain advantage over other participants. 

Yet, it's not difficult to show how unwise this behavior generally ends up being.
(More on this below.)

I'd emphasize Buffett's point above that "businesses continue to do well."


Well, as long as a fair price is paid in the first place, how the businesses perform will be the long-term driver of future returns.

Buffett adds this later in the letter:

"For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of 'frictional' costs. And that's my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We'll call them the Gotrocks."

In 2005, American corporations were earning roughly $ 700 billion each year and, as outright owners, this fictional family will spend obviously some of it. Yet that remaining large unspent portion is saved and compounds for these continuing long-term owners. More from Buffett:

"In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let's now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family's annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new 'beat-my-brother' game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he'll never outsmart the rest of the family. The suggested cure: 'Hire a manager – yes, us – and get the job done professionally.' These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family's disappointment grows. Each of its members is now employing professionals. Yet overall, the group's finances have taken a turn for the worse. The solution? More help, of course.

It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we'll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. 'What,' the new Helpers ask, 'can you expect from such a bunch of zombies?'

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that's where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).

A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one."

This 80% number might seem extreme. It's not. The reality that roughly 80% of returns is now going to "helpers" has been highlighted by John Bogle as well:

"Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

Buffett closes the "How to Minimize Investment Returns" section of the letter with the quote about Sir Isaac Newton that's located in the upper right hand corner of this blog.

For lots of reasons, I've liked the story of Isaac Newton's speculative folly for quite a long time. It not only highlights that being very smart and investment success need not have much to do with each other; it also highlights, despite massive progress in other ways, the persistence of human nature and how unlikely it is to change. Similar mistakes are made under what seems to be not sufficiently different circumstances. The lessons are there for the taking but not applied. Buffett's quote about Newton provides another dimension: The folly of allowing market hyperactivity and frictional costs to enter the equation. It emphasizes how poorly lots of trading activity is going to work out for investors as a whole. Of course, that leads many to conclude they'll be on the right side of this gross returns minus frictional costs game. What Buffett calls the "'beat-my-brother' game." Well, for most market participants, the odds aren't good that this approach will fatten their portfolio. It would seem that Buffett's parable and all the other available evidence would make this pretty obvious but, well, history suggests it won't change behavior.**

Some will rightly conclude that there's no point to buying individual stocks. For many that's the right conclusion. The good news is there are many convenient, low frictional cost ways available to approach long-term investment this way. Still, for those inclined and able to judge the prospects of a business well, the same essential lesson applies: It makes little sense to allow all the frictional costs to creep into the process.
(Not to mention the chance for additional misjudgments. When an action is taken, how the move might improve results isn't the only consideration. In fact, it's the opposite outcome that just might deserve greater consideration.)

Buffett points out that the annual growth rate required to produce an increase from 66 to 11,497 over 100 years was 5.3%.

Compounding is a powerful force.

Keep in mind that, in addition to that not exactly modest increase, long-term investors would have received a not at all small quantity of aggregate dividends (which were, earlier in that century, a much larger part of total returns) over that time frame.

Investment results via marketable stocks -- in contrast to speculative results -- come primarily from the increase to per share intrinsic business value (driven by what the business earns, in aggregate, over time). Those that achieve (or claim to achieve) above average results via cleverly timed trades make for great stories and headlines. Some individuals will actually even succeed at this kind of approach but results, in total, will otherwise inevitably be gross returns minus frictional costs. It's one of "the relentless rules of humble arithmetic."

So sure there will be exceptions, but is it wise to engage in a strategy that's based upon being the exception?

At any point in time some market participant will be able to promote the brilliant trade they made. It might even get its fair share of coverage. The incentive to boast is surely there. I'm guessing the not so brilliant trades will get promoted just a bit less.

Best to trust only carefully audited results over very long time frames.

Otherwise, skepticism is very much warranted.

Investing well means not being impressed by -- and not being susceptible to -- the compelling "story". That's not only true when attempting to judge the actual capabilities and results of other market participants. That's true when judging the risk-adjusted prospects of a particular investment alternative.

Investing is about how price compares to value.

It's about how well value is truly understood (or can be understood).

It's not about how compelling the "story" sounds.

In any case, hyperactivity among market participants, combined with the willful payment of excessive fees, is a recipe for making the "helpers" rich and paying lots of taxes.

Those putting up the capital take essentially all the risk (well, at least beyond "career risk") and end up compensated insufficiently or worse.


Long position in BRKb established at much lower than recent market prices

* Pages 18-19 of the letter.
** If attractive long run results at the lowest possible risk is the objective, being realistic about not only one's own capabilities, but also what approach has a high likelihood of working over time, is a good chunk of the battle. Unfortunately, overconfidence in abilities and overestimating future prospects gets in the way and, naturally, isn't likely to end up being particularly lucrative. Of course, efficient market hypothesis doesn't allow for such an outcome -- less risk, more reward -- but that's another subject altogether.
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