You might wonder why I spend so much time discussing and referring to Warren Buffett here at Fat Pitch Financials. I just ran across an academic article that might help support why I think Warren Buffett’s approach to investing is superior to the market average.
Gerald Martin and John Puthenpurackal, in their recent paper “Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway“, argue that the investment returns of Warren Buffett’s Berkshire Hathaway go beyond pure luck or excessive risk taking. They conclude that it is very likely that “…Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.” Warren Buffett’s stock investment performance goes beyond what can be explained under the efficient market theory.
That suggests to me that there are market inefficiencies that can be exploited to earn above normal returns. The key to beating the stock market indexes may indeed lie in the writings and action of Warren Buffett. Just take a look at what Martin and Puthenpurackal report as Warren Buffett’s Berkshire Hathaway stock investment performance:
The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.
Those are some pretty amazing numbers. Let’s take a little closer look at the transactions that make up that record. Martin and Puthenpurackal analyzed a total of 261 investments during their study period from 1980 to 2003. The average annualized returns for the stock investments in Berkshire’s portfolio from 1980 to 2003 are an amazing 39.38%. I was somewhat surprised to find out that 59 of those 261 investments could be labeled as arbitrage investments. The average annualized return for the arbitrage stocks was 81.28%! Given that statistic, I now know that I’m not wasting my time pursuing going private transactions and other arbitrage opportunities.
“When long-term investment possibilities are limited, Berkshire Hathaway has used risk arbitrage as an alternative to holding short-term cash equivalents. These are arbitrage opportunities that present themselves after an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. The major risk incurred is the risk of the event not happening. Berkshire prefers to engage in only a few large transactions each year because of the effort required to monitor the progress of transactions and the market movements of related stocks .”
I originally started researching arbitrage and special situation opportunities when I was having trouble finding long-term opportunities two years ago. My focus on going private transactions falls into the same category of risk arbitrage opportunities as those described above. However, I engage in lots of small transactions versus the few large transactions Buffett pursues each year. It is difficult for a small investor like myself to compete with the all the large hedge funds that use significant leverage seeking these arbitrage opportunities, so I have to focused on my competitive advantage with the small transactions provided by the reverse splits associated with going private transactions. My competitive advantage here being the relatively small amount of funds that I need to invest.
Returning to Buffett’s performance record, the average annualized return for the other 202 long-term stock investments made in Berkshire’s portfolio are an impressive 26.96% according to the paper. This is a very impressive performance, but I’m a bit surprised that it is so much lower than the performance of the arbitrage investments. I guess the key difference is that the arbitrage investments were only held for an average of 5.56 months, and thus were subject to much higher tax. Many of Buffett’s long-term holdings are virtually tax free since he has not sold stock in many of his large positions. When those positions are finally sold, they will be taxed at much lower long term rates than the short term arbitrage trades. The nice thing for me is that I can avoid tax in my Roth IRA and Coverdell ESA accounts, so the short holding periods associated with risk arbitrage opportunities doesn’t cause me much of a tax liability.
I also found it interesting that the authors found that Warren Buffett’s strategy was more of a large-cap growth style versus the mainstream view of him being a traditional “value” or “contrarian” investor. However, I do not really think the term “large-cap growth style” really portrays what is unique about Warren Buffett’s investment style.
I also found the fact that Berkshire’s top 5 holdings often comprise over 70% of the total portfolio to be a bit surprising. I knew Warren Buffett was a focused investor, but I did not realize how high the degree of concentration was. This is something for me to keep in mind when managing my own portfolio.