“Buffett says” is no excuse for intellectual laziness.
Buffett’s annual letter to shareholders was out a few days ago. As usual it’s full of folksy wisdom and has triggered much discussion about his investing style. While the man is obviously legendary, it’s important to understand the context in which he speaks.
Robert Armstrong at the FT put it best:
“Warren Buffett gets it. He manages to make Zegna suits look like they came from Sears, and you can be damn sure that is part of the I’m-just-capitalism’s-sweet-old-grandpa schtick he carefully honed while making enough money to buy Switzerland without financing.”
At times like these the news and conversations are full of commentary around Buffett and his investing style. There’s a lot of fan-girling around the big man and his pronouncements, frequently bordering on slavish worship – I’ve just realised he has a fair bit in common with Taylor Swift.
Buffett writes for and speaks to his median audience member: a retail investor. It probably reflects the way he interacted with his early investors – non finance professionals who entrusted him with a substantial portion of their wealth. His words are not only insightful but accessible. They were intended to provide insight into his investing process so an investor would have a high-level understanding of what he was doing and continue to trust him with their money. I doubt they were ever meant to be gospel and it is dangerous to treat them as such.
His biography, The Snowball, and the Berkshire Hathaway letters are often treated like The Bible, an apt comparison as contradictions abound in both forms of scripture.
Leverage:
Firstly, Buffett says he’s not overly enthused by leverage (i.e. borrowing money to invest). In letters and interviews he laments leverage saying “its insane to risk what you have and need for something you don’t really need” and warning investors that doubling their net worth slightly earlier with leverage will not make them any happier. He further cites his contemporaries who used leverage and were carried out of the trading floor as cautionary tales. Readers might find it somewhat surprising then that he borrowed 25% of his net worth in his early 20s to invest in stocks.
He has also used substantial leverage in his early days running money. He would take 50% of the performance over a 4% hurdle but wear 25% of the downside personally. Given his net worth was substantially below that of his clients, wearing 25% of the downside had the potential to quickly send him broke.
If you’re a weapons-grade investor like Buffett, some leverage is probably a smart play. If you’re a retail investor, perhaps not. To make leverage work, you must earn a return above the interest rate on your debt and at no point can the value of your investments fall to a level where your bank stops you out of your positions. Leverage can be a powerful tool if you’re a professional investor but can have harmful consequences for the median retail investor.
Trading:
It’s important to remember that while he’s viewed as capitalism’s sweet old grandpa he’s also one of the OG rapacious hedge fund managers. Not much about us has changed over time. Interviews with his early brokers indicate he played hard and he played fast – a far cry from his more recent genteel image: buying quality companies he can hold forever.
Buying companies you can hold forever is sound advice for the median investor. The average index returns ~7.9% p.a. The average retail investor tries to improve this return by trading in and out of the index and earns 2.9% p.a. Successfully capturing the worst aspects of the path of prices without reaping the benefits of their destination. If you’re a retail investor and you stop trading and buy and hold instead, you’ll increase your return by >2.5x.
If you look at Buffett’s early days, one of his plays was to find heavily shorted stocks and squeeze the short sellers out. In these cases he cares little for the fundamentals of the company… he’s playing the man, not the ball. If executed properly, a short squeeze is all over in a day or so with a nice pop in the stock price and a quick profit. If you short a stock, you profit from falls in the share price. If the stock price rises, you owe your broker money and will have to give them cash or assets so your liability to them doesn’t get too large.
A short squeeze occurs when the stock price rises substantially and short sellers can’t or won’t provide more capital meaning they have to cover their positions. You cover a position by buying shares on the market – which applies upward pressure on the share price which causes further covering and you end up in a rapid upwards price cycle. Buffett initiated these squeezes by buying a lot of stock himself, the price rose, triggered a lot of covering, rose further and he closed the position within a day or so.
Buy quality businesses you can hold forever? Not always the case in his early days.
He’s also a product of his success. A hedge fund portfolio manager with a largish book will manage ~10b USD. Berkshire Hathaway has 57 times that amount sitting in cash and short-term investments (the tape measures are out and I’m hearing flys unzip).
Moving a $10b portfolio around is tough – it can take days to enter and exit positions without substantially shifting the share price. Assuming you run a concentrated book of ~20 positions that’s $0.5b per position. There aren’t a huge number of stocks that trade volume in a week. Now imagine trying to do it with $570b.
You can’t.
That’s why he buys entire companies and holds them forever.
Both positions on “holding forever” are reasonable – it just depends on why he’s doing it.
To wrap it up, I hope I’ve shed some light on what Buffett says and why. The man is a legend but it’s important to understand why he says what he says before we go and implement it dogmatically.