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Why Is Warren Buffett Giving Bad Advice to Disciplined Investors?

Warren Buffett’s annual letters are better reads than most hedge funds’ investor letters. Especially rookie investors can learn a lot by reading them. Surprisingly this year’s investor letter had a very good advice followed by a bad advice for disciplined investors. We have seen this bad advice by Buffett repeated several times before and decided to pen this article. Yes, we are critical of one of our favorite investors who implies that his top picks such as Wal-Mart Stores Inc. (NYSE:WMT), Wells Fargo & Co (NYSE:WFC) and The Coca-Cola Co (NYSE:KO) will underperform index funds. Let’s first start with Buffett’s good advice:

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“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.”

Unconventional and great advice! Buffett is right about the fact that most investors are short-term oriented and this near-sightedness hurts their returns. Most people think that by watching over their investments very closely and taking action when markets decline they do the right thing. Short-term volatility isn’t such a big thing if you don’t have short-term funding needs. I want to point out a very important observation here though. Warren Buffett took the time and qualified his recommendation by emphasizing that “any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits”. Why is this important? Because this shows that, when necessary, Buffett takes the time to clarify his recommendations. Now, we are going to share Buffett’s bad advice. Here is what Buffett also said in the annual letter:

“If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.

The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.

There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent. Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship. Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing.

Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”

Most of Buffett’s advice for individual investors is really valuable. Unfortunately his advice about “buying a very low-cost index fund” isn’t the right advice for all investors. We are disappointed that Buffett didn’t qualify this advice. Let me explain why Buffett knows that “buying a very low-cost index fund” isn’t a good advice for disciplined investors who can spare a few hours a year to buy and sell stocks. If you don’t know anything about investing and don’t ever want to deal with buying and selling stocks, then “buying a very low-cost index fund” is probably a good idea than giving your money to an above average mutual fund or hedge fund manager who charges an arm and a leg for mostly mediocre stock picks. However, if you know something about investing, there are better alternatives. For instance, Warren Buffett, himself, doesn’t invest in “very low-cost index funds”. You may think that Buffett is an exception and there is no other investor who can fill his shoes.

Well, Buffett knows that he won’t be around forever. And he decided to hire 2 former hedge fund managers to replace him when the time comes. “Todd Combs and Ted Weschler, each of whom has spent several years on Berkshire’s investment team, are firstrate in all respects and can be of particular help to the CEO in evaluating acquisitions,” Buffett said about these two former hedge fund managers. Clearly, Buffett thinks he doesn’t need to invest in “very low-cost index funds”. In 2014, he bought new shares of his top 4 positions. This means only one thing: Buffett thinks these top four positions will perform better than “buying very low-cost index funds”. He also thinks Todd Combs and Ted Weschler, who are former hedge fund managers (I will explain shortly why I emphasize this point later), will be able to outperform the “very low-cost index funds” in the future.

We have good news for you. Buffett thinks that his stock picks will outperform the market because they outperformed the market in the past. We aren’t talking about 70s, or 80s, or 90s. Between 2008 and 2012, Warren Buffett’s top 5 stock picks outperformed the S&P 500 Index by 29 basis points per month. This is an annualized outperformance of 3.5 percentage points per year. Considering that Buffett has more than $73 billion invested in his top 5 holdings, an annual outperformance of 3.5 percentage points means additional gains of $2.5 billion per year for Berkshire shareholders. While, we understand why Buffett keeps buying his top 5 positions, we don’t understand why he keeps telling other investors to mindlessly invest in the other 495 stocks that aren’t good enough to make it into Buffett’s top picks.

Some Background

In 2008 Warren Buffett bet an opportunistic fund of hedge funds manager that a “very low-cost S&P 500 Index fund” would outperform a portfolio of hedge funds over the following 10 years. The opportunistic fund of hedge fund manager is Protege Partners’ Ted Seides who brilliantly calculated that it may cost him a maximum of $320 thousand to get to advertise his fund for a period of 10 years in all major financial magazines, sites, and business TV stations. Investing in hedge funds usually a terrible idea, investing in fund of hedge funds is even worse because you have to pay mind numbingly high hedge fund fees TWICE. If Seides would get lucky, as he initially did in 2008 and 2009 when the markets crashed, stocks would decline over the 10 year period and he would have looked very smart by beating Buffett. We believe that’s a very low probability event simply because inflation rates over a 10 year period usually runs closer to 30%.  There is also population growth of about 10% over a 10 year period. A flat market implies a decline of 40% in overall earnings per capita (real dollars) which isn’t very likely.

Anyway, when Warren Buffett made this bet in 2008, he didn’t go ahead and buy index funds. He liked his top 5 positions better than Vanguard’s index funds. Over the next few years, he hired two hedge fund guys instead of buying low-cost index funds. These were the right decisions. Our research has shown that hedge fund managers are extremely talented stock pickers. The 30 most popular large cap stocks among hedge funds outperformed index funds by about 2 percentage points per year between 1999 and 2009. Large-cap stocks are usually difficult to tackle and Warren Buffett is STILL TODAY one of the best stock pickers in the large-cap space. On the other hand, small-cap stocks aren’t efficiently priced. The 15 most popular small-cap stocks among hedge funds outperformed the market by an average of 18 percentage points per year between 1999 and 2009. We have been sharing the list of these 15 stocks with our subscribers since the end of August 2012. Over the last 2.5 years, these stocks delivered a cumulative return of 131.4%, vs. 57.2% gain for “very low-cost index funds”. That’s an annualized return of 39.9% for hedge funds’ best ideas vs. 19.8% gain for Buffett’s “very low-cost index funds”.

The truth is it is possible to beat the market but you shouldn’t pay an arm and a leg every year to a hedge fund manager who has only 1-2 good ideas that perform very well and invest the rest of his assets on large-cap stocks where he can’t outperform the market after mind numbingly high fees. This is the point Warren Buffett is making. He probably thinks that most investors won’t have the discipline to stick to a strategy (i.e. imitating his top stock picks or investing in the best ideas of hedge funds like we do) and the best alternative for these people who do the wrong thing at the wrong time is investing in a “very low-cost index fund”.

If an investor has the discipline to stick to a strategy, then there are better alternatives. Buffett should have qualified his recommendation. By not qualifying his recommendation, he gave bad advice to disciplined investors. Let’s take a look at one of these alternative strategies that we shared with our subscribers.

Creating an equal weighted portfolio of Buffett’s top 5 positions would have returned 66 basis points per month between 2008 and 2012. A very low-cost index fund returned 29 basis points per month during the same period. You probably noticed that an equal weighted portfolio generated slightly better returns than Buffett’s value-weighted portfolio (66 basis points per month vs. 58 basis points per month). This means investors would have outperformed the market by more than 4.5 percentage points per year by buying Buffett’s top 5 picks. This 5 stock portfolio also had lower volatility (risk?) than the market and produced a monthly alpha of 55 basis points. Its market beta was 0.78. These are great numbers. If you believe that these stocks will keep outperforming the market over the long-term (Buffett does, that’s probably why he keeps buying them), you should research them more closely. Let’s go over Buffett’s top 5 picks:

1. Wells Fargo (NYSE:WFC): Warren Buffett had more than $25 billion invested in this banking giant, making Wells Fargo his biggest pick. There are 9 other billionaires with positions in WFC including conservative value investor David Abrams, Stan Druckenmiller, and Ray Dalio. Wells Fargo returned nearly 19% over the last 52 weeks, and is currently trading at a forward earnings multiple of 12.2. Its earnings per share was $1.02 for the fourth quarter, in line with analysts’ estimates. The revenues for the quarter came in at $21.4 billion, up 3.3% on a yearly basis.

2. Coca-Cola (NYSE:KO): is Buffett’s second largest stock pick. Berkshire’s $17 billion is riding on Coca-Cola. Billionaire Ken Griffin boosted his KO bet by 150% during the fourth quarter, whereas Rob Citrone and Israel Englander’s hedge funds initiated new positions in the stock. Among the 700+ equity hedge funds that we track at Insider Monkey, fifty eight of them had investments in the company valued at $22.5 billion. The stock returned 11% over the last 52 weeks.

3. American Express (NYSE:AXP): Warren Buffett had more than $14 billion invested in AXP at the end of 2014. Billionaires Ken Fisher and Mario Gabelli are also among the top 3 holders of the stock among the funds and investors we track. American Express announced a Q4 earnings per share of $1.39 and beat the expectations by a penny. The stock has a forward PE ratio of 14 which is cheaper than the average stock on the S&P 500 Index.

4. International Business Machines Corp (NYSE:IBM) is the most contrarian pick among Warren Buffett’s top 5 picks. In November 2013, famed hedge fund manager Stan Druckenmiller revealed his short position in IBM saying that the company’s business will be replaced by emerging technologies such as cloud computing. He said it was “one of the more higher-probability shorts I have ever seen” in an interview with Bloomberg TV at the Robin Hood Investment Conference. The stock declined more than 10% since then. Buffett has been adding to his position which trades at a forward PE ratio of about 10. Billionaires Ken Griffin and David Harding seem to be supporting Buffett’s long-term positive view with modest positions.

5. Wal-Mart (NYSE:WMT): Warren Buffett and Bill Gates’ Foundation have the largest positions in Wal-Mart among the investors we track. Billionaire hedge fund manager Andreas Halvorsen (Stock Picks, Investor Letters), who returned an average annualized net gains of 17.8% since 1999, also initiated a new position in Wal-Mart.

Warren Buffett gave disciplined investor bad advice by telling them to stick with low-cost index funds. If we didn’t have any better alternatives like investing in hedge funds’ best small-cap ideas, and our two options were investing in Buffett’s top 5 ideas or very low-cost index funds, we’d invest in Buffett’s top 5 ideas. The reason is simple. These stocks have lower volatility than the rest of the market and performed better than the market by 4.5 percentage points recently. We’d rather take our chances with Buffett’s picks than follow a bunch of guys who work at S&P (members of its index committee) and managed to underperform Warren Buffett’s pick by a large margin over the years.