Felix Salmon Is Wrong: Berkshire Will Outperform
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Felix Salmon published a very interesting column in Reuters this week, where he explains the rationale for believing that the good times are over for Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) and Buffett will no longer outperform the markets over the next years.
Salmon is one of my favorite writers; he is very smart and fun to read, but I believe he is plain wrong this time. In fact, I would say that Berkshire is in a great position to outperform the indexes over the next five years or so.
The Bearish Case
The fact is that Berkshire has underperformed the markets over the last five years; investors would have achieved better returns buying an ETF like the S&P Depository Receipts (NYSEMKT: SPY) and reinvesting the dividends than holding shares of Berkshire.
Salmon thinks that Buffett has lost his edge; value investing is so popular and well understood that all opportunities to generate excess returns have evaporated:
All strategies eventually run out of steam. Some have longer legs than others: the fundamentals-based investing philosophy of Buffett, which he inherited from Ben Graham, worked for decades, while the clever excess returns that academics find hidden in the market tend to disappear as soon as they’re published. And in the world of quantitative investing, even unpublished strategies have ever-shortening shelf-lives.
Buffett had a good run, but at this point there’s really zero reason to believe that his kind of fundamentals-based value investing still gives anybody an edge.
The Intelligent Investor
In theory, once everyone understands how value investing creates excess returns, all kind of investors will go hunting for the same kind of undervalued deals, and this will bid up the prices to a level where there are no more opportunities for excess returns available.
But that's not how it works in real life: value investing requires patience, independence and a long term mentality, as well as the scarce virtue of discipline. In the words of Ben Graham himself: for an investor, intelligence "is a trait more of the character than of the brain."
Most market participants are short term focused, the rise of High Frequency Trading is a sign of the times, and even professional mutual fund managers are more worried about returns over the next five days than the next five years.
Shares of high quality businesses are often sold off relentlessly because the company missed earnings forecast by a penny, and the markets fluctuate widely in response to incomprehensible statements by politicians from one side of the Atlantic or the other.
Value investing is not just about intellectual knowledge, it's mostly related to strength of character and discipline. As long as most investors are lacking these virtues, Buffett and other value investors will continue finding opportunities for superior returns.
The Rear View Mirror
Buffett evaluates Berkshire's performance in terms of its book value as opposed to market price, and he has good reasons to do so. Management can be held responsible for what the company achieves in terms of book value, earnings or cash flows, but the stock price is out of their reach. You can't control how much the market decides to pay for each dollar of earnings or book value.
When comparing Berkshire versus the SPY in terms of book value, the company has actually over performed the markets over the last five years. The tricky part is that Mr Market has decided to deeply discount each dollar of the company's equity, and Berkshire is now barely trading above a price to book value ratio of 1.1, a level at which Buffett said last year that the stock would be cheap enough to merit buybacks.
Maybe part of this discount is justified, Buffett is not getting any younger, and the company has grown in size, which means that finding deeply undervalued opportunities is tougher than before. But Buffett knows a thing or two about buying great companies at attractive prices, and he thinks that Berkshire is cheap, so investors should pay attention.
The company is a collection of extraordinary businesses selected by Buffett himself over the decades, and Berkshire has the possibility to leverage at an exceptionally low cost via its insurance operations to invest in high quality companies. The company is holding more cash than what Buffett would prefer, but over the last years it has also made some exciting investments.
Wells Fargo (NYSE: WFC) is one remarkable case, Buffett has been consistently adding to the position recently, and it's now the second largest holding in the portfolio. The bank excels in comparison to its peers when it comes to risk management, and it has been able to continue expanding in businesses like mortgage lending while other big banks are still trying to streamline their balance sheets.
Wells Fargo is better positioned than any other major bank to benefit from a real estate recovery, and that provides some exciting potential over the long term. Berkshire has a large exposure to housing via different listed and private holdings, this may be an explanation for past underperformance, but also a driver of future returns once the real estate recovery gains some speed.
Buffett has even broadened his “circle of competence” by expanding into the tech sector and buying a big position in IBM (NYSE: IBM) in 2011. Big Blue is a top notch tech player, and the company has been smart enough to grow out of hardware and into high value-added businesses like software and services, and it has a unique competitive position among corporate clients. This exposes Berkshire to a more dynamic and innovative business area, and should provide opportunities for higher returns in the future.
Value investing will not beat the markets each and every year, no strategy can do that. But even when investment knowledge evolves, and everyone understands how value investing works, human behavior doesn't change that much, and that's where Buffett gets his edge.
Due to its size, we can't expect the same level of over performance from Berkshire it has delivered over the last decades. But the company is still a combination of many of the best businesses on Earth, and the stock is historically cheap, so it’s offering a big chance of doing better than the indexes over the following years.
acardenal owns shares of Berkshire Hathaway and IBM. The Motley Fool owns shares of International Business Machines and Wells Fargo & Company. Motley Fool newsletter services recommend Berkshire Hathaway, International Business Machines, and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!