Berkshire Hathaway Analysis - Follow Up Post (Part 2)

Happy Easter holiday.

This post follows from my post last week. In this post I look at Buffett's performance a bit more closely and discuss some strategies. This discussion isn't meant to be exhaustive - it is just some observations I have made over the years.

The central point of discussion is Buffett's Alpha, an article which decomposed Berkshire's performance for the period 1976 - 2011. Berkshire, with Buffett at the helm, has been going much longer than that. And previous to Berkshire, Buffett was more of a traditional fund manager via a series of partnerships from 1957 to 1969. This period is probably a better time to analyse his performance as no debt was involved. I say probably because there are stories of him finding good quality growth stocks selling for a PE of 1; you don't see that everyday! 

Anyway, his estimated pre-fees performance* over this time was 29.5% p.a. v the S&P500 performance of 7.4%. You would agree that's a truly extraordinary performance. That was during a time when Buffett managed a much smaller amount of money, and could therefore easily trade in and out small-cap situations and make great returns without leverage. That edge slowly disappeared as his funds grew and therefore his strategy had to evolve to the model we now see in Berkshire. 

So, if you aren't interested in using debt, however you want to really make a lot of money, then you will need to find investments that will deliver outsized un-leveraged returns. That may come from sources such as a job (a job with upside from commission, revenue or profit split is actually pretty cool: as an employee you risk absolutely no money, get trained, don't need to be loyal for a long period of time and still get upside potential), own a business or in the case of shares, go for the small cap space (as the younger Buffett did) where higher returns can be made (and lost). Un-leveraged property can work, but leverage is usually required unless the timing is bang-on. 

Let's consider using leverage. Would you go and get a margin loan to buy a portfolio of shares? After having gone through the GFC and seeing how badly both big-cap company's share prices and margin lenders themselves can act, I'm personally a bit iffy about it. In good markets the strategy can be amazing, however it gives you pause when it all goes pear shaped and you talk to a story of a postie who lost his life savings as he had a big fat margin loan against property stocks, Babcock & Brown and other similar stocks that are like Nassim Taleb's turkey just before July 4th. At the least, to use leverage in stocks you should have some other form of safety net such as using stop-losses, sticking to big relatively safe blue-chips, hedging through puts or shorts, an appropriate cash buffer etc. 

Personally (as an Australian), I think the Buffett-leverage model works pretty well with residential property for ordinary investors. Property is one of the very few assets that will undoubtedly be around in 10 years time (which is one of Buffett's criteria for an ideal investment) and bought cheaply should meet the 'value' criteria and bought in a location bound for growth (capital and rental) should meet the 'quality' criteria. Leverage on property is usually not a problem at all - in fact, banks love lending money against residential property. The major point of contention is the lack of cash-flow. Does neutral or negative gearing really fit the Buffett-leverage model? In isolation, no. However in context of overall income, tax minimisation and getting exposure to a relatively large amount of capital then I think it does. 

This is all obviously horses-for-courses and there are other considerations such as personal circumstance, experience, liquidity requirements, income requirements and appetite for debt. Naturally people should do their own research and please don't take this post as financial advice - it's not! 

Kristian 

*Estimated post-fees performance of 23.8% p.a. after paying 20% of profits above 6% threshold.