Imitation Is The Sincerest Form Of Flattery: Warren Buffett And Berkshire Hathaway via CSInvesting
Gerald S. Martin
American University
John Puthenpurackal
University of Nevada -- Las Vegas
April 15, 2008
Abstract:
We analyze Berkshire Hathaway's equity portfolio over the 1976 to 2006 period and explore potential explanations for its superior performance. Contrary to popular belief, we find Berkshire Hathaway invests primarily in large-cap growth rather than “value” stocks. Over the period the portfolio beat the benchmarks in 27 out of 31 years, on average exceeding the S&P 500 Index by 11.14%, the value-weighted index of all stocks by 10.92%, and a Fama and French characteristic-based portfolio by 8.56% per year. Although beating the market in all but four years can statistically happen due to chance, incorporating the magnitude by which the portfolio beats the market makes a luck explanation extremely unlikely even after taking into account ex-post selection bias. We find that Berkshire Hathaway’s portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value. While increased volatility is normally associated with higher concentration we show the volatility of the portfolio is driven by large positive returns and not downside risk. The market appears to under-react to the news of a Berkshire Hathaway stock investment since a hypothetical portfolio that mimics the investments at the beginning of the following month after they are publicly disclosed also earns significantly positive abnormal returns of 10.75% over the S&P 500 Index. Our evidence suggests the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson posses’ investment skill unlikely to be explained by Efficient Market Theory.
Imitation Is The Sincerest Form Of Flattery: Warren Buffett And Berkshire Hathaway - Introduction
Warren Buffett’s investment record suggests he is one of the most successful investors of all time.1 With his long-time partner Charles Munger, they transformed Berkshire Hathaway from a struggling textile manufacturer to a holding company with a market capitalization greater than $200 billion. In 1985 with the acquisition of GEICO, Lou Simpson was added to the collective that makes investment decisions for the company. According to Forbes, Buffett’s beneficial interest in Berkshire Hathaway gives him an estimated net worth of $62 billion making him the wealthiest person in the world.2 Berkshire Hathaway controls a diverse group of subsidiaries, many of which are industry leaders in both market share and financial strength, and an equity portfolio in excess of $74.6 billion in publicly traded companies whose value alone would equate to the 6th largest mutual fund according to Lipper.3 The performance of Berkshire’s equity portfolio has beaten the S&P 500 index in 27 out of 31 years from 1976 to 2006 exceeding its average annual return by 11.14% over this period.
While many books have attempted to explain Buffett’s investment philosophy and success there has been no rigorous empirical analysis of his exceptional performance. Academic research generally has focused on analyzing performance of mutual funds in order to determine if superior performance may exist however, obtaining a better understanding of the performance of arguably the world’s greatest investor would be valuable in determining whether it can be explained by such theories as the Efficient Markets Theory (EMT).
So how does one explain the investment success of Berkshire Hathaway which has been achieved over a long period of time? Consistent with efficient markets theory Buffett may just have been lucky.
That is, if enough investors participate in the market, due to pure luck, some investors can obtain very successful investment records.4 Buffett’s successful performance has also been identified after-the-fact so his record is subject to ex-post selection bias. We mitigate this bias in two ways. First, we begin our analysis in 1976, a point in time when Buffett had already developed a reputation as a very successful investor.5 Second we use a procedure developed by Marcus (1990) to show that Berkshire Hathaway’s equity investment performance is statistically not likely due to luck even after accounting for ex-post selection bias.
We show that Berkshire Hathaway’s high returns are not simply compensation for higher risk as measured by traditional empirical benchmarks and portfolio analysis techniques. We find the portfolio is concentrated in relatively few stocks resulting in a highly undiversified portfolio. Such concentration exposes the portfolio to significant amounts of unsystematic risk which will likely produce consistently superior returns only in the presence of investment skill. Using simulations of concentrated portfolios where stocks are picked randomly we find their performance is highly unlikely to produce an investment record like Berkshire Hathaway’s. Finally we show that Berkshire Hathaway’s portfolio historically has experienced low downside risk further indicating the presence of stock picking skills.
Can Efficient Markets Theory (EMT) explain Berkshire Hathaway’s investment performance? EMT does not claim that stock prices are correct at all times, it only states that stock prices are correct on average. At any point in time, stocks may be mispriced with the market reacting quickly to correct the mispricing. If an investor is successful in identifying the direction of pricing errors in a majority of their investments, they can earn positive risk-adjusted returns. Grossman and Stiglitz (1980) explain that skilled investors are rewarded for the cost of information production (acquiring better information and/or better processing of available information) that keep markets efficient. Such ability would enable the skilled investors (efficiency insurers) to identify mispriced stocks and earn positive risk-adjusted returns as compensation for information production. Under this interpretation, Berkshire Hathaway’s positive risk-adjusted returns are still potentially consistent with EMT.
It is not clear whether unskilled investors can profit from the information produced by skilled investors. Proponents of EMT proponents (e.g. Samuelson, 1989) state that skilled investors will charge a higher management fee thus capturing most of the excess return leaving little for unskilled investors. It is also argued that information produced by skilled investors is quickly incorporated into stock prices by the trading activity of skilled investors so that unskilled investors are unable to profit from this information. We find that unskilled investors who mimicked Buffett’s investments at the beginning of the following month after they are made public would have earned significantly large positive risk-adjusted returns. This suggests that information produced by skilled investors such as Buffett may not be rapidly incorporated into stock prices; a finding not consistent with traditional interpretations of EMT.
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