Why You Shouldn't Try to Invest Like Warren Buffett

June 3rd, 2015
in contributors

Money Morning Article of the Week

by Keith Fitz-Gerald, Money Morning

Many "experts" say that they can help you invest like the legendary Warren Buffett. Most, unfortunately, have no clue how he actually does it.

Follow up:

Even those few who do understand his deep-value investing style are holding something back from you. They'll tell you how you can invest like Warren Buffett while omitting a key detail:

You shouldn't try to.

I know that's heresy in an era when the Oracle of Omaha is rightfully lauded as one of the world's greatest, but simply mirroring what he does will not get you where you want to go. Chances are, it won't produce the returns he gets either.

Here are three reasons you shouldn't try to invest like Warren Buffett.

Reason No. 1: Buffett Plays by Different Investing Rules

It's well-known that Berkshire Hathaway has averaged an annual return of more than 20% in the 50 years since Buffett launched it. According to Buffett's 2015 letter to shareholders, the precise number is 21.6%, including a 27% gain for Berkshire Hathaway's stock last year.

No ifs, ands, or buts about it… that's a fabulous track record over a very long period of time. It's consistent, it's undeniably robust, and it's worth noting that the S&P 500's average annual gain over the same time frame was only 9.9%.

However, it's also misleading.

There are dozens of books that will tell you Buffett has his method down cold and that he's a master at planning long-term moves and spotting undervalued companies with low-risk, high-upside prospects.

But if Buffett were given a dose of truth serum before being asked to divulge his investing secret at a TED Talk, I suspect he'd give a one-word answer: leverage. Without that, his returns wouldn't be all that great. In fact, according to The Economist, they would have been "unspectacular."

People forget that Berkshire Hathaway, in addition to being a conglomerate holding company with a vast array of investments, is also an insurance company. Like all insurance companies, it commands a float – the premiums paid by policyholders, some of which will be paid out later as benefits.

Berkshire Hathaway's float – which now stands at a formidable $84 billion – essentially functions as a massive pool of capital it can borrow at an estimated 2.2% interest. That's three full percentage points and then some below the going rate if you or I were to try and obtain similar financing, or the average short-term financing costs of the United States government over the same time frame, according to The Economist.

In other words, Buffett is banking the big bucks because he's leveraged up to his eyeballs and, like most insurance companies, has a really large investment company operating by virtue of the insurance premiums it collects.

Let me give you an example of what a difference this makes and why leverage is a dirty little secret.

Imagine you have $1 million to invest in a promising company. So you take the plunge, buy shares, and enjoy the $200,000 in profits a year later after it's appreciated by 20% and you've cashed out.

Now imagine if your leverage is 2:1. The $1 million you invested is still worth $1.2 million at the end of the year, only you've invested $500,000 instead of the initial million. That means your profit on the same 20% move is actually 40% on your money.

According to New York University researchers and ARQ Management, Berkshire Hathaway has historically levered up around 60%. That means that Buffett's profits are, on average, about 60% higher than they would have been had he used only his own money and no leverage.

This has enormous implications for any investor hoping to emulate Buffett's approach.

Think about it for a minute. What this means is that, in contrast to everyday investors, locating stocks that beat the market is far less important to Buffett. He can - and does - rely heavily on safer companies with solid outlooks and impeccable balance sheets, knowing that his leveraged advantage will make these picks outperform even if they trail the market's performance by a few percentage points.

Of course, the flip side to increasing upside from leverage is increased risk. And that brings me to another reason you shouldn't strive to invest like Buffett.

Reason No. 2: Buffett's Strategy Is Too Risky for Typical Investors

Since 1965 when he started Berkshire Hathaway, Buffett has written a folksy letter to shareholders every year. As part of that, he highlights the annual percentage change in per-share value of Berkshire stock, and how it's compared to the yearly change in the S&P 500.

Quite often it's a stellar contrast. Berkshire Hathaway has averaged an annual return that's more than twice that of the S&P over the same time frame, after all. But what you may not have heard is that Buffett's empire has actually underperformed the major indices surprisingly often -sometimes by a shockingly big margin.

For example, Buffett reported a 27% gain for Berkshire Hathaway's stock in 2014 that was nearly twice the comparable S&P 500 return over the same time frame - not an unusual performance for Berkshire.

Yet, as recently as 2011, Berkshire shares saw a 4.7% loss for the year, even as the S&P saw gains of 2.1%. And in 2012 and 2013, Berkshire only managed to outperform the S&P 500's gains by 0.8% and 0.3% respectively.

According to Buffett's 2015 letter, there have been five years since 1964 where Berkshire's stock saw negative returns even as the S&P 500 posted gains - including a particularly bad run in 1999 when Berkshire stock fell by 19.9% while the S&P 500 roared to a 21% gain. And in 2008 Berkshire saw a 31.8% loss in market capitalization. True, that's less disastrous than the 37% loss the S&P 500 saw that year, but it apparently leaves a lot to be desired in the risk-management department.

But, again, Warren Buffett doesn't think about risk in the way you or I would. He doesn't have to, and that's what sets him apart from other investors.

At this point, Warren Buffett has so much money at his fingertips that Berkshire can take risks that would be sheer madness for other investors. He can move aggressively and decisively with hundred-million or multi-billion dollar bets that completely upend the normal rules of investing.

For instance, Buffett tied up 8.5% of the $58.5 billion Berkshire commanded in 2008 when he spent $5 billion to buy Goldman Sachs warrants. And, in doing so, he violated commonly accepted rules regarding position sizing that limit every investment to 2% to 5% of tradable capital as a means of avoiding catastrophic loss.

And that's the operative word here, "catastrophic." Berkshire Hathaway lost $11.5 billion of its wealth in 2008, according to Buffett's 2009 letter to shareholders, but the loss wasn't catastrophic for it. All told, it was only 16.4% of the money that had been entrusted to the company that year. That's a setback, but not nearly enough to seriously derail Team Warren.

The loss in 2008 didn't faze him because he operates under different risk management principles. Anybody who tries to imitate him, even with millions of dollars, is taking on a disproportionate amount of risk compared to what Buffett faces in a similar transaction.

Reason No. 3: You Can't Know If His Plays Are Speculative or Not

And, finally, Buffett is one of the very best when it comes to the "long game," meaning that he's thinking years in advance when he buys something. Yet, some of his plays have a lot more in common with a nimble trader's playbook than a deep value investor's strategy.

Occasionally, Buffett gets burned, too.

In 2009, for instance, Buffett admitted to making a terrible mistake the previous year when he took a large stake in ConocoPhillips, right before oil prices cratered. Recognizing his expectations for oil prices had been "dead wrong," he sold the shares. "The terrible timing of my purchase," he said in his annual letter to shareholders, "cost Berkshire Hathaway several billion dollars."

He had also paid $244 million for shares of two Irish banks he believed to be undervalued, only to see them written down to a market price of $27 million, creating an 87% loss. Any individual who bought alongside him in a copycat move got similarly burned.

Of course, plenty of his speculative moves have been profitable - some wildly so. He earned $2 billion dollars in five years with his $5 billion deal to rescue Goldman Sachs in 2008, for example.

My point is that Buffett's wins and losses - and the scale of the capital he puts into them - show that there are clearly times when he's speculating despite the fact that his moves appear as investments to casual onlookers and the media. Unless you clearly understand which is which, and can lose at least a few million dollars in a single trade without blinking, imitating him means flirting with disaster.

And what if you are still a Buffett fan?

Fortunately, there are some easy solutions.

Make sure any company he buys that you're interested in lines up with one of the Unstoppable Trends. That way you have the solid return on equity over many years that's infinitely more desirable than the flash-in-the-pan scenario most investors fancy. "Must-have" companies are definitely preferred over "nice-to-have" alternatives.

Pick your tactics carefully and make sure they match your risk tolerance. Not his. Buffett uses leverage liberally, but that's not always needed. Williams Co. Inc. (NYSE: WMB) is a great example of the over-performance you can enjoy without leverage. I recommended it to my Total Wealth readers on Jan. 7, and so far it's returned 22.67%, or more than 5X the 3.9% the S&P 500 has turned in over the same time frame. Sometimes all you need are straight stock buys, but other strategies can include options, ETFs... even funds.

Control risk carefully. Buffett has quipped that his favorite holding period is "forever," which, again, may be great for him. Not for you. This is where trailing stops, options, and even inverse funds are so valuable. No investor has to suffer the ravages of a bear market if these are used correctly.

In closing, there are a lot of reasons to be like Buffett, and it's certainly tempting. You don't get to be a billionaire by being stupid.

Just make sure you're investing in your best interests... not his.

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