Is Berkshire now too big to beat the market? I have been thinking about this question after reading the most recent annual report and some related commentary. Berkshire has underperformed the S&P 500 over the most recent decade. So is the run over? It is an obvious question and one very ably examined by Jason Zweig of the WSJ Money Beat Blog (subscription required). I enjoyed reading Mr. Zweig’s work, as always, and
Buffett devoted a lot of his annual letter this time to recapping a bet he mades with a hedge fund of funds sales outfit that the S&P would beat a sampling of five hedge funds over a decade. The focus on this bet naturally highlighted the fact that he has also lagged the S&P 500 during the most recent ten years.
For the uninitiated, Warren Buffett has compounded money at about 19% per year for the last 50+ years. This performance has been simply phenomenal (link to 50 Years of Berkshire wall chart/art). He has increased book value over 1,000,000%, from 1964 – 2017. The S&P 500 increased a little over 15,500% during this timeframe (9.9% CAGR). Ok, so he’s the GOAT (and he works for shareholders for almost free btw).
Buffett himself discounts his ability to continue to outperform (“smoke” would be more accurate) the S&P 500. As Mr. Zweig pointed out, Buffett has been warning for decades that his performance should tail off. In the 1994 Annual Report Buffett wrote:
Charlie Munger, Berkshire’s Vice Chairman and my partner, and I make few predictions. One we will confidently offer, however, is that the future performance of Berkshire won’t come close to matching the performance of the past.
The problem is not that what has worked in the past will cease to work in the future. To the contrary, we believe that our formula – the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people – is certain to produce reasonable success. We expect, therefore, to keep on doing well.
A fat wallet, however, is the enemy of superior investment results. And Berkshire now has a net worth of $11.9 billion compared to about $22 million when Charlie and I began to manage the company. Though there are as many good businesses as ever, it is useless for us to make purchases that are inconsequential in relation to Berkshire’s capital.
Buffett also went on to state that in 1994 Berkshire was limited to securities in which he and Charlie felt they could deploy at least $100 million.
Even back in 1994, however, this sort cautionary language was nothing new. Indeed, beginning in his first partnership letters back before Berkshire was even on the radar screen, Buffett liked to caution his investors against extrapolating recent results and warning them that he was not likely to be able to continue to outperform to such a large degree. See, Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor
As Mr. Zweig pointed out, Berkshire has a number of structural advantages, such as permanent capital, allowing the exercise of patience. What we are really concerned about here, it seems to me, is the size of Berkshire’s funds to deploy relative to the opportunity set. At some point, if Buffett theoretically continued to outperform the public securities market indefinitely, he would end up owning 100% of the securities market. It seems that well before this happened his capital base would be so large that his returns would have to regress to the market as they would converge.
He would become analogous to a whale so large that it could not move without displacing the sea all around and thus essentially constrained by size to sitting in place and subsisting on whatever plankton was brought to him by the tides.
I thought, therefore, it would be interesting to look at the size of Berkshire relative to the opportunity set. First, if we looked at Buffett’s own 1994 hurdle for an opportunity, a $100 million dollar investment was about .85% of the 1994 net worth. Rounding up to $1% and using the shareholder’s equity figure from the most recent 10-K ( about $352 billion), we are looking at $3.52 billion for a minimum hurdle. There are many companies which exceed this size.
If we assume that Buffett would not want a control position in publicly traded stocks, however, then we might be talking about needing around a $12 billion company before it is potentially on the menu for Berkshire (assuming around a 30% ownership interest, like KHC). So, we’ve potentially just ruled out all small and middle capitalization companies.
Although, if you do not make the assumption that Berkshire would seek to avoid control stakes (or if Buffett uses KHC or the like to be “platform” company/outsourced manager), you do seemingly bring the mid cap universe back into play.
It also might be informative to compare the money Berkshire has to manage to the overall market capitalization of stocks. So, the most recent figure I have seen for the Russell 3000 is $30 trillion. If Berkshire has $300 billion to allocate to public equities ($110 billion cash + $170 billion in public stocks + ~$20 billion for KHC) that is about 1% of the total public market capitalization. That does not seem like any move would result in massive market impacts.
I suppose, however, one could make the argument that about 50% of the U.S. market is now passive (and potentially static), so that percentage should be backed out, as it is no longer competing with BRK in the active/zero sum game. Even then, Berkshire is managing an amount equivalent to about 2% of the total market.
But I think we have to give Buffett more room to swim (or tap dance). He has the U.S. private business market remaining as an outlet for his cash (although maybe those are all reflected in the $30 trillion, as U.S. GDP is only about $20 trillion as I write (early 2018)). We also have to make at least some allowance for global businesses, as Berkshire has been making some investments abroad over the last several years (and even U.S. domiciled investments will deploy his capital into the global economy). According to MSCI, the total investable market cap is currently around $60 trillion. Thus, it appears that we are back to Berkshire managing about 1% of the assets in the market (even less if we back out the $110 billion in cash and equivalents). As another touchstone, if you added the American Funds, Growth Fund of America and the Fidelity Contrafund you would get to almost $100 billion in AUM.
None of this factors in the impact of the insurance operation and float. If insurance can be profitably underwritten (perhaps even very profitably in the future….with a hypothetically big hardening of the markets in insurance) it can serve as another source or return/place to deploy capital/hold against risks.
If you had a closed end fund with 60% leverage from issuing preferred stock, paying a zero percent dividend (or even better -2%), which was not subject to call risk, I would expect you to do very well over the long-term, even if you put 100% in the S&P 500.
In summary, I am not sure if we are to the point where Buffett can no longer outperform. I don’t think his repeated cautionary language is very persuasive, given that it is over 50 years old at this point. It is difficult to get concerned when the overall performance is just now rounding toward 19% (versus the long run of 20), he has only underperformed by about .8%, and this is after nearly a decade of a 1990’s type market, where momentum has ruled and it is difficult to find companies with above average expected returns (hence, the huge cash drag).
In the end, maybe all one can state with any conviction is that at the current valuation (of ~1.4 times book value) Berkshire is not an obvious “no brainer.” I would personally, however, be unwilling to bet even $1 against Warren Edward Buffett (and I would run the other way if he were the one offering me any bets)!