I am reviewing the most recent Berkshire annual meeting (and related press appearances). This has triggered a couple of thoughts which I now feel compelled to inflict upon you. One relates to a topic I have written about before: Is Berkshire too Big to Win? Well, Messrs. Buffett and Munger made some comments that seem to shed some light on their answers to this question.
Warren himself kicked things off in recent comments made to the FT in an April interview. In the FT interview, Buffett was asked whether the S&P 500 or Berkshire would be preferable for an investment made for the benefit of a small child. Buffett said, “I think the financial result would be very close to the same.”
We’ve been Talking about this for 60 years (well, not me personally)
This statement made some waves. As the FT immediately noted, however, this is not the first time that Mr. Buffett has understated his ambitions. Curious, I completed a quick survey of the Buffett partnership letters to see when this first came up.
By the way, if you want a good book about the Buffett partnership complete with the letters in an appendix, I recommend the book Warren Buffett’s Ground Rules.
The first relevant point to our current line of inquiry was in the 1960 letter (partnerships commenced operations in 1956) Buffett said:
My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average…. Unless we do achieve this superior performance there is no reason for existence of the partnerships.
1960 Buffett Partnerships Letter
However, I have pointed out that any superior record which we might accomplish should not be expected to be evidenced by a relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is achieved, it will be through better-than-average performance in stable or declining markets and average, or perhaps even poorer- than-average performance in rising markets.
So in that letter, he is stating a clear goal to beat the index (and broader market) but he was not pounding his chest. He simply directed his investors to focus on the likely underperformance in bull markets. This was in year 4, with a relatively tiny fund, after increasing value of his partnership by 140.6% versus 42.6% for the Dow. So he was already sandbagging in 1960; after just getting started with his decimation of the index. Today, he is similarly stating seemingly modest goals of creating more than $1 of value for every dollar retained (usually in response to questions about distributions of capital…primarily stemming from concerns about size/performance.)
The first time the direct question of diminished performance directly due to the size of his AUM was in the 1962 partnership letter. Buffett wrote:
Aside from the question as to what happens upon my death (which with a metaphysical twist, is a subject of keen interest to me), I am probably asked most often: “What affect is the rapid growth of partnership funds going to have upon performance?”
Larger funds tug in two directions. From the standpoint of “passive” investments, where we do not attempt by the size of our investment to influence corporate policies, larger sums hurt results….
1962 Buffett Partnerships Letter
However, in the case of control situations increased funds are a definite advantage. A “Sanborn Map” cannot be accomplished without the wherewithal. My definite belief is that the opportunities increase in this field as the funds increase. This is due to the sharp fall-off in competition as the ante mounts plus the important positive correlation that exists between increased size of company and lack of concentrated ownership of that company’s stock.
Which is more important…? I can’t give a definite answer to this since to a great extent it depends on the type of market in which we are operating.
Wow. So people have been asking Buffett about this for almost 60 years! [I also note the question about succession/mortality was already being asked.] If I were him, at this point, I would probably just respond, “see our 1962 partnership letter for the first of several thousand times when I addressed this question.”
He has basically repeated this answer many, many times over his career (including in the 2019 annual meeting). Now, to be sure, he can’t compound at 2x the index forever (or he would eventually own/become the whole public securities market).
Then again, as I pointed out in my prior post, he’s not just deploying capital in the public equities markets. He now has private businesses and insurance markets to which he can deploy capital.
The entire economic world is basically his oyster. He can engage in bespoke merchant banking deals, like he did with Goldman and GE during the financial crisis, or like he did last week with Occidental Petroleum. That wasn’t a zero sum buy/sell transaction in the open market, it was providing liquidity as part of a corporate transactions which added “product” to the securities market. These sorts of transactions arise because of size, not in spite of it. They seems very similar to the mentioned Sanborn map/controlled situations (with maybe a bit more tactful/”white knight” approach).
2019 Annual Meeting Question
So, I was mulling a “thought experiment” related to this question involving the impact of the float/structure of Berkshire and what might be likely to happen if you replaced the investments with the bogey (a passive index investment).
For me, Buffett actually sparked this thought with his comments about private equity. He basically was critiquing the record of private equity returns (in response to a question about the large amount of capital pouring into that “asset class;” in response to a question from a guy who works on the buy side in that area for a public pension).
Buffett said, if you set up cheap(er) non-callable leverage and applied it to common stocks you would have outperformed even the historical figures quoted by private equity firms (let’s say ~14% CAGR; which he thinks is “aggressively” calculated). So he was basically saying there returns aren’t necessarily due to great skill, but more attributable to their structure.
Using his example, taking historical long-term common stock returns, if you levered an index fund 1.6x with free debt that couldn’t be called during stock crashes, you would end up with like a 16% historical CAGR.
My thought was, similarly, if you assumed that you replaced all the BRK investments and businesses with a common stock index fund and levered it 1.6x using non-callable (or at least uncorrelated) insurance float you would, essentially, get 1.6x the returns of the investment (index). So under that scenario, it seems one could argue that BRK could continue to outperform, even in the absence of any investment or capital allocation skill (zero sum investment wins); based simply upon the model/float.
At least two logical sort of outer bounds I can think of for this continued outperformance might be: (1) when the investment portfolio got too large as a percentage of the available options (total market) and trading costs really killed your returns (for example being unable to sell KHC because you are too large and would trample yourself); and (2) your overall balance sheet grew so large that you eventually couldn’t get free or low rate float (i.e., you started underwriting bad risks with positive combined ratios which exceeded the equity/investment returns). There are probably a number of other scenarios where BRK could underperform in actuality, but I still thought this might be a useful analogy.
Carol Loomis Steals my Thunder and Buffett Artfully Dodges
So, I’m sitting there thinking about this and how I’m going to write it up on my blog and then Carol Loomis basically asks the Oracle about the exact scenario I was thinking about. Here it is:
CAROL LOOMIS: This question comes from Stephen De Bode of Danville, California.
2019 Berkshire Annual meeting afternoon session
“Mr. Buffett, in the past, you have recommended low-cost S&P — and again today — the S&P 500 Index funds as reliable, long-term investment vehicles. These funds have certain inherent structural advantages such as low costs, and automatic reshuffling of their holding.
“But Berkshire also has certain structural advantages, such as financial leverage from the float, and diverse capital allocation opportunities….
“For example, it seems to me that if Berkshire’s overall operating business and investment performance were to exactly match the total return of the S&P Index over a 10-year period, Berkshire’s growth in intrinsic value would outperform the S&P 500.
“If you agree, could you estimate by how many percentage points?”
WARREN BUFFETT: (Laughs) Well, the answer is, I won’t estimate anything. But the — if we just owned stocks, and we owned the S&P, our performance would be significantly worse than the S&P because we would be incurring a corporate tax, which would now be 21 percent on capital gains, plus possibly some state income taxes….
So, I wouldn’t — I don’t know whether we’ll outperform the S&P 500 or not. I know that we’ll behave with our shareholders’ money exactly as we would behave with our own money.
And we will have — we’ll basically tie our fortunes in life to this business, and we will be very cognizant of doing anything that can destroy value in any significant way. But we will probably —
If there were to be a very strong bull market from this point forward, we would probably underperform during that period. If the market five years from now or 10 years from now is at this level or below, we will probably overperform.
But I don’t think that I want to — I don’t quite understand the question in terms of when it said the total return of the S&P over a 10-year period and Berkshire’s growth in intrinsic value would outperform. I don’t know whether that will happen or not. Charlie?
CHARLIE MUNGER: Well, there would be one big advantage for the shareholders that pay taxes, and that is that the Berkshire shareholders, even if we just matched the S&P, we’d be way ahead after taxes….
So, I thought that was a great question and Stephan is a smart guy (obviously…), but the prediction on the performance was what Buffett latched onto and he executed an artful dodge.
I guess Buffett is probably never going to make a positive prediction like that. There’s no reputational upside and it’s kind of totally inapposite to his demonstrated character over the decades. He kind of totally blew off the float/leverage portion of the question, just going to the asset side of the balance sheet. (To be fair even if Stephan/Carol was able to press him on that he almost certainly is not going to be willing to publicly predict continued free/negative interest float).
There is no doubt that he thought they would beat the index back when he opened the partnerships, but he didn’t come out and say that. He just said basically the same thing he says in this 2019 quote, “we should outperform in down markets.”
In 2019 he adde “we have almost all our money in here.” That would have been true in 1956 as well.
In his 88th year, one might think, “well this is his baby, he just want to keep the money in there and play with it.” I don’t know about that. This is the guy who has hammered per share performance versus empire building to CEOs for decades.
He’s the same guy who idolized Henry Singleton and Teledyne and numerous other CEOs who have crushed it for shareholders by returning capital when it made sense.
He’s also the guy who is reportedly sifting for Japanese net nets and buying SRG for his personal account when neither could possibly materially impact his net worth. He seemingly just loves to “crush it.”
Hey Charlie, Will Brk outperform? “Damn Right!”
Ok, so maybe that heading is overly enthusiastic, but Munger did sound a little more positive. In his response to Carol/Stephan’s question, he primarily focused on the tax implications of the DRD (it sounded to me). Munger is … a bit more candid.
He also had another opportunity to directly address this question in the recent FANTASTIC long-form interview with the WSJ. It is located here [$]. If you want to subscribe, here’s our WSJ Kindle affiliate link.
Jason Zweig and co. asked a series of questions probing what Munger thinks about BRK’s future prospects (they really worked to try and nail him down on the relative performance question), culminating in this exchange:
Q: [How will BRK do] Compared to the S&P 500?
WSJ
A: I think it we’ll beat it a little. But that’s not bad with a market cap of over $600 billion. That’s difficult! Most people won’t do as well as we will. I talked to Warren today. We’re buying one little company…as we sit here. And we haven’t bought anything big for a long, long time. It’s really getting hard for us. These other people will pay a lot more.
Munger makes a couple of interesting points. First, he went right to a private business transaction, which really has no public securities market impact. He also says that prices are elevated (because PE firms are simply buried in money.)
Steven Schwartzman of Blackstone described a recent fund raising round as an “out of body experience” due to the incredible demand. hah!
Second, Munger talks about the drawback of BRK’s size. This kind of takes us back to the theoretical limitations in the above analogy/thought experiment.
When does Berkshire get so big that it has to converge with the market?
Let’s look at some of the competition. In the PE space: Blackstone has an estimated $472 Billion AUM. KRR has about $150 billion. Carlyle has about $200 billion. BAM has about $370 billion.
I think Buffett can still be nimble among these behemoths and can take a few points from them (or more accurately, from their “OPM” derived from investors and lenders). He doesn’t actually have to deploy $600 billion, as a lot of that market cap doesn’t directly correspond to investments they have to deploy (the public securities portfolio is $183 billion and cash is ~$100).
Again, he can also invest in public markets, whereas most of those institutions are essentially confined to private markets (mainly businesses and real estate).
Turning to (mostly) public markets players, the Capital Group (American Funds) has $1.87 trillion in AUM. Invesco has about $900 billion. Prudential has about $1.4 trillion. VFINX, one class of one index fund at Vanguard, has about $360 billion. Vanguard has about $5 trillion in total. Blackrock has about $6 trillion (all figures are from super lazy www.google.com inquiry results).
I understand index funds are not actively picking securities (for the most part), but those investors (at least a lot of them) are still going to pile in at the top and pile out at the bottom. I think BRK can run out with the buckets to catch the falling gold when everyone else is piling out (provide liquidity) and pick up a few points over the long-term. BRK can also probably be even less active/lower fee than they are and doesn’t have to take on the securities lending risks many of these funds do. That is, of course, before the impact of non-callable leverage comes into play.
Summation
To sum up, on the whole BRK’s size is probably a drag, but I am not overly troubled by Buffett’s recent statements. He’s been saying the same stuff for almost 60 years at this point.
It seems like the Berkshire model presents some unique structural advantages, even in the absence of investment skill (of which I have no doubt current management is very materially possessed).
It seems premature to worry too much about market impacts due to size until BRK gets a lot larger than many of its competitors in PE and the public equity markets. Compared to those behemoths, Berkshire doesn’t seem particularly unwieldy.
I expect Berkshire to materially outperform the equity return/risk premium with lower volatility and nice tax treatment over the next 10-20 years. Given the available options, that sounds pretty good to me.
I don’t really see why there wouldn’t be a pretty long runway yet (or at least a long curve gently bending downward from the ~20% CAGR still showing in the annual report). I think I have talked myself into buying some BRK!
Finally, may Charlie and Warren eclipse the length of the careers of Rose Blumpkin and Irving Kahn by as wide a margin as they have trounced the index over the past 50+ years!