Don't Bet Against Warren Buffett

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Don't Bet Against Warren Buffet
Jeff Kowalsky/Bloomberg via Getty Images Billionaire investor Warren Buffett speaks as Michigan Gov. Rick Snyder looks on at an event in Detroit in November.
By Steven Goldberg

To many investors, Warren Buffett is over the hill. At 83, they say, he has lost more than a few steps. Over the past five years, the Class B shares of Berkshire Hathaway (BRK-B), the sprawling conglomerate he presides over, returned an annualized 14.8 percent -- an average of 3.9 percentage points per year less than Standard & Poor's 500 stock index (^GPSC). There's nothing cutting edge about the insurance companies, railroads and utilities Berkshire owns. What's more, when Buffett leaves Berkshire, who will manage the company?

To all that skepticism, Matthew Coffina, editor of Morningstar Stock Investor, says, essentially, "nuts." I couldn't agree with him more.

Sure, Berkshire's stock will lag in powerful markets, as it has in the current one. But Coffina says Berkshire will handily beat the S&P 500 in flat and down years. Overall, he predicts that Berkshire will return roughly 10 percent annually over the next ten years, and that should easily outpace the S&P 500.

Coffina has made Berkshire the largest position -- 10.9 percent -- in his newsletter's model "tortoise" portfolio. (The newsletter also has a "hare" portfolio, which consists of slightly more-volatile stocks.) At its current price of $122, Berkshire shares are $21 below Morningstar's $143-per-share estimate of Berkshire's fair value. With so few stocks selling below what Morningstar (MORN) analysts consider to be fair value, Berkshire looks like a steal. (Unless otherwise noted, prices and returns are as of April 11.)

%VIRTUAL-article-sponsoredlinks%Berkshire's long-term record is astounding. Berkshire high-priced Class A shares have returned an annualized 20.7 percent since Buffett took over the company in 1965. That's more than double the return of the S&P 500. Ancient history? Since October 9, 2007, just as the catastrophic 2007-09 bear market was getting under way, Berkshire has returned an annualized 6.3 percent, an average of 1.7 percentage points better than the S&P index. (Berkshire's Class B shares came into existence in 1996.)

But Buffett doesn't focus on share price as much as he does on book value (assets minus liabilities), his preferred method of figuring his company's performance. From 1965 through the end of 2013, Berkshire's book value has compounded at an average annual rate of 19.7 percent. That said, Buffett believes that book value underestimates the "intrinsic," or true, value of his company by a "meaningful amount." He has said that Berkshire, which is awash in cash, will buy back shares when they fall to 120 percent of book value, or about $108.

Buffett's buyback plans, Coffina says, "put a psychological floor under the stock, not that far below where we are currently."

Perhaps the biggest question on the minds of Berkshire shareholders is who will replace Buffett and Vice Chairman Charlie Munger, who are both in their 80s, when they leave the scene. Buffett has hired two talented stock pickers, Ted Weschler and Todd Combs, to manage Berkshire's massive stock portfolio; each already manages $7 billion worth of Berkshire assets. The bigger issue will be who runs the rest of the company. Buffett and the Berkshire board say they have a plan in place and have identified potential successors, but haven't disclosed any names yet.

No doubt Berkshire's price will plunge when Buffett announces his retirement or dies. But Coffina says Buffett is "taking the right steps to ensure that Berkshire's culture endures." He adds: "Berkshire has assembled a unique collection of businesses with solid management, sustainable competitive advantages and the ability to compound intrinsic value for years to come."

Buffett likes to say that he stays within his "circle of competence" when buying stocks or entire companies. That has led him to avoid technology altogether. The empire he has built contains an enormous number of companies in a variety of businesses.

Berkshire's "crown jewels," says Coffina, are in its insurance businesses: Geico and reinsurers General Re and Berkshire Hathaway Reinsurance. Berkshire's financial strength gives it the capital to underwrite risks that most firms can't -- or won't -- touch. Coffina says Berkshire's underwriting discipline and investing discipline distinguish it from competitors.

The insurance businesses allow Buffett to invest money during the often lengthy period after premiums are received but before claims must be paid out to policyholders. This "float" now stands at $77 billion.

Outside of insurance, Berkshire owns the Burlington Northern Santa Fe railroad and utility MidAmerican Energy, in addition to a hodgepodge of other businesses. Among the more recognizable names: Fruit of the Loom, Benjamin Moore paints, Shaw carpets, Dairy Queen and Clayton Homes.

To get a sense of just how sprawling Berkshire is, the 30-plus newspapers it owns represent no more than a rounding error in the company's $222 billion book value.

Coffina puts it well: "Berkshire's existing businesses can stand on their own. Although I think management will continue to add value for shareholders through new acquisitions and investments, this isn't necessary for Berkshire to be a worthwhile holding."

Plus, of course, Berkshire has major stock holdings in such companies as American Express (AXP), Coca-Cola (KO), International Business Machines (IBM) and Wells Fargo (WFC).

My bottom line: Buffett is to investing as Albert Einstein was to physics. Buffett may well be past his prime, but Einstein was a pretty smart old man, too.

Steve Goldberg is an investment adviser in the Washington, D.C., area.

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Don't Bet Against Warren Buffett

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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