A Better Buffett Bet….

In an interview today on CNBC Warren Buffett said he couldn’t find someone to come to the annual meeting to explain their position against Berkshire Hathaway going forward.  He wants a big short to come in and explain the bear case.  But this strikes me as a common case of bad benchmarking (and frankly, a layup to make Buffett look good since the odds are heavily in his favor).

Buffett shouldn’t be asking for someone to explain why his firm will do poorly in the future.  He should be asking for someone to come in and explain why anyone should own Berkshire Hathaway relative to a highly correlated index like the S&P 500.  In this manner, owning a long only alternative is similar to being bearish on Berkshire in that you believe the highly correlated index will outperform his firm.

I think there’s a pretty strong case going forward that Berkshire likely won’t outperform the S&P 500.  Among the more basic arguments:

  • Berkshrie has become so large that it is becoming, by definition, a huge part of the economy and a broader index.
  • As the firm has grown performance has lagged.  Berkshire has underperformed by book value in 4 of the last 5 years and in 5 of the last 10 years.
  • When comparing the market performance the firm is starting to look more and more like a version of the S&P 500:

brka

 

  • On a risk adjusted basis, it would not be unreasonable to argue that Berkshire exposes you to performance that is similar to a broader index, but exposes you to substantially greater non-systematic risk.

Buffett shouldn’t be searching for someone to explain the bear case on Berkshire.  He should be looking for someone to explain why anyone should continue to hold his firm’s stock relative to a broader index.   Now, THAT would make for a fair and interesting discussion.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Comments

  1. Cullen,

    If you run the correlation numbers for Berkshire (I use Geoff Considine’s QPP software) it is not as highly correlated to SPY as you might think and is actually outperforming SPY over the last 3 years ( I am using 4/22/14 as the ending date). With that said, we might want to define what figure for correlation coefficient you classify as highly correlated. We may disagree on this figure.

    For the past 3 years, the correlation coefficient is .72.

    For the past 10 years, the correlation coefficient is .45.

    This seems to be the main thrust of criticism of Berkshire, yet the math simply does not support the thesis, at least to this point in Berkshire’s history Of course, the assumption is that Berkshire has a much higher probability of simply mimicking the index going forward, however, this argument is not new. Nobody knows the scope and characteristics of the next correction, so it remains to be seen. Interestingly enough, if you compare the Berkshire chart to the SP 500 during the tech bubble, Berkshire sold off way before the bubble burst and bottomed pretty close to where the bubble began burst.

    One further thought is what might happen to the performance relative to each other if the market simply trades sideways for multiple years burning off the valuations as a opposed to simply selling off 50%?

    I agree with you, certainly, that it would be a great question for Buffett to answer.

    • Yeah. Looks like it really depends on the timeframe though. Using risk adjusted returns:

      3 years:
      BRK – 1.25 Sharpe, 12.65 st dev
      SPY – 1.11 Sharpe, 14.05 st dev

      5 Years:
      BRK – 0.94 Sharpe, 16.34 st dev
      SPY – 1.09 Sharpe, 14.69

      7 Years:
      BRK – 0.44 Sharpe, 20.26 st dev
      SPY – 0.29 Sharpe, 18.53 st dev

      10 years:
      BRK – 0.43 Sharpe, 17.84 st dev
      SPY – 0.41 Sharpe, 15.9 st dev

      15 Years:
      BRK – 0.35 Sharpe, 20.16 st dev
      SPY – 0.14 Sharpe, 16.04 st dev

      Overall though, the numbers look surprisingly close to me, but BRK has tended to outperform in times of downturns. Obviously, these figures are pretty rough analysis, but it would be great to see Buffett spar with someone on this issue.

        • Agreed.

          Cullen, why don’t you take him up on a tweaked version of the challenge i.e. you’re not bearish on BRK but can’t understand why you’d prefer BRK over the S&P 500.

          Would get you some great publicity as well, and the timing surely can’t hurt your book release either :-)

          • Great idea! But I have no idea why they would invite me to do this. But hey, if they were to offer I’d certainly put together as good a case against BRK as I could!

  2. An interesting related question is why Buffett has stipulated that he wants his heirs to have their money in an S&P500 index fund instead of in Berkshire. Becky Quick asked him about this in a recent interview ( http://www.cnbc.com/id/101461797 ) :

    BECKY: … One viewer did write in– … asking about why– did you lay out that you had said you set this money aside for your wife to be put into a Vanguard index instead of put back into Berkshire shares.

    BUFFETT: Yeah. Well– Berkshire would be okay. But like I say, I’m giving away all the Berkshire shares. And Vanguard is fine. And– Berkshire would be fine. But– I wouldn’t wanna be touting Berkshire to people, generally. I have no problem touting the S&P 500 at a low cost.

  3. With 2 billion of free cash flow pouring in monthly and around 45 billion of cash on the balance sheet, Berkshire is still a solid stock. I believe it trades at around 1.3x book value per share now with historic book trading at 1.6X. Regardless, their book is way understated due to the 77 billion of insurance float being deducted as a liability on their balance sheet when they only paid out 18 billion or so in claims last year. Agreed that Berkshire’s size is a major impediment going forward but A shares are still are worth $225,000 at least. Their buyback program also starts at 1.2X book so $165,000 for A shares. That is not a bad cap on your downside risk (15% or so from today’s price.) I still think their is a place for Berkshire in a portfolio especially when finding value has become increasingly difficult.