Investment Myth #1: You Too Can Become Warren Buffett

The following is an excerpt from Chapter 4 of my new new book “Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance.”

Myth #1 – You Too Can Become Warren Buffett

Few myths in the world of finance are more pernicious than the many that surround the career of Warren Buffett. Warren Buffett is the most glorified and respected investor of all time.

After all, it’s widely believed that he became the world’s wealthiest man by essentially picking stocks. But Warren Buffett is also remarkably misunderstood by the general public.  I personally believe the myth of Warren Buffett is one of the greatest misconceptions in the financial world.

To most people Warren Buffett is a folksy frugal regular old chum who just has a knack for picking stocks.  He works hard at finding “value stocks” and then just let’s them run forever, right? It’s the old myth that you can buy what you know (say, Coca-Cola because you like Cherry Coke or American Express because you like its credit cards), go through the annual report, plop down a portion of your savings in the common stock and watch the money grow through the roof.

Well, nothing could be further from the truth and here we sit with an entire generation who believes the simplistic approaches of value investing or buy and hold are the single best ways to accumulate wealth in the market.  Contrary to popular mythology, Warren Buffett is an exceedingly sophisticated businessman.  In order to understand how dangerous this myth is we have to dive deep into Buffett’s story.

To a large extent, the myth of Warren Buffett has fed a stock market boom as a generation of Americans has aspired to make their riches in the stock market. And who better to sell this idea than financial firms?  After all, a quick allocation in a plain vanilla “value” fund will get you a near-replica of the Warren Buffett approach to value investing, right?  Or maybe better yet, reading six months of Wall Street Journals and reviewing the P/E ratios of your favorite local public companies will send you on your way to successful retirement.

By oversimplifying this glorified investor named Buffett the general public gets the false perception that portfolio management is so easy a caveman can do it. And so we see commercials with babies trading from their cribs and middle aged men trading an account in their free time.

And an army of Americans pour money and fees into brokerage firms trying to replicate something that cannot be replicated. Financial firms want us to believe the myth of Warren Buffett.  In fact, many of their business models rely on our believing the myth of Warren Buffett.

Let me begin by saying that I have nothing but the utmost respect for Mr. Buffett. When I was a young market practitioner I printed every single one of his annual letters and read them front to back.  It was, and remains the single greatest market education I have ever received.

I highly recommend it for anyone who hasn’t done so. But in digging deeper I realized that Warren Buffett is so much more than the folksy value stock picker portrayed by the media. What he has built is far more complex than that.

In reality, Mr. Buffett formed one of the original hedge funds in 1956 (The Buffett Partnership Ltd), and he charged similar fees to the fees he now condemns in modern hedge funds. Most important, though, is that Buffett was more entrepreneur than stock picker.

Like most of the other people on the Forbes 400 list of wealthiest people, Buffett created wealth by creating his own company. He did not accumulate his wealth in anything that closely resembles what most of us do by opening brokerage accounts and allocating our savings into various assets. Make no mistake: Buffett is an entrepreneur, hedge fund manager, and highly sophisticated businessman.

The original Buffett Partners fund is particularly interesting due to Buffett’s recent berating of hedge fund performance and fees. Ironically Buffett Partnership charged 25 percent of profits exceeding 6 percent in the fund. This is a big part of how Buffett grew his wealth so quickly.  He was running a hedge fund no different than today’s funds.

And it wasn’t just some value fund.  Buffett often used leverage and at times had his entire fund invested in just a few stocks. One famous position was his purchase of Dempster Mill in which Buffett actually pulled one of the first known activist hedge fund moves by installing his own management at the firm.  Buffett, the activist hedge fund manager?  That’s right.  He was one of the first. His venture to purchase Berkshire Hathaway was quite similar.

Berkshire Hathaway isn’t just your average conglomerate. The brilliance behind Buffett’s construction of Berkshire is astounding. He effectively used (and uses) Berkshire as the world’s largest option writing house. The premiums and cash flow from his insurance businesses created dividends that he could invest in other businesses.

Berkshire essentially became a holding company that he could run this insurance-writing business through while using the cash flow to build a conglomerate. But Buffett wasn’t just buying Coca-Cola and Geico. Buffett was engaging in real investment in many cases by seeding capital and playing a much more active entrepreneurial role in the production process.

He was also placing some complex bets (short-term and long-term) in derivatives markets, options markets, and bond markets. The perception that Buffett is a pure stock picker, as many have come to believe, is a myth.

It’s also interesting to note that the portfolio of stocks he has become famous for is the equivalent of just about 28 percent of Berkshire’s enterprise value as of 2013. His most famous holdings (Coke, American Express & Moody’s Corporations) account for roughly 8 percent of the total market cap.

Interestingly, two of Buffett’s most famous purchases weren’t traditional value picks at all but distressed plays. His original purchases of American Express and Geico occurred when both companies were teetering on the edge of insolvency. These deals are more akin to what many modern-day distressed debt hedge funds do, not what most of us think of as traditional value investing.

Make no mistake – Buffett has the killer instinct prominent in many successful business leaders.  Just look at the deal he struck with Goldman Sachs and GE in 2008. He practically stepped on their throats when they needed to raise capital in the depths of the financial crisis, demanded a five year warrant deal, and profited handsomely.

Of course Buffett described the deal as a long-term value play. If a distressed-debt hedge fund (which is a role Berkshire often plays) had made the same move, reporters might have described the fund manager as a thief who was attacking two great American corporations while they were down.

Warren Buffett is a great American and a great business leader, but do your homework before buying into the myth that you will one day sit atop the throne of “world’s richest person” by employing a strategy that is, in fact, nothing remotely close to what Berkshire and Mr. Buffett actually do.

To read this myth and 10 other prevalent investment myths please see my new book “Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance.”