Investment Strategy Ode

Why Buffett’S Investment Strategy Won’t Work For Buffett Anymore – But For You It Will Still Work!

You probably already know that Warren Buffett is the world’s greatest investor of all time. Starting with only $ 100, Buffett made an unprecedented journey in creating a personal fortune of $ 48 billon. A truly unprecedented accomplishment, especially when you consider he never started a company of his own and never invested a single penny in technology stocks. His complete fortune comes from investing in the stock market!

And, as a matter of fact, Buffett’s investment strategy isn’t that complicated: buy shares of quality companies when they are ‘on sale’. That’s all there is! With this straightforward strategy Buffett earned his billions of dollars. But, as we take a deeper look at Buffett’s returns over time something stands out...

The outperformance of Buffett compared with the S&P 500 diminishes over time. Between 1957 and 1966 Buffett outperformed the S&P 500 by a massive 14.5 times. In the most recent decade his outperformance has been diminished to ‘only’ 2.2 times the S&P 500. Of course, Buffett still shows that he is able to beat the indexes. But, now only at a fraction of the outperformance he achieved in earlier decades.

So, what’s the reason for this? Has Buffett’s system of buying quality companies on sale stopped working? Or has Buffett lost his ‘Magic Touch’? Twice the answer is negative.

The explanation behind the diminishing returns

The real explanation for the diminishing (relative) returns is actually quite simple. Nowadays, Buffett has to invest large amounts of money. Even investments of a few hundred million dollars aren’t worth the trouble anymore. Just, calculate along with me...

Buffett’s total investments currently have a value of approximately 110 billion dollar. So, should an investment still have some effect on the performance of the total investment portfolio this investment has to be at least 2 billion dollar. And that’s the problem.

As Buffett’s doesn’t want to influence a stock price too much (buying in large quantities drives the price of a stock up…) and wants to remain somewhat flexible, normally it isn’t possible to buy (or sell) more than 10% of the shares in a certain public company.

And, as the 2 billion equals 10% of the market capitalisation, we are speaking of companies with market capitalisations of at least 20 billion dollar. And, simply put, there aren’t that many companies with market capitalisations of over 20 billion!

And, besides the fact that there simply aren’t that many companies with market capitalisations that big, these companies are much more followed and researched by investment analysts and all kinds of investment professionals.

Because of this these companies are priced less inefficient. And voilà, here we have the second reason for the diminishing outperformance of Buffett.

Maybe you didn’t realize it, but as a consequence of this you have actually a considerably advantage over Buffett (unless you are Bill Gates…). After all, you aren’t limited to invest only in these giant, more efficiently priced companies. You can choose from a much, much greater supply of more inefficiently priced companies!

Buffett agrees with this reasoning:
"I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."
–Warren Buffett, Businessweek, 25 th of June, 1999.

Also the returns of a couple of hedge fund managers show that it is an enormous advantage NOT to have too much money to invest. We will look at two of them: Joel Greenblatt and Mohnish Pabrai. Both of these top investors can be considered as Buffett copycats.

Joel Greenblatt

A few years ago, Greenblatt became known to a wider public as author of ‘The Little Book That Beats The Market’. In this book Greenblatt outlines a strategy in line with Buffett’s investment strategy. Greenblatt’s desire for stocks with high returns on invested capital accompanied by high earnings yields is essentially the same as Buffett’s desire for ‘quality companies on sale’.

Greenblatt’s hedge fund earned annual returns of over 40% for over twenty years. In his first ten years he even achieved annual returns of over 50%. And, like Buffett, Greenblatt got the same problem as Buffett: too much money to invest. And that’s why Greenblatt choose to buy out all the external investors in his hedge fund and to continue investing only with his own, private money!

An example of a recent investment of Joel Greenblatt is his purchase of shares of Aeropostale, a highly profitable clothing retailer. Within only a few months shares of Aeropostale had appreciated over 40%. Greenblatt sold his shares already. With a market cap of around 1 billion dollar at the time of Greenblatt’s purchase, such a transaction would be unthinkable for Buffett.

Mohnish Pabrai

Pabrai, like Greenblatt, can be considered as a Buffett follower:
‘M r. Buffett deserves all the credit. I am just a shameless cloner .’ – Mohnish Pabrai

In 1999, Pabrai started his investment fund with only 1 million dollar to invest. Now, only eight years later, Pabrai manages over 500 million dollar. Of course, Pabrai’s performance justifies this enormous growth: an annualized return of over 28% (after all fees and expenses).

An example of a recent transaction of Pabrai is his purchase of shares of Cryptologic, a software supplier for casinos on the internet. Total market capitalisation of Cryptologic at the time of Pabrai’s first investment: less then 250 million dollar. Pabrai, meanwhile, has seen this investment increase in value over 50% in less than 6 months. Again, this would be totally unthinkable for Warren Buffett.

But, like Buffett, both Greenblatt and Pabrai will be confronted with the laws of financial gravity. Also their relative returns will diminish over time. For sure, some will claim that Greenblatt and Pabrai just had some good fortune and claim that Buffett’s investments strategy doesn’t work anymore.

But also in the future new Buffett’s will arise. And they will demonstrate the sceptic, once again, that it’s still possible to outperform the market. Simply by buying shares of quality companies when they are on sale!

Hendrik Oude Nijhuis is the cofounder of http://www.magicformulastocks.com and is an expert on value investing and a long-time value investor himself. He extensively studied the investment methods of Warren Buffett. More recently, he started studying other exceptional value investors like Joel Greenblatt as well. Hendrik holds an MSc in Public Administration from the University of Twente.

The website http://www.magicformulastocks.com is dedicated to explain private investors (free of charge) why to select stocks on combinations of Return on Capital and Earning Yield. You will learn exactly how to select the most promising and most profitable stocks.


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