Hi Guys,
If you choose one factor that characterizes Warren Buffett’s investment style, it is persistence. And Warren Buffett is an appropriate topic for MFO discussions; he manages his Berkshire Hathaway operation exactly like a focused mutual fund.
Buffett sharpened his business investment style under the tutelage of Benjamin Graham at Columbia University. In addition to Buffett, Graham informed the financial acumen of famous practitioners like Walter Schloss, Tom Knapp (Tweedy Browne founder), and Bill Ruane (Sequoia Fund). Buffett documented the performance of this pantheon of hugely successful investors in a 1984 debate at Columbia. Here is a Link to “The Superinvesters of Graham-and-Doddsville”.
http://www.beinvestors.com/wp-content/uploads/2011/06/superinvestors.pdfGraham and Buffett always insisted on enforcing the distinctions between an Investment and a Speculation. In particular, Graham extolled the virtues of constructing a defensive Investment portfolio; he mightily resisted the temptations of a speculative flier that promised, but rarely delivered, outsized profits. These guys invested using large safety factors when making a decision.
In the investment universe a large safety factor can be interpreted as one that is very asymmetric in its upside/downside expected payoff matrix. From probability theory (sorry about that), an Expected payoff is simply the result from multiplying the anticipated reward by the estimated likelihood of the event occurrence (its probability of happening). The probabilities of all possible outcomes must sum to a value of 1 if all possible outcomes are exhaustively listed.
Warren Buffett only commits resources when the ratio of positive Expectations (forecasted profits) to negative Expectations (loser outcomes) is considerably above 1. I suspect that Buffett only enters the fray when expected potential upside exceeds likely downside by factors in excess of 5. That’s one implementation of the safety factor rule that prudent risk takers often demand.
I suspect that this logic framework dominated Buffett’s decision to bankroll Bank of America with a 5 billion dollar cash infusion. He sees an undervalued corporation with little further downside risk contrasted against huge upside recovery potential. Buffett and Graham jumped at these opportunities; it is a classic asymmetric investment opportunity.
Buffett has firmly established his wealth and fame by persistently applying safety factor assessments as an integral part of his tool kit. The persistence element is a necessary component of his success story. Without it, he would never have been rewarded with decades of superior investing results.
So, performance persistence is one quality that an individual investor should seek when searching for a productive active mutual fund manager.
Unfortunately, even a rather long-term performance record for a mutual fund manager does NOT guarantee an astute, prescient leadership. The outsized performance might be due to skill, but it is also possible that luck was a major contributor. If an individual tosses 10 consecutive heads, he might be a skilled coin flipper, but it is more likely that he was simply lucky (a third possibility is that the coin was not fair; perhaps it was weighted).
It is a tricky assignment to identify truly perceptive active fund managers because of the dichotomous nature of this skill/luck tradeoff. Truly perceptive fund managers are a rare breed. The Standard and Poor’s annual Persistence Scorecard studies demonstrate just how rare this cohort is.
The S&P scorecard statistically illustrates that very few active fund managers produce excess returns beyond passive benchmarks for periods as short as 3 and 5 years. In many instances the statistics establish that the percentages of active managers who outperform their benchmarks are less than what would be expected from random, lucky coin tosses. That’s a gloomy finding.
A few days ago, I posted a Link to the current S&P Scorecard. Their Persistence Scorecard is a companion study; the two study sets supplement each other. I like to examine both to inform my portfolio decisions when choosing either passively or actively managed fund components. Unfortunately, the Scorecard is published twice a year, whereas the Persistence Scorecard is just issued annually.
Once again, here is the Link that will provide access to the Persistence Scorecard:
http://www.standardandpoors.com/indices/spiva/en/usPlease visit the reference. I suggest that you review both document sets to make better investment decisions.
The Persistence Scorecard consistently demonstrates that active managers have a difficult time overcoming their cost structure. Before costs are deducted, the active management cohort do typically outperform their proper benchmarks. However, costs prove to be a high hurdle to overcome. Once the costs are subtracted to determine the net returns delivered to their customers, actively managed funds often underperform passively managed options. Costs matter greatly.
Typically, the S&P Persistence Scorecard shows just how daunting the active manager’s task is. Here is an excerpt from their most recent release. It was issued in May, 2011 so there is a minor time distortion between S&P’s Scorecard and Persistence Scorecard documents. That time warp does not detract from their usefulness.
“Very few funds manage to consistently repeat top-half or top-quartile performance. Over the five years ending March 2011, only 0.96% of large-cap funds, 1.14% of mid-cap funds and 2.59% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.”
This most recent S&P finding is consistent with earlier results.
Do not interpret this submittal as a blanket endorsement for passive investing strategies. It is not. It is merely a cautionary alert. My intent is NOT to say that active mutual fund management is a loser’s game. It is not. About one-half of my portfolio is committed to actively managed products. However, when investing with active managers, exhaustive due diligence and emotional control is mandatory. It is not an easy task to identify these rare birds. The problem is made more complex by biased advertisements, and by the observation that even historical super managers have bad years.
The measure of a great manager is that he recovers from his shortfalls, is adoptive to an evolving marketplace, and resumes his march. Such is the case with Warren Buffett.
But even for superinvestors like Warren Buffett, good luck is an essential ingredient in the complex investing mix. Good luck to all of us.
Best Regards.
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