Buffett’s circle of competence

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After the weekend release of Berkshire Hathaway’s 2013 results and the letter from Chairman Warren Buffett, a few sceptics might be quietly wondering whether Buffett might have lost his Midas touch.

Over the last five years, Berkshire has lagged the S&P 500 index – notably in 2013 when the index soared 32.4% and Berkshire’s book value per share rose only 18.2 % – making it four years out of five of under-performance.

Looking for acquisitions

But the Oracle of Omaha reassures shareholders that he still thinks the company can outperform in years when the market is down, or only moderately up. And, while it always is hard for such a heavyweight investor to add value from new acquisitions, Buffett and his partner Charlie Munger are still looking for large “elephant” deals similar to the $US18 billion spent last year buying a majority of HJ Heinz and NV Energy.

Corporate acquisitions often subtract value (Buffett readily admits to several investment mishaps) but the group has a disciplined approach to investments, Buffett and Munger don’t invest unless earnings five years out are priced reasonably. If they can’t estimate those earnings, they move on to another prospect. They call this staying within the circle of their own competence.

This involves strict discipline: ignoring current economic or political environment or other’s views and not chasing anticipated price rises in a long-rising market or wanting to be “where the action is.” It takes confidence in your own belief and strength of mind to ignore the yelling of the market players who are, in effect, forever urging investors “Don’t just sit there; do something.”

Sit and wait

Buffett’s approach, once he has selected his stocks, in fact is to simply sit there and allow growth to compound. Over the past 49 years, Berkshire has achieved total growth of more than 693,500% (that’s not a misprint) or 19.7% compound a year. This makes many investors (both professionals and amateurs) dream of investing like Buffett – but lack the many decades of experience and accumulated wisdom. And he says he tried everything – charts, listening to commentators and watching the tape – before becoming a disciple of Benjamin Graham’s text, The Intelligent Investor and its message of value investing.

But, instead of hankering for these skills, investors should buy the broad market (he suggests the Vanguard S&P 500 index fund) instead of trying to pick winners. Over the same period, that index fund has produced a total gain of 9841% or 9.8% compound a year.

Buffett’s “how” of investing involves amateurs using index funds to achieve diversification and low costs. As for the “when”, Buffett has two pieces of advice: don’t sell when the news is bad and don’t buy when prices are booming. In what is possibly his quip of the year, Buffett quotes the late Barton Biggs: “A bull market is like sex. It feels best just before it ends.”

An eye on the future

In fact, Buffett is putting his money where his mouth is – both now and in the future. His will directs that his widow’s cash should be split 10% in short-term government bonds and 90% in an S&P 500 index fund. That strategy, he says should prove superior to the results of most other investors (pension funds, institutions or individuals) who use high-fee managers.

And he also has a 10-year bet, involving a $US1 million stake, with a New York money manager (Ted Seides of Protégé Partners), that the index approach would beat a selection of five hedge funds over a 10-year period. ‘

So far, that challenge is tracking well for Buffett. At the end of 2013 after six years, the S&P has done 43.8% and the five hedge funds are lagging with only 12.5% growth.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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