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June 7, 2007

Warren Buffett's Secrets

If you measure Warren Buffett by his net worth he is undoubtedly the greatest investor the world has seen.

Curiously, Ken Fisher uses Warren Buffett to explain that investing is not a craft and the proof he adduces is that Buffett's acolytes have not become superior investors despite Buffett's numerous teachings. Here is Ken Fisher's view taken from the preface to The Only Three Questions That Count:

"Some say Warren Buffett is the greatest money manager of all time. I don't think he is a money manager at all, a point most observers miss. He is the CEO of a very successful insurance company owing a few stocks and often takes companies private when he wants (something you most certainly can't do and most money managers don't and shouldn't do). While he is a great man and a great success, he isn't a portfolio manager and has no correctly calculated performance record over the past 35 years as a portfolio or money manager. While folks often call him a money manager he isn't in the sense Peter Lynch was, or Bill Miller or Bill Gross are. Those three are big names and very successful and there are thousands and thousands of real money managers (as stated earlier, most of them lag the market over the long term).

Someone can be an investor without being a money manager. Buy an apartment and you are an investor. In the long term, regardless of all other things, Mr. Buffett's fame and reputation rest on the results of Berkshire Hathaway stock and what it does -- plain and simple. Note, when Berkshire takes over a company, lock stock and barrel, it's impossible to know what the return is on that investment after that point because it's simply internalized in Berkshire. Therefore you can't tell individually if it was a good investment or not. All you can see is how Berkshire Hathaway stock does which is largely driven by its insurance operations. For decades Berkshire was a terrific stock and made tremendous money for lots of folks in the same way Microsoft or AIG did (or a lot of other great single stocks did). Many investors came to confuse Berkshire the stock with a portfolio, which it isn't. It's a single stock. There is virtually a religion around Berkshire stock and Mr. Buffett. But it's still just a single stock. In that regard, it hasn't done that well recently. In the past decade, its returns would have placed it in the 51st percentile relative to the stocks in the S&P 500 (if it were included -- it doesn't meet the liquidity requirements for inclusion in that index). In 2005, for example, the S&P 500 was up 4.9 percent and Berkshire Hathaway had a return of exactly 0.8 percent, basically no change. It lagged the S&P 500 in 2004 and 2003 as well. And no one seems to notice much. While spectacular in prior decades, Berkshire Hathaway now rests largely on the laurels of its prior glory and somehow avoids being seen as mediocre currently, maybe because there is such a religion around the man and the stock.

But here is my point. Suppose I'm wrong about all that. Suppose Mr. Buffett isn't the CEO of an insurance company but instead the manager of a portfolio in the same way Bill Miller or Bill Gross is. And suppose he is the greatest money manager the world has ever known. He certainly has talked about investing a lot over the years -- talked about things like asset allocation and stock selection and many of the things money managers talk about daily. And he has countless disciples devouring his tea leaves to figure out what they should do. And he has been famous for over a third of a century. Yet precious few of his disciples have been able to beat the market over the long term. If what Mr. Buffett did and does were a viable craft, he would have been able to teach his disciples how. But you don't see top investors (or even some huge percentage of them) all being Buffett-philes. It remains true the person many consider the greatest money manager of all time hasn't been able to pass this along to others in a way that is repeatable with any consistency. Sure, some will stand up and scream, "I'm great at it and I do it that way," but in the competitive world of verifiable performance records, these people are nowhere to be seen.

If it were a craft in the very long term, there would be a clear sense Mr. Buffett's way had generated an army of disciples who did better over the very long term than conflicting approaches. But such evidence doesn't exist. Mr. Buffett's approach is often seen as a subset of value investing. Yet, long-term, value and growth investors as discrete groups have done essentially the same in alternating waves over the decades as each approach cycles in and out of favor. Despite both value and growth investors claiming their styles to be vastly superior to the other, neither style has rendered a preponderance of the top market beating investors. Within value investing itself, there is no dominant approach broadly accepted as yielding inherently better results through an army of practitioners who have beaten their peers. "

One of the arguments that Ken Fisher puts forth to convince us that we should listen to his advice is that he is one of the world's richest people, he is on the Forbes 400 list of Richest Americans ranked 297 in 2006. Warren Edward Buffett is ranked number 2 with 40 billion to his name. What a conundrum. Maybe we should listen to Buffett but according to Fisher it won't do us any good. What's wrong here?

The problem is that Fisher is "Really, Really, Really Wrong" to borrow a phrase from his latest book. Fisher has swallowed Buffett's story, hook, line and sinker, in the most uncritical way, just like Buffett intended it to be swallowed. Fisher has not applied the methodology he lays out in his book to the question: "Who or what is Warren Buffett?" He simply has taken a myth for granted and this is leading him astray.

The myth, of course, is that Buffett is an extraordinary stock picker and an extraordinary investor in the "conventional" sense. I'm reminded of an Agatha Christie thriller where the thief hides a very valuable diamond in plain sight of all. Warren Buffett's teaching and preaching are designed to hide his true methods which are also hidden in broad daylight for all to see. Mary Buffett is one of the people who has written about this issue in Buffettology. But Ken Fisher forgot to ask the questions he recommends we should ask, or, if he did, he got the wrong answer.

The basic premise of Fisher's latest book is that if everyone knows what you know then you don't have an edge. That being the case, why would Buffett tell the world what his secret sauce is? On the contrary, would he not strive to hide it as much as possible so that other people don't start to imitate him and thus take his edge away from him? Buffett has told the world that he will disclose only what is legally required of him and his company. My conclusion is that all his preaching and teaching never touches on the real sources of his success. Whenever Buffett is on stage he performs like a talented magician. He makes people believe what he wants them to believe all the while keeping his methods well hidden. Ken Fisher is just one more member of the audience that has been lulled by Buffett.

In the preface I quoted above, Fisher says that Buffett is not a money manager like Lynch or Gross. True enough in his present incarnation but he was initially a money manager, the general partner of his limited partnership, initially Buffett Associates, Ltd. and later Buffett Partnership, Ltd. A good question to ask would be why Buffett changed to a corporate/conglomerate form of business when he in reality was a money manager? Mary Buffett tells us in Buffettology:

"Now, back in the old days when income taxes were 50% or better for high-income types, it was advantageous to invest through a corporation, which was taxed at a lower rate..."

You don't need to be a rocket scientist to figure that one out! As an aside, just to show you how Buffett is not the perfect investor, let me quote some more from Buffettology:

"So Warren went out and bought himself 48% of a textile company called Berkshire Hathaway, which he picked on the basis of a Grahamian bargain, which turned out to be a Grahamian dog... "

Buffett managed to turn a disaster into an opportunity. I continue quoting from Buffettology:

"The textile business, though once great, was a commodity business, and Berkshire's mill just couldn't compete. Warren, upon seeing this, did a very smart thing and started buying insurance companies with the working capital of Berkshire. In essence, money that at one time would have been put into new looms was spent buying the National Indemnity Insurance Company.

"Why insurance companies? It's not that they are such a great buy. The economics of the business attracted Warren. You see, when you send in your check to your insurance company for your car, house, life, and so forth, the insurance company puts that money into a pool of funds. If you crash your car, burn down your house, or die, and you or your spouse files a claim, the insurance company will pay you out of that pool of funds. But that claim may come years from now, and until then the insurance company gets to use your money. It is this pool of funds, known in the insurance business as the float, that Warren so coveted."

At that point in time, 1996, the float was $6.7 billion. Imagine the leverage, leveraging a moribund textile mill into a $6.7 billion investment fund.

Earlier in Buffettology we are told why Buffett didn't start a mutual fund:

"First of all, you must decide on the investment vehicle you will use. Warren had the choice of many, but the most simple and the most profitable is the limited partnership. That is what he chose when he first started to raise money on his own back in 1956.

I say it is simple because as long as you don't take on more than one hundred investors, you are exempt from SEC rules requiring registration for mutual funds. If you are a mutual fund you have to comply with more regulations than a private in the Marine Corps.

Another advantage of a limited partnership is that you can charge whatever fees you want. With a mutual fund you are limited by federal law."

By now we have discovered many ingredients in Buffett's secret sauce:

1.- Use other people's money. Convince some people to let you manage their money.
2.- Get Uncle Sam out of your hair. Don't use any vehicle such as a mutual fund where you will be hemmed in by government regulations.
3.- Pay as little tax as possible.
4.- Use leverage to the max. Use insurance float and any other source of free cash to leverage your investments to the max. In addition to trading coupons and insurance other sources of investing capital include the working capital of your subsidiaries.
5.- Make fairly decent investment decisions as otherwise none of the above will help.
6.- Convince the people that your success is based on superior stock picking, intrinsic value, margin of safety, moats, brand names, Charlie Munger, Ben Graham, Philip Fisher, prudence and Cherry Coke.

Denny Schlesinger

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