Lessons from the Oracle

By James Kwak

[I wrote this post a month ago but just realized I never clicked "Publish." It's about a book that was published more than two years ago, though, so it shouldn't have gotten any more stale.]

I recently finished reading Snowball, Alice Schroeder’s 2008 biography of Warren Buffett. It wasn’t a bad read, although at over eight hundred pages it was on the long side and began to seem repetitive; the impression I got was that Buffett had the same kinds of relationships with his family and friends for a long time, and not much changed over the decades.

The big question about Buffett for people like me — people who invest in low-cost index funds, that is — is whether he is smart or lucky. After all, since Burton Malkiel’s Random Walk Down Wall Street, the main argument against stock-picking skill has been that in a coin-flipping tournament featuring thousands of players (and with survivorship bias), someone is bound to win time after time after time.

The answer, at least the one from the book, is that Buffett is smart. And that shouldn’t be too surprising. I recently read a pile of papers about active mutual fund management, mainly from the Journal of Finance, and I’d say that while there’s no consensus per se, the general trend has been that there are some mutual fund managers who can beat the indexes and can more than cover their costs.* There aren’t many of them, they are outnumbered by the ones who do worse than the indexes, and they are probably hard for you and me to find, but they exist. And I say this despite the fact I didn’t want it to be true.

But the image you get of Buffett isn’t that he’s a great stock-picker; it’s that he’s a great manager, and he had some luck. Yes, in the early years (the 1950s and 1960s), he seems to have made a killing buying stocks with very low price-to-earnings ratios — as low as one, in some cases. He was able to do that because he consumed data voraciously, and he was able to find undervalued stocks that other people didn’t find. But Buffett himself acknowledges that since then it’s gotten much more difficult to invest that way, presumably because of the increased availability of information, a much larger asset management industry, and computers.

So most of the book is about Buffett’s ability to judge whole businesses and find the ones that, in his hands, could be worth more money. Along the way, he had some luck: he won a newspaper war in Buffalo whose outcome was by no means predetermined, the Federal Reserve didn’t shut down Salomon in the early 1990s (by shutting it out of bids for Treasuries), and so on. And as with many business titans, a lot of the story involves having good underlings, like Ajit Jain at Berkshire Hathaway or Jack Byrne at GEICO. Part of this could just be the bias you get reading a biographical narrative; stories of corporate drama involving larger-than-life figures are more exciting than details of passive investments. But also, at the scale Buffett operates at, you just can’t make that much money through passive investing.

One thing I found interesting about the book was that it didn’t make Buffett out to be some kind of business superman, either. Sure, he’s better than most. But he could be inconsistent, or insufficiently cold-blooded. He talks about hanging on to Berkshire Hathaway’s textile mills for much longer than he should have because he couldn’t bear to pull the plug. He donated money to reproductive rights organizations, but backed down when right-to-life groups boycotted one of his companies, shutting down Berkshire’s charitable contributions program. He generally seems like a fine person, but neither a hero nor a money-making machine, just someone who was right more often than not and who was lucky enough to find the thing in life he was best at.

* If you’re interested, see for example Werners, “Mutual Fund Decomposition: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses,” Journal of Finance 55 (2000), which finds that actively managed funds do hold stocks that beat the market, although in aggregate that advantage is more than eaten up by fees and costs; Kosowski et al., “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis,” Journal of Finance 61 (2006), which finds that the top mutual funds do have persistent superior performance; Fama and French (yes, that Fama and French), “Luck Versus Skill in the Cross-Section of Mutual Fund Returns,” Journal of Finance 65 (2010), which finds that a few fund managers can more than cover their costs.

21 responses to “Lessons from the Oracle

  1. This has always been my impression of Buffett’s success.

  2. I read Snowball about a year ago. I got the same impression and I think the key point to highlight is that Buffett succeeded most when he bought entire companies and had a controlling interest.

    If all you are buying is 5% of XYZ I believe you should read Malkiel and learn why to buy an ETF / low cost mutual fund instead.

  3. James,
    Maybe Buffet isn’t either lucky or smart. Maybe (??) he has the “right-insider” informations that allow him to be either smart or lucky. After all, is mr. Buffett’s brain bigger than others’s?

  4. The last-man-standing (lucky) idea is intriguing. What are the odds that an newborn female proto-mammal in the primordial jungle will survive to mate and reproduce at least once? What are the odds that she can do that again, one thousand times again ? Yet for each of us alive on earth, our ancestors did just that– beat the odds to reproduce at least once, ten million times in a row.

    The Chinese think luck is very important. Maybe they’re on to something.

  5. What I got from that book is that he is rather like a Samurai warrior, he answers to a higher creed, in his case, always choosing what will make the most money.

    He doesn’t do things, like senseless takeovers, for ego, he doesn’t waste money on himself, he doesn’t (until recently) get involved in philanthropy, he focuses with monastic devotion on making choices that will make money.

    When you do this and you start at the right time in history and you’re smart and you stick with it for years, you can get rich.

    The sad thing but instructive thing about Buffett is that power corrupts and no one is immune. After years of talking about how important a good reputation is and how he would avoid short term gains in order to preserve his (Berkshire’s) good reputation, during the financial crisis he reached out his hand to help the thieves at Goldman. When you give loans to the mob you pretty much are the mob.

  6. Herbert Wetherby

    @ Molly: The Chinese think luck is very important. Maybe they’re on to something.

    I totally agree, and they are not even linear but will still want their money reguardless. Which is NOT the way the free world operates, I wonder where they shall find the leverage to guarantee their luck stays with them?

  7. Being smart is not the only criterion for keep winning. Yes luck has role and many other factors also effect which were there in Buffet’s case.

  8. “is whether he is smart or lucky”

    First, one does not exclude the other.
    Second, proving he is smart does not prove that luck is what got him where he is.
    Third, luck is what got him where he is, and the last 12 years of performance demonstrates that.

  9. Luck is likely what made the difference between Buffett being a SVP and being the head of Berkshire. He was very different than the people who became Wal-Mart greeters.

  10. Even if there are “some mutual fund managers who can beat the indexes and can more than cover their costs” there is no way, when looking to the future, to distinguish between such managers and the next Long Term Capital Management. So as an investment strategy, indexes still win.

  11. I realize this is just reiterating what others have said, but I believe Buffett is both lucky and smart. I have no doubt that Warren Buffett would have been above average at any job he took and would have found himself in the upper 20, even 10% of income earners in the US no matter what era he was born in, he’s just that talented. What makes him one of the three wealthiest people in the world out of almost 7 billion people vs. being Omaha’s best lawyer, or the five term Senator from Nebraska is luck. He found Benjamin Graham at a time when he could still work directly for him, he entered a field where his mind allowed him to discover things about companies that as James pointed out, a computer can now dig up in a millisecond. He built the base of his wealth during the post war economic upswing that is still the largest wealth creation machine in history – truck driver friends of my grandfather had summer homes on Cape Cod. Had he turned 21 in 1929, or 1861 or 1999 instead of 1951 I’m sure he still would have been a success – but to be that successful takes luck and brains. Even just luck can win you $300 Million in the Powerball, but after taxes you’re still 1% of Warren.

  12. Never was to impressed with Warren. His purchase of the countries 2nd largest railroad Burlington Northern Santa Fe(BNSF), and most recent purchase of Lubrizol tells me he’s got “Bilderberg Lineage” [?] with White House inside data.
    Obama’s new energy program will start with coal which needs rail transportation, “Big Time” – “Blue Gold” (Natural Gas) will need Lubrizol’s excellent lubricants to frack! But there’s more…the (Buffett’s) rail-lines will transport the “Liquidized Natural Gas (LNG)” throughout the country. {(Note: Fracking will also need specially built water treatment plants separate from Sewage Treatment Plants to rid the used fracking water of trace radioactive elements, and various carcinogens)(coal has the same pollutants if mine is dug deep enough)}
    Buffett hasn’t done nothing for 15yrs. but made a cool ~5.0bn. off Goldman Sachs (GS) on a lucky deal[?]. Yea!
    Ref: “Nathan’s Economic Edge”: Damon Vrabel -PR vs. Truth: Corporate (7/21/10)…story line about Warren Buffett, and Bill Gates
    http://www.economicedge.blogspot.com/2010/06/damon-vrabel-pr-vs-truth-corporate.html

    Thankyou James, and Simon

  13. People can’t still be this naive. The people who eliminate risks make money from Wall Street and big business on a consistent basis. These are the people who own the casino, and as mentioned above, own the information. What the secret of Madoff’s long-term success? Keeping it humble and consistent, and being such an insider that he nearly became head of the SEC. The people he’s been involved with over the years have been involved with the biggest mobsters in the country. Burgers, Coke, See’s Candy, popcorn and cardigans. Want a clue? Central Trucking… Ambassador Bridge.

  14. “The big question about Buffett for people like me — people who invest in low-cost index funds, that is — is whether he is smart or lucky.” That’s not an either-or question, nor is “smart, or lucky” an exhaustive list of possibilities!

    How much evidence do you need to have that the system as a whole is deeply corrupt and dysfunctional, before you’ll consider the other possibility — that he might be either crooked, influenced by crooks, or simply more willing and able than most to take advantage of material nonpublic information? … and maybe smart enough and respected enough not to get caught?

    Also, let’s not forget that Warren began with some substantial personal advantages due to his father’s wealth and political position…

    We might also consider the possibility that he operates in a system in which success is nonlinear, where somewhat random events can be amplified in ways that don’t require either luck or talent (after a certain point). In that case, what matters is getting a good start (luck, skill, connections) and then not screwing up. The book _Outliers_ gives a number of examples of systems like this, which we have in everyday life but tend to overlook. Some of these are opposites of Black Swan events — unexpected virtuous circles.

    Most likely, IMHO, is that all of the above played a role. But in the system we have saddled ourselves with, we cannot blame folks for making the most of every advantage and opportunity. Although perhaps we can blame them for failing to notice that the accumulation of wealth is pointless in and of itself. Do the current crop of capitalists need to be reminded that history rewards those who achieve benevolence by using financial wealth to produce lasting nonfinancial wealth? Our nation is great for more than just it’s GDP data and corporate profits!

  15. Your point about coin flipping is essentially invalid. How many players would you need to win a perfect streak in a 50 coin flip contest? Approximately a million billion. That is approximately 1×10^15 players

    In other words, we don’t have nearly enough investors to expect many streaks by chance alone. A 50 investment streak would require more people than have ever lived and probably ever will. Also, if a winner emerges, it is unlikely that they will maintain their performance after we take note of them. They should revert to the mean extremely quickly if it is just luck.

  16. «He built the base of his wealth during the post war economic upswing that is still the largest wealth creation machine in history – truck driver friends of my grandfather had summer homes on Cape Cod.»

    As others have said, he was both smart and lucky.

    But in a way very different from what most people think, and hinted at by the title of the book.

    He id not pick stocks, but a a trend: that the USA upper working and lower middle class incomes were going to go up, and that companies that sold branded staples to them would make a lot of money on volume in the long term.

    That was a very smart bet. It was partially lucky that the trend lasted 3 decades (it is now over) despite some troubles, but then it was smart of him to bet that way.

    It was very lucky that because of political reasons the PE ratios of all companies have doubled or tripled in those same 30 year.

    Without those somewhat unpredictable political reasons driving that explosion in P/Es the bet on long term “snowball” effect of rising volumes would have been a lot less impressive.

    The same or expanded political reasons have then pushed up the P/Es of financial companies and related bubble sectors to even more ridiculous levels since 1995, but he has largely stayed out of those because they were clearly a lot less sustainable than the great industrial/service stocks PE bubble of 1965-1995.

  17. Even if there are “some mutual fund managers who can beat the indexes and can more than cover their costs” there is no way, when looking to the future, to distinguish between such managers and the next Long Term Capital Management.

    …including Buffett himself. Even if he genuinely beat the market in the past, by something more than luck, he could lose that ability tomorrow. Heck, he could have lost it 6 months ago and there just hasn’t been enough data to see it yet.

  18. Warren has been straddling the fence for a decade…quietly investing in China, and building out his stealthy nexus distribution center here in America.
    Remember his purchase of BNSF RailRoad is about to get growing pains once Obama gives coal the premier green light via a “Carbon Tax” (of course natural gas won’t be far behind) !
    His (Warren) “Ace-n-the-Hole”? The “Kelo vs. City of New London {(Ct.)(5/2005)}” eminent domain statue, whereas the Supreme Court voted in favor of “Blight” – giving big business/ big industry, the right to demolish eyesore’s? Laughable, but sad…for nobody today with any clout will have much of a problem in todays America?)
    The question is pending? Who will Warren Buffett award contracts/ investment money for manufacturing the massive implementation of “Liquid Natural Gas” Flex-Fuel Carburetor Conversion Units for (1st)Long Haulers/ (2nd) Automobiles? The Chinese? Interesting…for America already subsidizes the Chinese Communist Party to build most of our Wind Turbines, amazing!
    Also worth mentioning is that the lucky (Buffett) clairvoyant just purchased “Lubrizol”, which by the way is the critical patented lubricant that runs LNG Engines to their max! Strange how it all comes together in less than “Two Years” (instrumental in Fracking also)!
    Sorry about my error regarding his $5bn investment to Goldman Sachs – his take was a measly ~$4bn profit that was a gift by the Fed via GS Holding Co.?
    Lastly as I previously said, eminent domain will get access rail lines anywhere in the future for Burlington Northern- Sante Fe RailRoad throughout this great once America!
    Warren will either move his Chinese imports, coal, or LNG…by the options I mentioned, not bad! The cream-of-the-crop comes from the “Long Hauling Tractor Trailer’s” running his goods offloaded onto America’s Highways with or without Chinese LNG Conversion Units? As I mentioned, what stupid American Manufacturing Company would want to get into a hundred-billion dollar plus business annually for the next 50 years designing/ producing [this]these product when they can get the Chinese to do it for peanuts?
    Hey, maybe we can give them all “the inclusive “All” amnesty on past/ present “Corporate Tax’s”, a free-for-all centrist move by Obama to boot his GOP opponent into the stratosphere for 2012?

    God Bless You, Julian Assange:-))

  19. Stock market is a very risky place. Here one can loss every thing and other can be a winner. So should be more smart.

  20. The thing I like about Buffett is that he lives in effing Nebraska. I’ve been to Omaha. Good God. If I had a billion dollars it is very low on the list of places I’d live, but he just doesn’t seem to be a guy with grandiose notions of himself, but he does like raking it in. I have a feeling that money, to him, is like a score on a video game, and he wants to put his initials in on the record board at the end and know they will stay there for a while.

  21. I believe luck has more to do then hard work and smartness because they are meaningless without luck.