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.