How To Beat Warren Buffett At His Own Game

Last week, I wrote about Buffett’s bet with the hedge fund industry (for more on that, go here). I also advised readers to check out Buffett’s letter to Berkshire Hathaway Inc. (BRK.A,BRK.B) shareholders, which was released last weekend.

How To Beat Warren Buffett At His Own GameI hope you took the time to follow my advice. Despite amassing a $76 billion fortune, Buffett remains as folksy and accessible as ever. He’s not perfect — but then again, he’s also rarely wrong.

A few years ago, the Wall Street Journal reported that Buffett made an absolutely stunning $10 billion on investments he made at the height of the financial crisis. True to form, Buffett sheepishly commented that any average investor could have done just as well. In fact, more recently, he has stated that it should be possible for any individual investor to beat his performance at Berkshire Hathaway going forward.

Does this mean Buffett has lost a step? Hardly. It’s simply a matter of the law of large numbers coming into effect.

To earn that $10 billion, Buffett had to invest $26 billion. That put his return at about 38%, or 6.7% a year over five years.

Now let’s put that into context. Buffett made his first investment in April 2008 and his last a year later. The SPDR S&P 500 ETF (SPY) was trading as high as $140.59 in April 2008. Assuming an investor bought at the high that month and did nothing else, his 20.3% gain would be slightly less than Buffett’s. But remember Buffett added to his investments throughout the financial crisis.

If you had invested in SPY throughout the year, according to our number crunching, you would have likely beaten Buffett. In fact, the number we came up with (remember, this all depends on timing) was a 74% return, or 11.7% a year.

Of course, Buffett’s timing was excellent with these investments. But his disadvantage is clear: Buffett can only invest in large companies because he has to make large investments in order to move the needle on his portfolio. Otherwise, it would simply have no effect on his returns.

He is also no longer able to respond quickly to the market. If the market or a specific stock tanks, then it’s that much harder for Buffett to dump his position and avoid losses (or, conversely, get in at the right time at the bottom). So creating outsized returns is harder now than ever before.

You and I are not burdened by this (though one can dream, right?). But the bottom line is this: If you could have beat Buffett’s returns over that five year period, then you should be able to beat him over the next five years. That should be comforting when you really think about it.

Why Buffett Isn’t A ‘Cigar Butt’ Investor Anymore

One important thing to keep in mind when studying Warren Buffett is understanding that he would not be where he is today without Charlie Munger, his business partner.

Munger may not be as famous as Buffett, but he has been instrumental in not only Berkshire Hathaway’s success — but also Buffett’s evolution as an investor.

Warren Buffett came up as a disciple of Ben Graham, the father of “value investing”. This can be basically defined as buying stocks trading for dirt-cheap valuations. And it was this approach that led Buffett’s investment partnership to acquire Berkshire Hathaway in 1965.

Back then, Berkshire was a failing textile manufacturer. The stock was selling for around $7.50 per share, a major discount from the per-share working capital of $10.25 and book value of $20.20. Buffett also noticed that the company was using the proceeds from closing down some of its plants to repurchase shares.

So Buffett quietly began purchasing shares until Berkshire’s then-CEO issued a tender offer to buy back shares for $11.375. This would have given Buffett a weighted return of about 40% in less than two years.

Instead, Buffett decided to purchase more shares, increasing his stake from 7% of the company to 40%. This was classic value investing in action, but Buffett has since said it was one of the “dumbest” investing moves he ever made.

Let that sink in for a second. Warren Buffett said Berkshire Hathaway was a dumb investment.

Here’s what my colleague Jimmy Butts, Chief Investment Strategist of Top Stock Advisor, had to say about this to readers:

As a disciple of Benjamin Graham, Buffett was taught how to identify a company that was trading at a significant discount to its net assets, and whether it was a worthy investment. He dubbed this investment style as his cigar-butt strategy, and this framework for value investing served him quite well in his early years.

For example, had his ego not gotten the better of him, his investment of Berkshire Hathaway would have turned out to be exceptional. According to his newsletter, had he simply accepted the $11.375 offer, his weighted annual return on the investment would have been about 40%, an incredible return in less than two years.

Remember, Buffett knew that the textile business had its problems, but he was picking up shares of the company for a fraction of what they were worth. This strategy of buying mediocre companies trading at bargain prices worked well in the short-term.

But this cigar-butt strategy wasn’t the way forward for someone who wanted to build a large and enduring firm. Don’t get me wrong, I’m not saying value investing doesn’t work — it very much does. It’s just that thanks to Buffett’s longtime business partner they found a better way…

As Jimmy points out, it was Munger who taught Buffett that while buying decent companies at cheap prices was good, it was far better to “buy wonderful businesses at fair prices” and hold on to them “forever.”

That’s exactly what Jimmy preaches in Top Stock Advisor: Find excellent companies trading at good prices that can compound their earnings and reward shareholders for many years.

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It’s this change in philosophy that led Buffett to make investments in names like Coca-Cola, American Express, Wal-Mart and many others. It’s this creed that also leads Jimmy to make his recommendations in Top Stock Advisor. It’s why his portfolio is currently showing gains of 35.6%, 38.8%, 105.9% — and more. And here’s the kicker: It’s also why many of the names in the portfolio are well-known to the broader public. They’re instantly recognizable.

The point is, successful investing doesn’t have to be complicated. I said it last week, and I’ll say it again: Buy fantastic companies at reasonable prices. Own them for the long haul.

It also helps to have a partner — like Buffett has Munger — to help guide your thinking, challenge your assumptions and keep you accountable. If you don’t have someone like this in your life already — and even if you do — consider joining Jimmy and his subscribers at Top Stock Advisor. Each month, Jimmy provides timely guidance and timeless wisdom that will make you a better investor. (You’ll also profit handsomely from his picks, too.) If you’d like to learn more about Top Stock Advisor, go here.

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