Warren Buffett wins bet and charity gets US$2.2m instead of US$1m

Back in December 2007, Warren Buffett made a ten-year US$1  million prize bet (background reading: Warren Buffett is set to win this US$500,000 wager) with asset manager Protégé Partners.

Essentially, Warren Buffett wanted to prove a point:  that his pick – a virtually cost-free investment in an unmanaged S&P 500 index fund – would, over time, deliver better results than those achieved by most investment professionals, however well-regarded and incentivized those “helpers” may be.

“Addressing this question is of enormous importance. American investors pay staggering sums annually to advisors, often incurring several layers of consequential costs,” Mr Buffett, the legendary investor who is chairman of Berkshire Hathaway,  said in his FY2017 letter to shareholders.

“In the aggregate, do these investors get their money’s worth? Indeed, again in the aggregate, do investors get anything for their outlays?
“Protégé Partners, my counterparty to the bet, picked five “funds-of-funds” that it expected to overperform the S&P 500. That was not a small sample. Those five funds-of-funds in turn owned interests in more than 200 hedge funds.”

In Berkshire Hathaway’s  2005 annual report, Mr Buffett had said “that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still”.

Recalling his argument, he said in his FY2016 letter to Berkshire Hathaway shareholders: “I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund. ”

Warren Buffett named a low-cost Vanguard S&P fund as his  contender.

“What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds,” Mr Buffett said in the FY2016 letter.

“For Protégé Partners’ side of our ten-year bet, Ted picked five funds-of-funds whose results were to be averaged and compared against my Vanguard S&P index fund. ”

Mr Buffett’s bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

In the FY2017 letter, Warren Buffett said: “The five funds-of-funds got off to a fast start, each beating the index fund in 2008. Then the roof fell in. In every one of the nine years that followed, the funds-of-funds as a whole trailed the index fund.”

And why did the charity, Girls Inc of Omaha, received US$2.2 million instead of US$1 million?

“Originally, Protégé and I each funded our portion of the ultimate $1 million prize by purchasing $500,000 face amount of zero-coupon U.S. Treasury bonds (sometimes called “strips”). These bonds cost each of us $318,250 – a bit less than 64¢ on the dollar – with the $500,000 payable in ten years…

“After our purchase, however, some very strange things took place in the bond market. By November 2012, our bonds – now with about five years to go before they matured – were selling for 95.7% of their face value. At that price, their annual yield to maturity was less than 1%. Or, to be precise, .88%.
“Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared to American equities. Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10% annually on shareholders’ equity (net worth).

“In November 2012, as we were considering all this, the cash return from dividends on the S&P 500 was 21⁄2% annually, about triple the yield on our U.S. Treasury bond. These dividend payments were almost certain to grow. Beyond that, huge sums were being retained by the companies comprising the 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well.
“Either course would, over time, substantially increase earnings-per-share. And – as has been the case since 1776 – whatever its problems of the minute, the American economy was going to move forward.
“Presented late in 2012 with the extraordinary valuation mismatch between bonds and equities, Protégé and I agreed to sell the bonds we had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares. The result: Girls Inc. of Omaha found itself receiving $2,222,279 last month rather than the $1 million it had originally hoped for.”


Warren Buffett: Don’t treat marketable common stocks as ticker symbols

In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.” – Benjamin Graham

Legendary value investor Warren Buffett, the chairman of Berkshire Hathaway, once again cited the abovementioned  maxim of Benjamin Graham in his FY2017 letter to shareholders.

What is so endearing about this quote of the late Benjamin Graham, the man known widely known as the father of value investing? Warren Buffett is of course the best known disciple of Benjamin Graham.

In the FY2017 letter, Warren Buffett said: “The connection of value-building to retained earnings…will be impossible to detect in the short term. Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true.”

Explaining, Mr Buffett said:  “Charlie (vice-chairman of Berkshire Hathaway) and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits.

“Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back.”

To illustrate, Mr Buffett said: “From our stock portfolio – call our holdings “minority interests” in a diversified group of publicly-owned businesses – Berkshire received $3.7 billion of dividends in 2017. That’s the number included in our GAAP figures, as well as in the “operating earnings” we reference in our quarterly and annual reports.

“That dividend figure, however, far understates the “true” earnings emanating from our stock holdings. For decades, we have stated in Principle 6 of our “Owner-Related Business Principles” (page 19) that we expect undistributed earnings of our investees to deliver us at least equivalent earnings by way of subsequent capital gains.

“Our recognition of capital gains (and losses) will be lumpy, particularly as we conform with the new GAAP rule requiring us to constantly record unrealized gains or losses in our earnings. I feel confident, however, that the earnings retained by our investees will over time, and with our investees viewed as a group, translate into commensurate capital gains for Berkshire.

That led Warren Buffett to say that “the connection of value-building to retained earnings that I’ve just described will be impossible to detect in the short term” as stocks surge and swoon, but “over time, however, Ben Graham’s oft-quoted maxim proves true”