"Rule #1: Never lose money. Rule #2: Never forget Rule #1.” – Warren Buffett
Few would argue that Warren Buffett is one of the greatest investors of our time. Buffett has built his reputation as a sage over multiple decades of delivering superior long-term investment results through multiple investment environments. Although some staunch “efficient market” advocates may consider Buffett’s track record nothing more than a lucky anomaly, most regard the man and his style of investing as superior to others. As such, the annual meetings for Berkshire Hathaway have now become a sort of Woodstock for investors as tens of thousands of people flood Omaha, Nebraska every year to soak up the nuggets of investment wisdom Buffett hands out.
But well before “investor Woodstock” existed and back when Berkshire Hathaway was nothing more than a fledgling textile company, Buffett ran a hedge fund in which he managed money for his friends, family, and other associates in the form of a private partnership. During this time, and subsequently throughout his investment career, Buffett made a practice of writing an annual letter to his investors to provide insight into the rationale for his investments. Excerpts from two of these partnership letters were brought to my attention last week, which provided the inspiration for this week’s Insight.
Some might guess that a younger, less experienced Buffett managing a hedge fund might have a drastically different investment philosophy than the sage we know today. If nothing less, surely he would be more aggressive and willing to take risk to establish himself as an up and coming, hot shot manager? As it turns outs, nothing could be further from the truth. Even in his late 20’s and early 30’s Buffett held to the same “rules of investing” stated in the opening quote. At the end of a decade in which US large cap stocks had more than quadrupled in value, Buffett penned the following excerpts as part of his 1959 partnership letter.
Most of you know I have been very apprehensive about general stock market levels for several years. To date, this caution has been unnecessary.
The present level of security prices contains a substantial speculative component with a corresponding risk of loss. Perhaps other standards of valuation are evolving which will replace the old standard. I don't think so.
I may very well be wrong; however, I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a “New Era” philosophy where trees really do grow to the sky.
Reading between the lines we can see that Buffett was feeling the pinch of under-performing a rampant bull market in stocks. Even the greatest investor of our time had to explain his rationale and justify his conservative strategy to his investors. The following year, he expanded upon this same theme stating that his long-term objective was to outperform the benchmark (in his case and index of US stocks such as the Dow Jones Industrial Average) but that the outperformance was most likely to come during periods of relative weakness in the market.
My continual objective in managing partnership funds is to achieve a long-term performance record superior to that of the Industrial Average.
However, I have pointed out that any superior record which we might accomplish should not be expected to be evidenced by a relatively constant advantage in performance compared to the Average.
Rather it is likely that if such an advantage is achieved, it will be through better-than-average performance in stable or declining markets and average, or perhaps even poorer-than-average performance in rising markets.
Season Investments was launched in late 2011 with the goal of building truly diverse portfolios that allocated risk and generated returns across multiple asset classes. We coined the term Diversification 2.0 to mean a portfolio built with a meaningful allocation to traditional (stocks, bonds & cash) as well as some non-traditional (real estate, precious metals, commodities, hedge funds, etc.) assets. But as we have written about in previous Insights and as many of our clients already know, diversification outside of US large capitalization stocks has been the kiss of death over the past several years.
The embedded chart shows the difference in a two year rolling return of stocks versus the average return of the three other asset classes we monitor: bonds, hedge fund (alpha) strategies, and hard assets (commodities, precious metals, and real estate). It is no surprise that stocks have drastically outperformed the other three asset classes over the past two years. In fact, the only other times, over the past 20 years, stocks have outperformed to this degree was at the peak of the tech bubble and two years into each rebound following the two major sell-offs during this time period.
All this to say, markets and asset class returns go through cycles. Unfortunately, no one knows which asset class will outperform the rest in any given year, which is why we don’t like to put all our eggs in any one basket (stocks), even if that basket is dramatically outperforming the rest. Similar to how Buffett felt the pinch of underperforming a red hot stock market, we feel and understand the pain of diversification when stocks are “the only game in town.” In the same way that short term underperformance didn’t change Buffett’s opinion on investing, we too still believe that the most prudent way to invest is to have an active, risk management process in place and/or spread risk across multiple, uncorrelated asset classes. Lastly, we also believe that the lion’s share of outperformance from any kind of defensive strategy will be realized during the turbulent periods of time, which tend to come in short bursts versus the prolonged periods of strength. It can be difficult to stick with a strategy that lags during the go-go times, but that is exactly how one of the greatest investors of our time made his fortune and his fame.
For more information on the importance of “downside protection” please see our video on the Economics of Loss.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.