Wednesday, December 27, 2017

My Bet With Warren Buffett

A decade ago, Warren Buffett made a famous bet with hedge fund manager Ted Seides. Buffett believed that hedge funds cannot beat the S&P 500 due to their high fees. Both parties put enough money in treasury bonds at the end of 2007, which was supposed to be worth $1 million by the end of 2017.

Buffett’s pick of S&P 500 did better than the portfolio of hedge funds selected by Ted Seides. This bet has been widely publicized by many investors. Those who believe in indexing use it as a reason to reinforce their beliefs. After all, the S&P 500 did much better than the hedge funds.

Unfortunately, the reason why the hedge fund bet did worse than S&P 500 over the past decade comes down to the fact that it had high costs and because it was globally diversified.

It makes sense that a hedge fund that charges high fees has a high hurdle rate relatively to a low cost portfolio of stocks. For example, hedge funds charge investors a 2% annual fee. In addition, they also charge investors a performance fee based on assets under management. The fee is for roughly for 20% of gains on investment. This is a rather steep set of fees, given the fact that the investors are the ones coming up with the capital at risk in the first place.

The other fact is that those hedge funds focused on US Equities, Foreign Equities and other asset classes. This is why the comparison to S&P 500 is not really an apples to apples comparison. However, even if we compare the performance to an equally weighted portfolio of US stocks, Foreign Stocks and Bonds, the hedge funds did not deliver either due to fees. However, the margin of error was lower.

I believe that the reason why the bet didn’t do as well was due to high fees, and the fact that we are not comparing apples to apples. As a DIY investor, I do not understand the need to have someone else look after your money. Wall Street makes its money by making investing complicated, so that they can charge you fees forever.

The truth is, building your own portfolio isn't really that difficult. I will illustrate this concept with this article.


So for the fun of it, I decided to make another ten year bet with Mr Buffett. I assumed he will take the S&P 500 just for the sake of the argument. Actually, Buffett doesn’t probably even know about this site, but this is beyond the point. He is also not going to take another ten year bet with anyone else, according to CNBC.

The point is, coming up with a portfolio of companies to hold for a period of ten years (or longer) is a fun thought exercise.

I am going to challenge the assumption that no one can invest successfully on their own. I believe that anyone can find quality companies to buy for the long term. I am going to assume that I am dealing with a complete know-nothing investor, who has nerves of steel nevertheless.

You do not need to own an index fund in order to do as well as “the market”. In fact, I have argued that in order for investors to be successful, they need to focus on their goals, and not on relative performance relative to a moving benchmark. This is why I have focused my attention to tracking dividend income, which is more stable reliable and easier to forecast that share prices. But let’s move on with the point of this article.

I believe that anyone can create a diversified long-term portfolio, without any effort or insight knowledge. I will share “the secret” with you below ( which is not really a secret). The real reason S&P 500 does better than most mutual funds is due to lower costs and lower turnover. This is why the portfolio I have selected has no costs and will have an even lower turnover. I am not sacrificing on quality, however I am being valuation ignorant for the purposes of this exercise. It will be fun to see in a decade, whether limiting my choices to those with a P/E below 20 would have done better or worse. But I digress.

The steps are below:

1) Open an account in a low cost brokerage account, and put money in it. There are plenty of brokers that allow free trading in the US on new or existing accounts ( Merrill Edge, Robinhood), and free dividend reinvestment. This is why I assume practically no costs.

2) Obtain the list of 30 companies in the Dow Jones Industrials Average as of December 28, 2017. These are the largest blue chip stocks in the US, which are chosen by the editors of WSJ and a few S&P employees to be representative of the US economy. These professionals have done a great job for the past 100+ years in selecting quality companies that are representative of the US economy, which also have delivered great performance over time. We have diversified sector exposure in this portfolio. In addition, those individuals have a strong track record for their selections, since the performance of Dow Jones has been as good as that of the S&P 500. Most of these companies also have strong competitive advantages. Some will do very well over the next decade, while others will fall down on their luck. However, as a group, they should deliver a respectable total returns to their shareholders. Plus, I believe that they will be able to deliver more dividends over time.

The companies in Dow Jones Industrials average have managed to grow dividends between 2000 and 2008, followed by a small decline in 2009 and 2010. They have managed to boost dividends every year since 2010.  (source: Dow Jones Industrials ETF (DIA))


I believe that the dividends will be higher in a decade. I also believe most of the companies will be relevant a decade from now, and prosperous. A few will not succeed, but the successful ones will more than compensate for that.

3) Allocate an equal weighted amount to each one of those companies at the close of business on December 29, 2017. I want to give each investment equal weight. An equally weighted portfolio is more diversified than a market capitalization or price weighted approaches, which tend to concentrate the portfolio fortunes on the largest companies.

4) Reinvest dividends automatically for each company into more shares ( I will use closing values on the date dividend is paid). This will smooth out the ride, resulting in the discipline to buy when stocks are low. However, this will also result in situations where companies may look overvalued as well.

5) Buy and hold those shares for at least a decade. Do not sell any shares under any circumstances. Do not buy shares in the new additions to Dow Jones Industrials Average. This “active” portfolio will be even more passive than an index fund.

- The portfolio will hold on to any spin-offs received.
- If a company is bought out/acquired in stock, we will hold on to the shares of the acquirer, and not sell a single thing.
- If a company is acquired in cash, we will allocate the cash into the shares of the acquirer, assuming it is traded on an US exchange. If not, we will allocate equally over the other holdings.

On a side note, this same strategy would work with an equal weighted portfolio of all Dividend Champions or all Dividend Aristocrats. For the purposes of this exercise, I will use all the companies in the Dow Jones Industrials Average to make it easier on myself to calculate results over time.
By the way, this passive approach has been influenced by a few backtested and real world money portfolios I have reviewed over the past few years.

The first approach is the paper by Jeremy Siegel on the performance of the Original S&P 500 companies between 1957 and 2003. This paper found that buying and holding a portfolio of all original 500 companies from 1957, and their descendants resulted in results that are slightly better than the S&P 500. This was an interesting fact, despite that less than 15% of original companies survived intact.

The second approach was the performance of the Corporate Leaders Trust since 1935. This was a passive portfolio of 30 blue chip securities, identified in 1935. The list of blue chip companies remained relatively static for over 80 years, requiring limited management input. This fund is a relic from a time several decades ago, when investors built their own portfolios of blue chip stocks, and lived off their dividends. Since transaction costs were so high, these investors built those portfolios to last many decades, and probably had a low amount of turnover. One such investor was the millionaire-janitor Ronald Reed, who left a multi-million dollar dividend portfolio to charity when he passed away a few years ago.

The third influence was my calculation on the performance of the Dividend Aristocrats and Dividend Champions between 2007 and 2016. My analysis identified that an equally weighted portfolio of such an index did slightly better than the S&P 500, while showering investors with growing dividends. It should not be surprising that high investment turnover is correlated with lower investment results. The analysis of my investment performance over the past decade confirmed the fact that I should buy my stocks, and not touch them any more after that.

The last influence was my review of the performance from Dow Jones Industrials Average, S&P 500 and Total Stock Market since 1992. I found out that they had roughly similar returns over time. This means that you do not need to own hundreds or thousands of companies to create a diversified portfolio.

If you made it this far, congratulations on your patience!

This is the portfolio as of yesterday:

Symbol
Name
 Forward P/E
Forward Annual Div Yield
Dividend Payout Ratio
Last Price
(AAPL)
Apple Inc
        14.88
1.41%
20.94%
169.23
(AXP)
American Express Co
        16.82
1.33%
22.39%
99.31
(BA)
Boeing Co
        29.10
1.80%
52.40%
294.91
(CAT)
Caterpillar Inc
        24.31
1.97%
47.91%
157.58
(CSCO)
Cisco Systems Inc
        15.70
2.93%
45.93%
38.30
(CVX)
Chevron Corp
        30.06
3.45%
103.60%
125.19
(DIS)
Walt Disney Co
        17.44
1.44%
25.12%
107.51
(DWDP)
DowDuPont Inc
        22.25
2.57%
57.14%
71.22
(GE)
General Electric Co
        16.41
5.47%
89.72%
17.45
(GS)
Goldman Sachs Group Inc
        13.45
1.09%
14.65%
254.76
(HD)
Home Depot Inc
        25.67
1.77%
45.53%
189.53
(IBM)
International Business Machines
        11.15
3.77%
42.03%
153.42
(INTC)
Intel Corp
        14.29
2.28%
32.62%
46.16
(JNJ)
Johnson & Johnson
        19.23
2.34%
45.05%
139.72
(JPM)
JPMorgan Chase & Co
        15.50
1.90%
29.52%
106.94
(KO)
Coca-Cola Co
        23.95
3.19%
76.44%
45.88
(MCD)
McDonald's Corp
        26.22
2.20%
57.58%
172.12
(MMM)
3M Co
        26.06
1.97%
51.22%
235.37
(MRK)
Merck & Co Inc
        14.32
3.33%
47.72%
56.27
(MSFT)
Microsoft Corp
        25.17
1.83%
46.02%
85.54
(NKE)
Nike Inc
        27.54
1.14%
31.30%
62.55
(PFE)
Pfizer Inc
        13.91
3.48%
48.46%
36.22
(PG)
Procter & Gamble Co
        22.21
2.94%
65.23%
91.88
(TRV)
Travelers Companies Inc
        19.33
2.06%
39.83%
135.64
(UNH)
UnitedHealth Group Inc
        21.99
1.25%
27.50%
220.46
(UTX)
United Technologies Corp
        19.32
2.10%
40.54%
127.57
(V)
Visa Inc
        27.70
0.58%
16.18%
114.02
(VZ)
Verizon Communications Inc
        14.19
4.34%
61.54%
52.93
(WMT)
Wal-Mart
        22.39
2.04%
45.60%
98.75
(XOM)
Exxon Mobil Corp
        23.00
3.62%
83.29%
83.64

Average
        20.45
2.39%
47.10%

The forward P/E ratio is 20.45, while the average yield is 2.39%. The average dividend payout ratio is 47%.

I will update this post with the list of companies, and year-end prices as of December 29. 2017 by December 30.


I also asked a few other investors about it, and I will link to their responses as they come my way.

Would You Take The Warren Buffett Bet?  by Carl at 1500days.com

Challenging Buffett’s 10-Year Bet by Nick McCullum at SureDividend.com

I’m taking on Warren Buffett’s Million Dollar Bet by Joe Udo at retireby40.org


My friend from Budgetsaresexy.com took the side of Warren Buffett, and wrote the following: "My bet will always be on index funds, whether Warren Buffett is involved or Jimmy Buffett is involved (wanna guess if they're related?). I don't think any of us is smart enough to beat the market over time, so I save the energy - and the money! - and stick with indexes all day, every day” His stock portfolio is 100% invested in Vanguard's Total Stock Market index.

In general, winning or losing this bet may or may not be indicative of anything.

If my selections do better than the S&P 500, I will have a lot of naysayers providing input as to why it doesn't matter that I have more money in the bank than what I would have had if I just bought S&P 500. I would probably be called lucky.

However, if my selections do materially worse than S&P 500, I would be used as an example as to why you should avoid being an overconfident and arrogant investor, and just index. It is very likely that this article will be written by a financial advisor who actively picks index funds for their client portfolios, and charges them 1% - 2%/year for this privilege.

All of those points have some value however. Despite all the information we have about past performance of various investments, the past performance is not indicative of future results. Nothing is guaranteed in investing, as the future horizon is always cloudy.

For example, the original bet between the hedge fund manager and Buffett would have had a different outcome if the US stock market had gone nowhere over the past decade. While S&P 500 delivered strong returns, the foreign and emerging stock markets didn't. In addition, the timing of those bets matters. Someone who had made a bet with Buffett in the year 2000, and focused on value stocks, would have probably done very well. On the other hand, someone focusing on value stocks in 2007, would not have done as well. There is a certain level of cyclicality in returns over time, and the starting points for comparison further exacerbate that.

I am putting that last paragraph, because forward expected returns on US equities are really low for the next decade. If valuations compress the P/E ratio downwards, the portfolio listed above can generate annual total returns between 4% - 5%/year over the next decade.This will be driven by the current yield, plus earnings growth, minus the impact of the valuation contraction. I do believe that a static portfolio of the 30 companies listed above is actually a conservative portfolio for a know-nothing investor. It is low fee, low turnover ( and no fee if placed in a tax-deferred account such as a Roth IRA)

But let's wait and see how those selection do over the next decade.

Relevant Articles:

How many individual stocks do I need to consider myself diversified?
The Coffee Can Portfolio
Time in the market is your greatest ally in investing
The Perfect Dividend Portfolio
Investing in the Dividend Champions from 2007

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