Thursday, January 23, 2020

My Bet With Warren Buffett - Year Two Results

Two years ago, I made a bet with Warren Buffett. This was a continuation of the bet that Warren Buffett had done with a hedge fund manager over the preceding decade.

Per the original bet, Buffett believed that index funds would do better than hedge funds over the next decade. He believed that, because hedge funds are very expensive to their investors. Hedge funds usually charge investors a 2% fee for assets under management, coupled with a 20% performance fee. In other words, if a hedge fund generates a 10% return on investment for a given year, 2% of that return goes to the hedge fund manager, in addition to any recurring fees for a total outlay of 4%. When you hold shares through a low cost index fund, you have much lower costs of investing. Of course, when you buy and hold shares directly through a commission free brokerage, you have even lower costs than the average fund.

Needless to say, Buffett won the bet. But I think that he won the bet because of the high costs of hedge funds. Hedge funds have a very high hurdle rate to succeed, because of their high costs. Let's look at a situation where the average index fund on S&P 500 returns 10%/year, and a hedge fund charges a 2% performance fee, as well as a 2% management fee. In order for the hedge fund to generate a net return of 10% after fees, it needs to generate a gross return of 15.40%. If the hedge fund generates a return of 10% before fees, investors would end up paying close to 4.20%/year in fees alone.

The irony of the bet is that the most vocal index fund fans would have lost the bet to Buffett as well. Anyone who held fixed income funds, or international and emerging market funds would have done much worse than someone who simply held on to the S&P 500 between 2007 and 2017. This is a fact that is seldom mentioned about this bet. Perhaps Buffett is not only good at picking stocks, but at picking index funds too.

It makes sense that if you pay high fees, your investment returns will be reduced. For example, if you buy shares of Johnson & Johnson (JNJ) today, you will generate a dividend yield of 2.50%. If you paid someone a 2% fee, you will end up with a dividend yield of only 0.50%.

I decided to make my own bet with Warren Buffett, in an effort to challenge assumptions, and share anything I learn in the process. Of course, Buffett doesn't know about this bet, and it is highly probable that he doesn't know I exist. But I will do this bet anyways.

I believe that noone knows in advance what the best investments of the future are going to be. The only thing you can control is your savings rate, the types of investments you make, your holding period and the investment costs you incur. This is the real reason why index funds are so popular - they have low costs, since they do not employ expensive manager to select investments. They are also cheap, because they do not turnover their portfolios frequently.

I wanted to select an investment portfolio that is adequately diversified, and which anyone can build in five minutes or less. There is no accounting knowledge required, just some initial capital and basic computer literacy that almost everyone in the world today possesses.

I decided to invest equal amounts in the 30 companies in the Dow Jones Industrials Average at the end of 2017. My strategy was to reinvest dividends automatically in the companies that produced them, keep any spin-offs, and not sell any company (unless I am forced to, due to an acquisition). If a company was dropped from the index, I kept it, for as long as it is publicly traded. Since there are commission free brokers everywhere, the cost is zero. If held in a Roth IRA, there are no tax costs either.

The goal of this portfolio is to be as passive as possible, because investment turnover is costly to long-term returns. This is a very passive portfolio, which will be selected, and tucked in safely for the long-run. The idea behind this passive portfolio stems from the idea for the coffee can portfolio. When you buy quality blue chip companies, which are leaders in their industries, you are putting the odds of success in your favor. After all, a group of companies with earnings power and strong competitive position is likely to continue doing well for a few decades down the road, even as things change over time.

My analysis of the Corporate Leaders Trust, showed me that a portfolio of blue chip stocks can produce great long-term returns, even if no new securities are selected for 80 years. The Corporate Leaders Trust is a mutual fund that was launched in 1935. The fund invested in a portfolio of 30 companies, which was unchanged for the next 85 years. No new securities were selected, and all securities were held for as long as they kept paying dividends. When companies were acquired for stock, the stock in the acquirer was held. When a company was acquired for cash or when it was sold due to a dividend cut, the dollars were allocated in the remaining portfolio companies. A lot of blue chip stocks generate earnings, and have the scale to continue succeeding in the long-run. In addition, companies often go through mergers, spin-offs and acquisitions, which can rejuvenate an otherwise passive portfolio, but doesn't require any additional input from the investment analyst. The lack of activity also ensures that any behavioral costs are minimized.

My analysis of the performance of the original companies in the S&P 500 also reiterated the idea that it pays to buy and hold companies, and not sell no matter what. Jeremy Siegel calculated that if someone put an equal amount of money in the original 500 securities of the S&P 500 index in 1957, and never sold, they would have done better than the S&P 500 index itself over the next half a century. That's because the portfolio was held static, dividends were reinvested for decades, each company received an initial equal weighting, and because all spin-offs were kept.

For example, a lot of investors know that Eastman Kodak went to zero in 2011 after the company became bankrupt. It is a little known fact that it spun-off Eastman Chemicals (EMN) in 1994. As a result, an investor who put $100 in Eastman Kodak in 1957, who held on to their stock and any spin-offs would have ended up with $640. This calculation assumes reinvesting dividends back into the security that produced them in the first place. It is surprising that the investor actually made money, despite the fact that their original thesis was wrong as Kodak went to zero. Had they reinvested dividends strategically into other dividend paying stocks would have even further reduced risk, and increased returns. It just goes to show you that things can turn out for the better, even if an investment is doomed. That's the same lesson that shareholders of Sears and General Motors can attest to.

The important thing to remember is that we are talking about long-term returns and long-term investing. There will be year to year fluctuations in total returns and relative returns.

That is my cue that last year, the portfolio did well, but not as well as S&P 500. It looks like the portfolio is up 23.93% since the end of 2017. (through 12/31/2019)

The S&P 500 is up by 25.45% over the same period, from 12/29/2017 to 12/31/2019.

In the first year of the bet, the portfolio was down 1.63% versus a loss of 4.38% for the S&P 500.

You can see the returns by security below. These are life-to-date returns since the launch.

This year presented one of the most challenging math problems I have ever seen in my life. That is the split of DowDupont (DWDP) into three separately traded companies. The company itself was formed in 2017 by merging Dow Chemical and DuPont, only to be split up two years later.

On April 1, 2019, shareholders received one share of Dow (DOW) for every three shares of Dow Dupont they had held. This means that I have to allocate 1/3rd of the worth of the investment to Dow from that date forward (0.33562 to be exact), with 2/3rds to DuPont (0.66438 to be exact for DuPont). (Source)

On June 1, 2019, shareholders received one share of Corteva for every three shares of Dow Dupont they held. I am not sure how this happened, but 74.13195% of the net worth is attributed to DuPont and the remaining 25.86805% to Corteva. DowDupont then did a 1:3 reverse stock split to turn itself into DuPount. (Source)

In both cases, there were fractional shares, that I presumed were converted to shares of the new entity being spun-off. In reality, fractional shares were converted to cash for shareholders. However, I am presuming we are dealing with a million dollar portfolio here, and a fractional share here and there can be cashed in and then reinvested for a net effect of a fractional share. So to keep things consistent, the fractional shares were kept.

All of this activity has just made accountants and bankers richer, as it definitely took away from the ability of management and employees to focus on the business instead. A $1 investment in Dow Dupont at the end of 2017 has resulted in owning shares of Dupont (DD), Dow (DOW) and Corteva (CTVA), and a total loss of 30%. This also increased the number of securities in this passive portfolio from 30 to 32.

I also kept the valuation ratios and dividend yields for each company as of 12/29/2017. Last year, the companies with a P/E above 20 had done better to-date, than the companies with a P/E below 20. By the end of 2019 however, the life-to-date returns on companies with a P/E below 20 is slightly higher than the average, and the returns on companies with a P/E above 20. Is this a trend, or are we all being fooled by randomness by the cyclical changes in investor fashion of growth versus value?

There were three other bloggers, who were brave enough to get into a 10 year bet. Those include:

Carl from He selected four technology companies. He has been able to ride the wave of technology for the past decade. He is the clear winner so far - his portfolio is up 30.77% since the launch. His portfolio was up 2.80% in 2018 as well.

Carl is a great stock investor. The problem is that he has allowed to be convinced by others that he is going to be mediocre in the future. As a result, he has been selling stock in companies, and buying index funds with the proceeds. But the stock he has been selling has done much better than the index funds he has been buying. If Carl wins this contest, he may realize that he has squandered millions of dollars in potential returns by selling the best companies in the world, and buying investments that didn't do as well.

Ben from selected the Dividend Aristocrats Index, which is a wise choice. The dividend aristocrats lost 2.73% in 2018, but gained 27.97% in 2019 for a life-to-date return of 24.48%. Source: S&P Global

Joe from, selected the S&P 500. In a sense, he is the yardstick against we measure ourselves.

Let's circle back again in one year, and see how things are progressing in year 3?

Thank you for reading!

Relevant Articles:

My Bet With Warren Buffett
My Bet With Warren Buffett – Year One Results
The Perfect Dividend Portfolio
Time in the market is your greatest ally in investing
The Coffee Can Portfolio

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