ON BECOMING THE NEXT WARREN BUFFETT: A ROAD MAP FOR APMP GRADUATES!

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1 ON BECOMING THE NEXT WARREN BUFFETT: A ROAD MAP FOR APMP GRADUATES! By: Joseph Dancy, LSGI Venture Fund L.P Michigan Tech Fund Trustee, Finance Committee Member Professor & Mrs. Othmer - Living quiet, unpretentious lives Mr. and Mrs. Othmer he was a professor of chemical engineering at Polytechnic University in Brooklyn and she was a former grade school teacher - died in the late 1990 s. They had no children. When the Othmer's died, friends were shocked to learn that their estate was worth $800 million! How did these two teachers get so rich? Like many long term investors, they put their money into well managed undervalued companies. The Othmers had an additional benefit: in the early 1960s they each invested $25,000 in an investment partnership run by Warren Buffett. They received thousands of shares of Berkshire Hathaway at $46 a share when he dissolved that partnership. Today those shares trade at $70,500 a share. Mrs. Othmer's shares were worth $578 million; her husband's, sold on his death when the price was lower, were worth $210 million. A graphical representation of the Othmer s investment in Mr. Buffett s Bershire Hathaway is as follows: Had Mr. & Mrs. Othmer invested in the S&P 500 index instead of with Mr. Buffett they would have an account worth around $2.7 million today (a return of around 11.8% a year) very impressive - but not anywhere near the almost $800 million obtained with Mr. Buffett (annual returns of around 24.1%). Note several things from this example: An investment manager that can outperform the market has an incredible impact on total long term investment returns! Time is one of the most valuable assets an investor has and APMP students have more of that asset than Warren Buffett! Even small differences in annual returns can have enormous longer term impacts on total investment returns Strategies that have a high probability of outperforming the market are incredibly valuable to investors with a long term time horizon! Lots of the early investors with Warren Buffett are incredibly wealthy

2 Is it easy to find a money manager like Warren Buffett 1 that beats the market? The data suggest that over longer periods active managers in the domestic large cap asset class have had difficulty in beating their benchmarks... (Hammond & Assoc.) ****** Percent of all equity funds with 10-year track records that beat the Vanguard S&P 500 index fund by more than 2% a year for the period ending 30-Sept-95: 5.5%. So investors have roughly a 1 in 20 chance of investing in a mutual fund that will outperform the S&P 500 by 2% (data for earlier years was similar) (Source: O Shaughnessy, What Works on Wall Street ) ****** The more assets under management, the less likely a fund is to outperform. Of the 45 largest stock funds only one beat the Standard & Poor's 500 index between 1995 and and that one outperformed by a scant 0.60% per year! (Source: Warwick, "Searching for Alpha") Asset Class Benchmark Index % of surviving funds that outperformed the benchmark index over a 20 year period Large Cap Blend S&P % Large Cap Growth S&P 500/BARRA Growth 24% Large Cap Value S&P 500/BARRA Value 14% If active managers can t consistently beat the market, what do investment consultants recommend? Index! Recommended portfolio methodology (Hammond & Associates): Passive Indexing 43% Enhanced Indexing 23% Active Management 34% Note: 2/3rds of the portfolio is indexed under Hammond s recommendation! The pension fund industry has gotten the indexing message loud and clear, and the rush into indexing has been accompanied by a flood of pension assets under management: (Source: Clowes, The Money Flood ) U.S. Pension Fund Assets % of Pension Funds Indexed $ Trillions U.S. Pension Assets Percent 40% 35% 30% 25% 20% 15% 10% 5% 0% % of Pension Funds Indexed 1 Polytechnic University, which once faced bankruptcy, unexpectedly found itself heir to $175 million from the Othmer s estate. Planned Parenthood received $65 million. All told, the couple bequeathed $340 million to several perennially cash-strapped Brooklyn institutions. Buffett claims that several other early investors have larger estates. 2

3 Most experts agree that active managers have a very difficult time beating the market averages longer term. It is very rare to find an active manager that performs as well as Mr. Buffett. 2 Historical data supports this conclusion. What factors did Mr. Buffett use to outperform the market? Hint: Dennis Hammond notes a 1986 study by Brinson, Singer, and Beebower that found the following determinants of portfolio performance : Asset allocation/asset mix 91% Security selection/other - 9% Believe it or not, studies indicate that the most crucial decision an investor can make is how to divide up investments between different asset classes that is how to allocate capital between money market funds, bonds, large capitalization stocks, small capitalization stocks, oil & gas, timber, real estate, gold, etc. This allocation decision will have more impact on the total return of a portfolio than the decision of which stock, fund, or bond they invest in. "Investors add more than 85 per cent of value by virtue of deciding the type of asset they want to invest in... The performance of any fund is dictated by its asset class, and less so by the skill of the fund manager" according to Singapore based asset manager Hon Cheung. What financial characteristics are present in portfolios that have outperformed historically? With regard to the micro-cap sector James P. O Shaughnessy in his book entitled What Works on Wall Street notes: Most academic studies of market capitalization sort stocks by deciles and review how an investment in each fares over time. The studies are nearly unanimous in their finding that small stocks do significantly better than large ones. We too have found tremendous returns from owing tiny stocks. (emphasis supplied) Long Term Market Performance by Capitalization Market Capitalization Under $25 million $25 to $500 million Over $1 billion % Compounded Annual Return Using 43 years of historical data for his studies, O Shaughnessy goes on to note that the returns of microcap stocks have been stunning! 2 In 1957, Buffett started his first investment partnership. A group of Omaha investors handed him $25,000 each. Buffett put in $100 of his own money, appointed himself general partner and began to purchase small undervalued stocks. His goal was to beat the Dow Jones Industrial Average by an average of 10 percent a year. When the partnership dissolved in 1969, Buffett's investments had ballooned at a compound rate of 30.4 percent annually, compared to just 8.6 percent annually for the Dow. 3

4 Buffett and partner Charlie Munger originally invested in small companies very small companies well before the historical market data was statistically analyzed that indicated this sector grossly outperforms the overall market. Besides small market capitalizations, what other factors have increased historical returns for investors? The use of multiple value factors, in addition to the small capitalization factor, tends to increase investors returns: Using multifactor models [like market capitalization combined with low price/sales, price/cash flow, and low price/book values to screen for stocks] dramatically enhances returns. O Shaughnessy Professor Fama (of Efficient Market Hypothesis fame) in his Three Factor Model claims that small capitalization stocks that also have low price/book ratios historically have outperformed the market the market is still efficient, but the investor earns excess returns for the additional risk incurred. Financial Ratio Impact on Performance Low P/S High P/S Low P/B High P/B Low P/E High P/E Market Average % Compounded Annual Return Source: O Shaughnessy, What Works on Wall Street How come institutions and individuals don t take advantage of this micro and small cap niche and the opportunities it presents investors? Clearly, the data indicates that undervalued small and microcap stocks with above average relative strength have historically outperformed the market by a significant amount. Institutions have difficulties managing funds in this sector for the following reasons: The liquidity of many small and micro-cap firms is limited, and it is hard to establish or sell any sizeable position without impacting the share price The cost to analyze the small or micro-cap company for a firm is very high compared to the dollars that can be invested As a percentage of assets, any position a large investment management firm can take in small and micro-cap firms will have very little impact on total portfolio performance Due to the lack of liquidity it is very hard to establish or invest in index funds that mimic the performance in this sector. Those index funds that attempt this (Dimensional Funds 9-10) tend to under-perform actively managed accounts Regulations limit how much of a small cap firm can be purchased without making SEC filings, and limit the total interest that can be acquired by a fund 4

5 Individuals for the most part ignore the small and micro-cap sector for the following reasons: Most individuals have little understanding as to how to identify an attractive small or micro-cap firm for purchase, and little unbiased and reliable analyst coverage exists Micro and small cap firms are much more volatile than the market, and losses hurt investors three times more than gains are pleasurable Most individuals equate these companies with high risk which may be true if risk is defined as beta Few funds effectively invest in this sector, and most investors have gravitated to larger capitalization mutual funds if they are looking for growth Most individuals have little concept of the excess returns that can be earned in this sector, and the long term impact on their net worth (note Warren Buffett s Berkshire Hathaway was a microcap in 1965!) Aren t small and micro-cap stocks risky? Yes if you define risk as volatility! But note that over the longer term, volatility decreases. Jeremy Siegel, professor of finance at the University of Pennsylvania, examined market history going back nearly 200 years. He found that the standard deviation for stocks over one-year periods was 19%. Since the average annual return for the S&P has been about 11%, this means that in two-thirds of the years investment returns fall between minus-8% and plus-30%. But Professor Siegel found that for 10-year holding periods volatility plummets to 5% - meaning that average annual returns fall in the range of plus-6% to plus-16% in two-thirds of the holding periods. And if a portfolio is held for 30 years, volatility dwindles to nothingness - a standard deviation of about 2%. In fact, Siegel found that if the holding period exceeds 15 years the volatility - and hence risk - of stocks is less than that of bonds. If most of an investor s return depends on the asset class, can APMP graduates invest in an asset class that outperforms to achieve Warren Buffett like returns? The answer to this question has tremendous implications for APMP graduates or potential money managers. If the answer is yes, a viable business can be developed around this hypothesis. Remember, the studies indicate that a manager is limited as to the excess returns that they can add the manager only contributes around 10% to 20% of total returns according to most studies! The trick, in our opinion, is finding an asset class that has historically outperformed the market then developing an expertise in that sector. There are many inefficient markets many of them are also illiquid where an investor can develop a systematically exploitable advantage. Note the success Mr. Phelps has had in the distressed debt sector! We think that the micro or small cap sectors offer one of these opportunities, and a manager in that sector has a number of advantages: 5

6 1. no institutional competition (remember, institutions can t invest in this sector well due to liquidity, size of their portfolios, and the cost of research) 2. no indexing competition very hard to index the microcap sector, and certainly not the value segment (DFA 9-10 index has performed poorly) 3. high probability that as manager in this asset category you will outperform ALL the major indexes and ALL the major mutual funds (Fidelity Magellan, etc.) over the longer run (neat way to impress folks at parties) 4. no competition from individuals (most folks can t read a bank statement much less a balance sheet, are afraid of the volatility, don t know where to get information or how to identify these firms, have no analysts to help them, and don t have the time or interest to conduct due diligence) 5. direct access to company CEO s and executives for information (9 of 10 will take you calls if they know you are an investor if they don t talk don t invest) 6. small companies are easy to analyze, model, and value especially for those who have acquired the skills taught in the APMP program. 7. small portfolios are an asset in inefficient sectors, and a competitive advantage The opportunities to exploit this market niche have never been better according to many including Warren Buffett! If I was running $1 million today Buffett notes, or $10 million for that matter, I d be fully invested. Anyone who says that size [of the portfolio being managed and the companies you invest in] does not hurt investment performance is selling. The highest rate of return I ve ever achieved was in the 1950 s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It is a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that. (1999 Business Week interview, emphasis supplied. Buffett s partnership in the 1950 s averaged over 30% returns per year for over a decade!) What advantages do the APMP graduates have over Mr. Buffett? Individuals with well grounded investment philosophies have the opportunity to outperform the major market indexes, most institutional investors, and even Buffett s Berkshire Hathaway: When Warren Buffett started managing money he would buy a few shares of a company just to get the annual report, and recalls that he spent 12 hours a day searching stock-picking guides for attractive investment opportunities. No widely available financial databases were available to search, SEC filings were not available online, and the use of computers to conduct due diligence was unheard of. More than three quarters of the world s venture capital is invested in U.S. based companies. The exit strategy for many of these venture capitalists is to take the company public as an initial public offering or IPO. Because of this venture capital activity the number of publicly traded companies listed on U.S based exchanges has almost doubled in the last decade. Most of these firms are not followed by analysts. Trading costs and commissions were much higher a decade or more ago due to the industry s regulatory structure and lack of competition. Such trading costs were not insignificant, and reduced total returns to investors. 6

7 SEC Regulation FD has created the situation where many small and micro-capitalization firms publish in their press releases their forward-looking financial forecasts. Ignored by many institutions due to their small size, this information is very valuable to the individual investor. Online sites allow an investor to screen, research, chart, analyze, and trade companies much more efficiently in fact an analyst with online research capability can conduct as much research in one hour as they could in two or three days in the past. Establishing an investment advisory firm, with little at risk Several things to think about if you are interested in becoming an investment advisor or establishing an investment advisory firm: The main attraction for investors will be total return on investment, after fees and expenses A hypothetical portfolio can be manipulated using play money and does not accurately reflect the ability (or inability) of a manager to outperform the market since a hypothetical portfolio does not deal with illiquidity, spreads, emotions, and risk issues realistically. A real money portfolio, regardless how small, illustrates that the manager can outperform in the real market not just on a theoretical basis. It can also be audited. Should a real money portfolio perform well, the strategy and philosophy can be developed into a hedge or mutual fund format with historical performance data available for investors to review Should a real money portfolio perform well a newsletter tracking it would be of interest to investors no registration or regulation is attached to investment newsletters and they can generate substantial subscription income. The consequences of failure is low should the account under-perform or the strategy not be implemented effectively Time is a friend of the long term investor, and you have plenty of it. You are truly gifted to have had the opportunity to participate in the APMP program at Michigan Tech! Live long, enjoy life, and prosper! ************************ Like the early prospectors in the Copper Country who found great challenges and difficulties, and in some cases great wealth 3, the micro capitalization sector is rich with opportunities for those who dare to prospect therein. 4 Small companies are, in every sense of the word, the investor s Mother Lode. 3 Shareholders in the successful mining ventures could do quite well. Henry Hobart, school teacher at Clifton, wrote on February 3, 1864 that: Many have made a fortune her investing their money in stock. This is an easy way but it also an easy way to lose a fortune. But it is said that a man must run some risk if he wishes to make anything. Hobart references the wealth created by investing in mining stocks numerous times in his diary and indicates that he purchased shares in the North Cliff mine during this time period. See: Hobart, Copper Country Journal, The Dairy of a Schoolmaster, (republished 1991). 4 Remember, Warren Buffett s Berkshire Hathaway was a micro-cap in the 1960 s and 1970 s, only to develop over time into the large capitalization firm it is today 7