How Buffett’s Bet On Index Funds Beat The Best Hedge Funds

Steve Pomeranz: I would like to welcome Becky Quick back on the show. Becky is co-anchor at Squawk Box, seen Monday through Friday on CNBC, and she is also anchor of the nationally syndicated On the Money. Becky always gets to the heart of the issues when she’s conducting interviews of some of the world’s richest and most influential investors. She recently conducted a long interview with Warren Buffett about his most recent shareholder letter which was published in his annual report. Welcome back to the show, Becky.

Becky Quick: Hey, Steve, it’s great to be here with you, thanks for asking.

Steve Pomeranz: So, this was the 53rd annual letter to shareholders. What was different about this one?

Becky Quick: This letter was a little different. He stripped away the boilerplate of things that he’s been putting in the letter for years and years. Just ways to measure the business, strip away some of that. And I think made it more of kind of a heartfelt letter trying to help investors understand how to value Berkshire.

There’s some differences that are taking place. I think the number one was the big changes, the impact from the recent tax legislation that added a lot to Berkshire’s bottom line. And then secondly, there are some accounting changes that are going to be put into place. And for a company like Berkshire, which has so many holdings in other companies, the stocks that it owns in so many of the big blue-chip companies, that accounting change will kind of skew the bottom line so that you won’t have as clear of an idea of what’s happening with the operations of the businesses that it owns outright.

Steve Pomeranz: Yeah, I wanted to talk about that. So, first of all, let’s talk about the taxes and the tax cut. There was a $29 billion Increase, an extra increase in the net worth of Berkshire because of the tax cuts. But it really wasn’t in the form of cash, it was kind of in the form of future deferred liabilities. Can you just talk about that very briefly?

Becky Quick: Yeah, I mean when you look at, I mean Buffett kind of breaks this down in a way that makes it so easy to understand. The way he looks at it is, you own the business, but as a shareholder for every share you buy the government was getting 35% of future profits and you were getting 55%. With the changes in the tax, you get a big increase because the government is going to be taking a smaller part. So it does make the company more valuable overall. Big number, it does skew things a bit, but I haven’t really thought about it that way until Warren Buffett played it out that way.

Steve Pomeranz: I think when you’re an owner of a business, the way he looks at this, he is an owner, he is going, “hey, this is my money. But no, 35% is not mine.” So, it’s a little bit different than many of us think about it. This accounting change though, I know this stuff sounds boring and I don’t want listeners to tune out here. This accounting change is really important because you said it’s going to skew the numbers. And it is going to skew the numbers, and I just wondered whether he was going to publish another set of numbers to kind of adjust it. Did he say anything about that?

Becky Quick: Yeah, I don’t think he’s going to report a different set of numbers, but he will, in his letter every year—he made a point of saying he will in his letter every year try and break out the accounting differences and the values that rise and drop so rapidly with share prices and some of the things that

go along with that. To try and break out the actual operations of the companies they own outright. So it’s got like 65 or 70 different business that Berkshire owns outright, and what he wants to make sure that shareholders understand is how those businesses are operating. And so I think he will go out of his way in every letter from here on out to really make sure that they make a clear case for it despite what the government requires or what the agencies require, SEC requires with accounting. He did make a point of explaining to people what’s happening.

Steve Pomeranz: I think the idea that what the government is doing is wrong, I think he thinks it’s wrong as well. We won’t get into the details.

Becky Quick: I’m not even sure he thinks it’s wrong as much as it’s wrong for Berkshire. Berkshire is a very unique company. Berkshire’s got billions and billions of dollars in stock they

own, and so that can really skew things. But I don’t think he thinks the government is trying to do a bad thing, but it doesn’t make sense for a diverse company like Berkshire.

Steve Pomeranz: Yeah, also other insurance companies. You mentioned CHUBB, where they have

stocks as well. So, let’s move on here, Berkshire currently has a cash hoard of $116 billion, that he is desperate to put to work. But he says that he can’t really find anything right now at the right price. Is he saying the market is overvalued?

Becky Quick: Steve, it’s so funny that you say that because when I read the letter that’s the same thing I thought. Wow, if Warren Buffett says if they can’t find a business to buy that must mean the stocks were at large are overvalued and that the stock market is getting into bubbalicious territory.

And I asked him that, and he said, no that’s not really the case, that they are still buying stock, that Berkshire is still actively buying shares of other companies. They have been net buyers in the year to date for the first couple months of the year. But he can’t find a business that he wants to buy outright because in order to buy an entire company you have to be willing to pay a premium. So if you’re looking at paying a 15, 20, 30, 40% premium, then he thinks that things are overvalued.

But if you’re just somebody who is buying individual shares, yeah, that’s still worth doing, and even he at Berkshire is still putting money to work to the tune of billions of dollars that they’ve been…I think he said that they spent $3 to $3 and a half billion net at the beginning part of this year. And that’s even with Phillips buying back some shares. So they’ve been spending billions of dollars in the market to buy individual pieces of companies. They just can’t find the company, a big company that they’d like to buy outright and pay that premium.

Steve Pomeranz: It’s harder to swallow the whole cow. It just costs more—but buying individual stocks. So I thought his thinking was bifurcated there as well, and I wanted listeners to understand the difference. Because everybody, the pundits talk about, the market’s so overvalued and so on. So we want to know what Buffett is thinking about the stock market.

And he’s saying, no, he’s finding places to go and buy stock, so I think that was very important.

Becky Quick: I think so too. That’s, I think, one of the most important takeaways I took from it because I went into that interview thinking he was going to say that stock prices were getting expensive and that’s not at all what he said.

Steve Pomeranz: So, he’s got $116 billion, he’s really looking for a great market sell-off, not that he’s wishing for that, but that when he buys, he gets his best deals. But there’s other things that he can do with his $116 billion. He can establish and declare a dividend, and he talked about that. Why won’t he just do that?

Becky Quick: I think he’s always been against the idea of a dividend because he feels like if he can’t make better use of it, the whole way Berkshire was set up was to create insurance companies in the beginning and that would kick off a float, and then he felt he could be a better investor and make more on that money than you’d be able to otherwise if he gave it back to you. He said he looks at Berkshire kind of as a savings account. For the early investors, that’s what it was. They gave all their excess money to him, he found the best way to put it to use and to get a higher return on investment for people.

I think he still feels that he can get a higher return on investment for people and that having that money sitting around for a rainy day serves a purpose. So Berkshire really went to work back in 2008 and 2009 in the aftermath of the financial crisis. And you’re right, the rainy days are the great days for Berkshire because they have the ability to stand in when everybody else is running for the exits. And because they are so conservative, they can really have a lot of excess cash that they can put to work in those times. He didn’t rule out the idea of ever having a dividend, but I think right now he still thinks that he’s in the position of being able to eventually put that money better to use than giving it back to shareholders.

The other things he’s pointed out in the past about a dividend is, that’s not a tax-advantageous situation for shareholders. You give them the money back and they’re going to have to pay taxes on it. Whereas if you can re-invest it within the Berkshire entity, as shareholders they’re not paying taxes on those gains, they’re just getting gains that are accumulated to the bottom line.

But I was a little surprised by that too, Steve, that he didn’t rule out the idea of dividends because maybe there is a point where he feels like he can’t make a better return on investment than-

Steve Pomeranz: Well, he also said it’s an implied promise that you’re going to keep paying forever, not decrease the dividend and so on. So he would even think about a re-purchase, he’s talked about that in the past, and he set a limit of

120% of book value as his number where he would come in. And I think that he, under special circumstances, he would increase that maybe to 125, 127%. Now everybody listen, you can go online and you can find out what the book value per share of Berkshire Hathaway is. Both the A and the B shares, and you can multiply it times 125% and you will see the number that

we’re talking about. It’s not rocket science. My guest is Becky Quick, Becky, of course, is the co-anchor of Squawk Box, we all love her. She is on Monday through Friday on CNBC and also the anchor of On the Money as well.

All right, so let’s talk about some of the little bit more sensitive issues around today. You talked, there were questions that you read from other watchers of your show about investing in gun manufacturers, what do you say about that?

Becky Quick: That’s been a politically charged topic in the wake of the shootings at that school in Florida.

And there have been calls for companies that are involved with either the selling or manufacture of guns to maybe put down some laws that don’t look like they’re very likely to pass Congress. Things like raising the age that you can buy guns at, things along those lines. And some companies have waded into that. Buffett says he is reluctant to play sides on some of these things because in some ways it can be a slippery slope, right? One person’s rallying cry is somebody else’s, you’re stepping on someone else’s toes. And I think he typically wants to keep Berkshire out of the frame with some of those things.

Now, Warren Buffet is somebody who was very clear in his support of Barrack Obama and Hillary Clinton. But he says that he never wants to put his political beliefs on Berkshire shareholders or on the Berkshire companies. And so his point is, look, there’s a million other things that the board should be talking about. By the way, they don’t manufacture guns, or weapons, or sell them. So, this is little bit of a theoretical question when it comes down to it. But his point is that you can run down an entire gamut of issues, but you’re going to be dividing the country and basically alienating half your customers if you wade into some of these things.

And he just doesn’t want to put Berkshire as a company in that position.

Steve Pomeranz: Yeah, he said he has his own personal views but they may not, may or may not be Berkshire’s views. I think he made that pretty clear. Okay, so let’s talk about his bet, we only have a few minutes left.

Let’s talk about his bet with the hedge fund managers. That was ten years ago, they both put up, I think, $300 and some odd thousand, and the idea was to try to get it to $500,000. And then together, it would have equaled $1 million. And he bet on the S&P 500, the unmanaged, low-cost S&P 500 index. And he bet against a fund manager, Protege Partners, which had access to all like 200 of the best and brightest hedge funds. How did they do?

Becky Quick: Well, Buffett blew the hedge fund managers out of the water with his simple bet on the S&P 500. And there’s a point he’s been trying to illustrate for years. You know this too, just the idea that average investors are going to get taken advantage of by Wall Street. And because if you’re an average investor, you’re not going to be able to get. He says he only has about five hedge fund managers or five managers in the world who would be able

to outperform the S&P 500 on a regular basis.

But most of us are not going to have access to that, and if you are paying for some of the manager money, you are paying often a big fee, maybe 250 basis points or more to get them to manage, move you in and out of stocks and take advantage of all these things and make decisions all the time.

So, the point is, we’re not experts, we shouldn’t be trying to do this. We’ve all got day jobs, this is not our job.

Steve Pomeranz: Right.

Becky Quick: So just put your money aside, don’t worry about it. Let it go and you’ll do better. He wanted to prove that you could do better by doing that, and so his point came out, I forget what the actual numbers are. I don’t know if you have it right in front of you, but the S&P 500 blew it out of the water.

Steve Pomeranz: Yeah, well the S&P 500 was up 8.5% and the average of the managers was 2.9%.

Becky Quick: Right.

Steve Pomeranz: Yeah, so I mean it’s not even close.

Becky Quick: On an annual basis, right. And so he keeps trying to prove to people, you don’t have to pay Wall Street to do all these things, you don’t have to be super sophisticated. That if you are simply an investor with a long-term outlook, and you have a lot of years to invest, and you continue to put money aside and don’t get panicked, don’t sell just because the market crashed.

Steve Pomeranz: Yeah, there’s the key. I think he’s talking about two separate things here. Number one, the actual money management itself, the day to day buying of stocks and other instruments just to try to outperform the S&P 500. Now this may be a little bit biased because I am an investment adviser,

but I can tell you from the 36 years that I’ve been sitting at this desk, people do need help with their emotions and making the right decisions, so, I don’t think, I actually…

Becky Quick: He made that point too, that look, the biggest thing is you need to be unemotional in getting into these things. You can’t run and trade with it. And if you have that, and his whole point is if you have that ability to be unemotional on those trades then this is what you should do. But you’re right, there are a lot of people who want to sell when everybody else does. They panic, they see it on nightly news and they want to immediately run out and sell just because everybody else is running. And that’s the wrong thing to do.

Steve Pomeranz: Yeah, exactly. Well, Becky, thank you for joining us. To hear this interview again, to read the facts covered on this topic, we’ll also give you a link to the annual report from Warren Buffett so you can read it for yourself. It’s incredibly readable, and it’s really for all of us to sit, and there’s lots of other lessons there about trading on margin and so on and so forth.

Don’t forget to go to StevePomeranz.com. Becky Quick, thank you so much for taking your time to join us today.

Becky Quick: Steve, thank you, it’s always a pleasure so thank you for the time, I appreciate it.

Steve Pomeranz: You’ going to be out in Omaha this year?

Becky Quick: I am, in May. Are you going out?

Steve Pomeranz: Yeah, I’m going out, I’ll see you there.

Becky Quick: Okay, fantastic. I’ll talk to you soon, Steve.