I recently read a Barron's article regarding Warren Buffett (Trades, Portfolio)'s underperformance relative to the index. The article listed some numbers that suggest a very unimpressive return from the world's best value investor. It said:
Berkshire's A (BRK.A, Financial) (BRK.B, Financial) shares “are up an annualized 12% in the last 10 years, slightly behind the 12.2% yearly total return, including dividends, for the index. Berkshire also is behind the S&P 500 over the past five years with a 13.4% annualized return, compared with 16.4% for the index, according to Bloomberg calculations. The stock is roughly even with the index over the past 20 years with a 9.8% annualized return.
Berkshire stock's lagging performance shows how difficult it is for even an investor of Buffett's stature to beat an index driven by powerful megacap tech stocks, especially given Berkshire's huge size. Its asset base is about $1 trillion.”
Buffett's 10 year and 20 year underperformance is a historic milestone for the value investing world. Incidentally, another value investing legend, David Einhorn (Trades, Portfolio) took a step further and warned that "value investing probably won't ever recover from the 'debilitating' outflows that shifted to passive or other strategies."
Indeed, over the past decade, I have witnessed the struggles of value investors across the globe. Some even went out of business. Very few have outperformed the index over the past five, 10 and 15 years.
I have been advocating that value investors should adapt to a changing environment since a few years ago. Today, it seems even more urgent and relevant for value investors to evolve and adapt because two huge paradigm shifts are accelerating.
The first paradigm shift is the emergence of passive funds. This is nothing new. But the milestone finally came last year. According to an article by Financial Times:
“Passively managed U.S. mutual funds and exchange traded funds have for the first time amassed more money than their actively managed counterparts, thanks in large part to years of strong inflows into the increasingly popular ETF wrapper. At the end of December, passive U.S. mutual funds and ETFs held about $13.3 trillion in assets while active ETFs and mutual funds had just over $13.20 trillion, according to data released by Morningstar. The ascent of passive strategies has been years in the making, beginning with Vanguard's launch of the world's first index mutual fund in 1976 on the premise that stock pickers do not beat the market over the long term.”
The second paradigm shift is the super-fast growth of quant funds. I have not found the latest data on the market share of quant funds, but according to this article, back in 2019, “across the $31 trillion of U.S. stock market value, quant funds now own 35.1% of market capitalization, compared to 24.3% of human-managed funds.” I would imagine that quant funds' market share is higher now than it was in 2019. To be fair, there is some overlap between quant funds and passive funds. But undoubtedly, quant funds are also taking shares from the traditional human-managed funds.
There are other paradigm shifts in the investing world as well, but I regard the above two the most disruptive and relevant for value investors. One of the foundational concepts for value investing is intrinsic value, which says that equity price is derived from discounting future cash flows back to the present. In other words, discounted cash flow is the most appropriate method for valuing equities. To project future cash flows, value investors would focus on building what Buffett calls “circle of competency” and really dig into a company's fundamental metrics.
However, neither passive funds nor quant funds price equities using the DCF method. The algorithm used by quant fund can be very opaque. From what I read, business fundamentals and valuations do not really matter in the algorithm. Therefore, a stock can be extremely overvalued by traditional valuation metrics, but the quant fund can still make money as long as the algorithm is superior. On the other hand, a stock can be extremely undervalued using DCF, but no quant fund or passive fund will pick it up. This means mean-reversion may take much longer than it did in the past. For some stocks, mean-reversion may never take place.
The good news is business fundamentals still matter to some degree. Even for the “Magnificant 7” stocks, most of them have very strong earnings during the past few years. It is just that valuations are pushed to the extreme in a very short period of time and have stay elevated for a while now.
Now comes the important question. What should value investors do to cope with the challenges posed by the paradigm shifts?
I think the most obvious solution is value investors should rely less on the mean-reversion mentality. Some value investors still use historical multiple analysis, which has worked beautifully for many decades. It is time to re-examine the validity of assumptions behind the mean-reversion theory.
Another way to cope with the paradigm shifts is to identify areas in which the traditional valuation method still works. For instance, many high dividend yield stocks still appear to be valued by discounting future cash flows and the implied future dividend yield.
Thirdly, value investors should keep an open mind to embrace technological changes and adapt to technological changes. In this regard, I have gladly seen many traditional value investors owning Amazon.com Inc. (AMZN, Financial), Apple Inc. (AAPL, Financial), Meta Platforms Inc. (META, Financial), Microsoft Corp. (MSFT, Financial) and Alphabet Inc. (GOOG, Financial) in their portfolios. This is a very encouraging sign.
Back to Berkshire Hathaway, both Buffett and Munger have warned shareholders for many years that they are finding it increasingly difficult to keep up with the index. The conglomerate's massive size and the decreasing information advantage (due to the combination of a rapidly growing expert network industry and the faster and wider information dissemination) will translate into fewer mispriced opportunities for Berkshire.
Does this mean value investors should abandon Berkshire? Of course not. But it is time for Berkshire's shareholders to heed Buffett and Munger's advice for a long-lasting marriage - low expectations.
