Interpreting Warren Buffett

31 October 2016 | by Sean Stannard-Stockton, CFA

Every great investor has learned from the greats that came before. Reading Benjamin Graham, Warren Buffett, Charlie Munger, Phil Fisher and a host of others is absolutely required. But learning from those that came before does not mean devining a set of rules that have been handed down and must be followed. The investment greats are not deities whose words are eternal, they are simply people who discovered important elements of successful investing, but whose words must be interpreted carefully before applying to the current environment.

Robert Hagstrom has called investing “the last liberal art”. Understood this way, it is clear that studying the great investors of the past and present should be approached as one might study philosophy rather than physics. There are few immutable laws of investing. Instead, the great investors offer frameworks for thinking about investing that can be used to wrestle with new investment opportunities and environments. The reason Benjamin Graham’s writings, first published over 80 years ago in the midst of the Great Depression, are still relevant today when analyzing software as a service, biotechnology, and social media companies is because Graham’s most important lessons are not found in specific formulas, but in his investment philosophy.

Recently, the investment manager John Hempton of Bronte Capital, who writes a very intelligent and well regarding blog, wrote about a particular lesson from Warren Buffett. John is clearly a brilliant guy and a successful investor, but his interpretation of Buffett’s lesson runs counter to how we think investors should interpret the investment greats.

Hempton wrote:

“One thing that had a profound effect on me was Warren Buffett’s twenty punch card. (Quoted here…)

Buffett has often said, “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”

There are plenty of people out there who call themselves Buffett acolytes – and as far as I can see they are all phoneys. Every last one of them. Find any investor who models themselves off Warren Buffett and look at what they do. And look at their investments against a twenty punch card test. They fail. They don’t even come close… I used to profess myself a Buffett acolyte too. But somewhere along the line I realised I was a phoney too.”

Hempton seems intent on self-flagellation for his supposed sin of failing the “twenty punch card test”. But we think he’s missing the point by reading Buffett literally rather than figuratively.

Buffett, like many great teachers, offers his wisdom in the form of parables. His instruction to use a twenty punch card ticket to measure your lifetime allowance of investments is meant not as direction to only make twenty investments, but rather as philosophical guidance to help people make their own decisions. Since we know that Buffett himself has made far more than twenty investments, we’d have to call him a “phoney” as well if we were going to interpret his advice literally.

So if Buffett isn’t actually calling for investors to limit themselves to twenty investments, what is he trying to say?

One lesson is that investors should have a bias to inactivity. This lesson was explored by John Huber on his Base Hit Investing blog when he too responded to Hempton’s post. But inactivity, or “buy and hold” investing is another Buffettism that has been fetishized as if it was morally superior to make money slowly rather than quickly. Huber knows this well and some time ago explored the idea that rapid turnover of a portfolio is indeed one way to generate outsized returns.

We feel that the most important lesson of Buffett’s punch card parable is that investments should be made with deep and careful consideration. An investor who strives, as Buffett does, to produce investment returns that are superior to the market needs to acknowledge that doing so is difficult. If all it took to beat the market was to hear an exciting story, peruse Yahoo finance and look up the PE ratio, beating the market would be easy and we all could find hundreds of stocks that were worth investing in.

What Buffett is trying to tell those who care to listen is that you should approach investing as if you had a limited number of opportunities. By considering each investment against a bar of “does this qualify for my twenty card punch list?”, you are forced to greatly raise your requirements and only make an investment when your odds of success seem very high.

The fact is, beating the market is incredibly difficult. But one thing we do know is that investors that own hundreds of stocks (as the average mutual fund does) systematically underperform, while those that manage focused portfolios of a small number of high caliber investments outperform at a much higher rate (for instance, see here, here and here).

So there’s nothing “phoney” about having made more than twenty investments in your lifetime. In fact, I doubt any successful investor has ever made that few. Instead, it is the Buffett acolytes who mistakenly hear his advice as a sort of Ten Commandments of investing that miss the many deep and everlasting lessons he has imparted over his career.

Warren Buffett, of all people, would readily admit that investing is difficult and no checklist of rules will ever turn someone into a great investor. But by grappling with the lessons of the great investors of the past and present (certainly not Buffett alone), investors can attempt to distill some form of insight that can help them in their journey.

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