Ideastorm #15
Ideastorm #15
How Buffett made 50% returns, the pollution premium, gold as an investment, and more..
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Actionable Insights
Buffett grew his private account from $0 to $500M, leveraging fringe inefficiencies in the market.
Companies that were excluded from the ESG list generated statistically significant alpha.
Low-volatility stocks are more effective than gold in reducing volatility without sacrificing returns.
Looking at fundamentals, large-cap growth stocks are over-valued, and large-cap value stocks are under-valued.
Little fringe inefficiencies
One of Buffett’s most controversial takes came from an interview he gave to Bloomberg in ‘99.
"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's 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."
Buffett doubled down on this at the 2019 Berkshire Hathaway annual meeting.
I can assure you if Charlie was working with a million, or I was working with a million, we would find a way to make [50% a year] that with essentially no risk, not using a lot of leverage or anything of the sort.
Buffett ended by stating that the key to making these kinds of returns is to focus on "little fringe inefficiencies that people don't spot."
A classic example of such an inefficiency Buffett found was with Bayuk Cigars in 1982. Bayuk was the fourth-largest cigar maker in the U.S. but had been in decline for the past decade. The shareholders voted for the company to liquidate its assets and distribute the proceeds. The expected liquidation value was $27M ($15 a share).
But before the sale could happen, the DOJ blocked the sale of the company to American Maze. Instead of a single sale, Bayuk sold one of their business holdings to Culbro for $10M and hoped to find a buyer for the rest over the next few months.
Buffett started buying Bayuk at $13.50 in March 1982. The idea was that Bayuk would pay $8.00 within weeks (from their sale) and the remaining $4 within the next few months. As Buffett anticipated, Bayuk was able to sell the rest of its business by June for $5M.
Even though the total distribution of $16.13 produced a 20% return on Buffett’s $13.50 purchase, the front-loaded payouts pushed Buffett’s IRR to 50%!
Source: Bayuk Cigars (turtlebay.io)
The Pollution Premium
A 2023 report published in the Journal of Finance highlighted that a long-short portfolio that invests in companies with high toxic emissions generates an alpha of 4.42% per annum. This pollution premium could not be explained by any of the existing systematic risks.
A simpler way to expand this concept would be to check the performance of companies excluded from the ESG index. When researchers backtested the firms that were excluded from Norway’s Oil Fund (oh, the irony), the excluded firms had an alpha of ~5%.
Another interesting finding was that most firms do not change sufficiently to have their exclusions revoked. Only the firms with very high investment needs (or desperate for liquidity) were likely to act to get their ESG ratings upgraded. This is reflected in the portfolio performance as firms that improve their ESG ratings subsequently do not exhibit superior performance.
Source:
The Expected Returns of ESG Excluded Stocks. Shocks to Firms Costs of Capital? Evidence From the World’s Largest Fund (SSRN)
The Pollution Premium (SSRN)
Does Gold act as an inflation and volatility hedge?
Warren Buffett’s first rule of investing is to never lose money, and his second rule is to never forget the first rule. While Buffett eschews investing in gold, most investors consider it a great inflation hedge and a safe haven in times of crisis.
To test this theory, Pim Van Vilet and Harald Lohre examined the strategic role gold plays in investment portfolios.