Warren Buffett Misunderstood

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Warren Buffett Misunderstood
Greg Forsythe
CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
February 27, 2007

Excerpted from the February 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Warren Buffett is unquestionably one of the greatest stock market investors ever. But while much of his stock-picking philosophy can be readily grasped and put to practical use, I believe there are at least two "Buffettologies" that are commonly misinterpreted in ways that could harm unsuspecting investors.

Buy and hold?
There's no doubt Warren Buffett is a long-term investor. He looks for outstanding businesses that he can buy at a fair price with the intent of holding them for a long time—"ideally forever." Unfortunately, Buffett's philosophy is often twisted into advice like "Search for a few great companies whose stocks you can buy and hold forever."

Of course, there's nothing wrong with being a long-term investor and focusing your research on finding high-quality stocks, though it's much easier said than done. My problem is with the belief that a buy-and-hold strategy can be successfully applied to individual stocks (as opposed to mutual funds). It's easy to name some stocks that could have been bought years ago and profitably held until today. But remember, those winners are known now with the benefit of hindsight—and, just as troubling, are less common than many presume.

A recent study showed that high historical growth rates do not tend to continue into the future. For example, a company with above-average five-year historical earnings-per-share (EPS) growth is no more likely than chance to have above-average EPS growth five years from now.¹ Why? Competition, market saturation, operational complexity and technological change are just a few of the forces that conspire against high sustainable growth rates. Worse yet, since investors tend to believe growth persists, stocks with high historical growth rates tend to underperform when actual growth falls short of optimistic forecasts.

So if finding quality stocks to buy and hold is so hard, how does Buffett do it? Despite his desire to hold "forever" when first buying a stock, Buffett doesn't actually do it all that often. Contrary to popular belief, Buffett buys and sells stocks all the time. His approach is better described as "Buy with a long-term perspective, hold while ignoring intermediate business and market fluctuations, and sell when long-term business prospects are no longer attractive." Or in short: "Buy and hold until the facts change."

The primary reason Buffett has held stocks like Washington Post and Coca-Cola for so long is that they have retained the attributes he originally found attractive. But over the last decade, Buffett has sold holdings such as McDonald's, Disney and Freddie Mac when he felt they were no longer worthy of his capital.

Concentrate your investments?
Buffett has also preached that stock investors should be patient in searching for truly great opportunities and should only buy stocks in businesses that are fully understood. In Berkshire Hathaway's 1993 Annual Report, he said, "If you are ... able ... to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense." Unfortunately, Buffett's research and portfolio management philosophy is often twisted into advice like "Buy a few great stocks you know very well and don't worry about diversification."

I have no issue with Buffett's premise, but investors too often forget that his statement above starts with the qualifying word "if." Again, finding such exceptional investment opportunities is much easier said than done. Be aware that the volume of research you do on a stock or how well you know a company does not guarantee market-beating returns. The stock market rewards exceptional returns only to investors who discover something material about a stock that hasn't yet been uncovered by other investors. In other words, the market rewards positive surprise anticipation, not just knowledge or familiarity. So while focusing your investments in a few stocks can potentially produce great returns, a concentrated portfolio will likely be volatile and will outperform only if you are right in your stock selections. If you're wrong, look out below!

Lessons for investors
Properly applying Buffett's wisdom has the potential to improve any investor's results. Retaining a long-term investment horizon, staying fully invested, being patient while searching for opportunities, ignoring short-term market fluctuations, and buying and holding stocks until their prospects fade are all solid directives.

Schwab Equity Ratings can be a great tool to help you be selective about which stocks to buy and when to sell. The strategy of constructing a diversified portfolio of dozens of stocks, managed using the discipline of buying A's and selling D's and F's, has historically produced fine results with low portfolio turnover. Perhaps an even better solution that provides greater diversification with less effort would be to consider the mutual funds or managed accounts based upon Schwab Equity Ratings.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

1. Chan, Louis, Jason Karceski, and Josef Lakonishok, "The Level and Persistence of Growth Rates," The Journal of Finance, April 2003.

Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio. Please read Schwab's Schedule H of Form ADV for important information and disclosures relating to Schwab Managed Account Services™. Services may vary depending on which money managers you choose, and are subject to a money manager's acceptance of the account.

The Schwab Equity Ratings are not personal recommendations for any particular investor; do not take into account the financial, investment or other objectives; and may not be suitable for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Schwab Equity Ratings are based upon a disciplined, systematic approach that evaluates each stock on the basis of a wide variety of investment criteria from four broad categories: Fundamentals, Valuation, Momentum and Risk. This approach attempts to gauge investor expectations since stock prices tend to move in the same direction as changes in investor expectations. Stocks with low and potentially improving investor expectations tend to receive the best Schwab Equity Ratings ("A" or "B" ratings), while stocks with high and potentially falling investor expectations tend to receive the worst Schwab Equity Ratings ("D" or "F" ratings). From time to time, Schwab may update the Schwab Equity Ratings methodology.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment or investment strategy. All expressions of opinion are subject to change without notice.

The Schwab Center for Investment Research® is a division of Charles Schwab & Co., Inc.

All charts and research have been compiled from publicly available, proprietary and/or licensed data.

Past results are not indicative of future performance.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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