Sunday, June 29

Week 156 - The Buffett Plan vs. the Top 34 Stocks in Our 63-Stock Universe

Situation: Let’s face it. Here at ITR we recognize Warren Buffett as the “Oracle of Omaha” and endorse his maxims for the retail investor. But up to now, we haven’t explained exactly what those maxims are.

Investing in stocks takes time, and the ability to accept errors as you climb the learning curve. Small investors are in a tough place because they have neither the resources nor advanced knowledge of professionals. What words does Mr. Buffett have to offer us? Let’s look at the maxims: On 5/3/14, at the annual meeting of Berkshire Hathaway, an investor asked Mr. Buffett if she should buy Berkshire Hathaway stock, invest in an index fund, or hire a broker. Warren’s answer was: "We never recommend buying or selling Berkshire. Among the various propositions offered to you, if you invested in a very low cost index fund (where you don't put the money in at one time but average-in over 10 yrs) you'll do better than 90% of people who start investing at the same time." In response to another questioner, he said: "If you like spending 6-8 hours per week working on investments, do it. If you don't, then dollar-cost average into index funds. This accomplishes diversification across assets and time, two very important things." At another juncture, he said: "Just pick a broad index like the S&P 500. Don't put your money in all at once; do it over a period of time. I recommend John Bogle's books. Any investor in funds should read them. They have all you need to know." John C. Bogle is the founder and retired CEO of Vanguard Group. His most recent book is “Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns.”

Before the Annual Meeting, Mr. Buffett sent out his usual letter to investors, taking care to address them as honest and willing beginners who have set up a Trust for their heirs: "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions, or individuals -- who employ high-fee managers." Again, Warren bluntly points out to us that costs are the main issue. Avoid those, let a computer make all the decisions, and you’ll do fine.

Here at ITR, we take a slightly different approach for our one and only specific recommendation. Invest in a very low cost S&P 500 index fund but choose one that is hedged. So, the Vanguard Balanced Index Fund (VBINX) is our benchmark. Readers with neither the time nor the compulsivity needed to pick stocks should dollar-cost average into VBINX. It hedges against the risk that the S&P 500 Index will overshoot in either direction, up or down. You’re buffered against a stock market crash because it invests 40% of assets in a broad-based, high quality bond index. You’re buffered against the “opportunity risk” of not capturing the successes of a booming economy because it invests 60% of assets in a stock index that moderately expands beyond the S&P 500 companies to include international and smaller companies

The result? VBINX lost only 28% of its value during the 18-month Lehman Panic, whereas, the Vanguard 500 Index Fund (VFINX) lost 46.5%. And, by not losing as much during the last two recessions, VBINX has returned 5.0%/yr to investors since the S&P 500 Index reached its inflation-adjusted all-time high on 9/1/00, compared to the 3.4%/yr total return for VFINX (see Week 155). Like the Buffett Plan (Line 49 in the Table), VBINX has a 5-yr Beta of 0.9 (Column I). In other words, it has 90% of the volatility of the S&P 500 Index, meaning you’ll be in for a bumpy ride. Our recommendation is that you build a Rainy Day Fund and resupply it promptly after any withdrawal (see Week 119). To get a significantly less bumpy ride from a broad-based low-cost mutual fund, your best bet is to dollar-cost average into the bond-heavy, advisor-managed Vanguard Wellesley Income Fund (VWINX). It has a 5-yr Beta of 0.51 and lost only 16% during the Lehman Panic, while beating both VBINX and VFINX since 9/1/00 by returning 7.7%/yr (see Week 155). 

In this week’s Table, we compare results for VBINX and VFINX by going back 8 more years, to 9/1/92. We include results for the top 34 stocks in our 63-stock Universe (see Week 155), i.e., those with a Finance Value (Column E) that beats our benchmark (VBINX). The starting point for our analysis (9/1/92) was when the US economy was slowly emerging from the July 1990-March 1991 recession, similar to the current situation. This upturn hit its inflation-adjusted market peak on 9/1/00, and was followed by two recessions. In other words, this week we’re looking at total returns (Column C) from 3 complete market cycles vs. two and a half. 

In September of 1992, the US (and the world) was beginning to emerge from a recession triggered by the collapse of the Savings and Loan industry. Here is the Wikipedia summary of events: “On Black Monday of October 1987, a stock collapse of unprecedented size caused the Dow Jones Industrial Average to fall by 22.6%. This collapse, larger than that of 1929, was handled well by the economy, and the stock market began to quickly recover. But in North America, the lumbering savings and loans industry was beginning to collapse, leading to a savings and loan crisis that put the financial well-being of millions of Americans in jeopardy.” 

Over 3 market cycles, returns for the inflation-corrected S&P 500 Index fund (VFINX) should align with 135-yr returns of the inflation-corrected S&P 500 Index, and they do (see Lines 50 and 52 in the Table): 6.6%/yr for VFINX vs. 6.6%/yr for the inflation-corrected 135-yr returns for the S&P 500 Index. The Buffett Plan had inflation-corrected returns of 6.1%/yr since 1992 vs. 5.6%/yr for VBINX and 6%/yr for VWINX. The secret ingredient of these outstanding returns is the expense ratio, which in every case is less than 0.25%/yr whether you are investing a lot or a little.

Now for a word about inflation-adjusted returns for the top 34 stocks in our Universe (see Table). Sure, these were great over the past 22 yrs: ~8%/yr for defensive stocks and ~12%/yr for growth stocks. But to an accountant they don’t compare that well with the ~6% inflation-adjusted return for the hedged S&P 500 Index fund (VBINX). Why not? There are two reasons: 1) Nobody is going to be prescient or compulsive enough to hold similarly valued shares of all 16 defensive stocks and all 18 growth stocks, so an accountant would point out that sampling errors and selection bias are distorting any one investor’s portfolio (a big disadvantage compared to an index fund); 2) transaction costs are material, meaning that the long-term expense ratio of at least 1%/yr is more than 5% of long-term returns, even in our best-case scenario which assumes that our hypothetical investor builds her entire portfolio online by dollar-cost averaging into dividend reinvestment plans (DRIPs). You’d have to put in 6-8 hours a week and become quite skilled at stock-picking to beat VBINX by 2%/yr over two market cycles.

Bottom Line: Warren Buffett is right, of course, when he says that 90% of small investors will be better served by sticking to Vanguard index funds, particularly the lowest-cost S&P 500 fund (VFINX). The Buffett Plan (see Line 49 in the Table) beats our benchmark (VBINX) over the past 3 market cycles. However, our benchmark beats it on a risk-adjusted basis (see Columns E & I in the Table). And, a low-cost bond-heavy Vanguard mutual fund (VWINX) beats both on a risk-adjusted basis, as does Berkshire Hathaway (BRK-A). Top-performing stocks from our 63-stock Universe (see Table) do a lot better but come with a trifecta of impediments for the stock-picker, including: selection bias, sampling error, and transaction costs.

Risk Rating is 4 for VWINX, BRK-A, VBINX and The Buffett Plan if opportunity cost is included. There is no material difference between these 4 from an accounting point of view but you’ll sleep best with VWINX. Stocks with similar sleepytime advantages include MCD, JNJ and WMT, as well as 4 utility stocks (NEE, XEL, ED, SO).

Full Disclosure of current investment activity relative to items in the Table: I dollar-cost average into T-notes as well as DRIPs for JNJ, XOM, NKE, IBM, KO, NEE, WMT, and ABT.

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