Warren Buffett bought his first shares of GEICO sometime in the late 1970s. His average cost was $6.67/share. Seven years later, the company generated about $9/share in after-tax operating profit. Buffett, in other words, bought GEICO for less than 1x earnings seven years out. The underlying business is one of the best business franchises in history. The investment goes down as one of the best investments of all time.
There are two sides to every blockbuster investment: the enlightened investor that sees the opportunity and the poor slob that sells it to him.
When Buffett bought his shares of GEICO in the 1970s, he quite literally swiped value from the seller. Value shifted from the seller to the buyer the moment Buffett bought the stock.
A broad and diversified portfolio of equities held over very long periods of time - that is, through multiple stock market cycles - compounds at about 10%. The 10% average long-term return for equities is just that: an average. A distribution of actual returns for individual investors exists around the 10% average. Some investors will experience returns above the average and some investors will experience returns below the average.
The distribution of returns above and below the average is a zero-sum game. That is, what one person wins another person loses. If one investor achieves a return above the 10% average, another investor must achieve a return below the average.
The dispersion of returns around the long-term average is set in motion every time a mispriced security changes hands.
Many trades are done at prices within the range of fair value. Not much value changes hands with those.
Other trades are done at prices outside the range of fair value, some higher than the range and others lower. It is those trades done at prices outside the range of fair value where value shifts from one participant in the trade to the other.
For trades done at prices far below the range of fair value – like Buffett’s GEICO trades in the 1970s – value moves from the seller to the buyer. For trades done at prices far above the range of fair value, value moves from buyer to seller.
Some asset managers are consistently on the wrong side of most trades, buying overvalued stocks and selling undervalued stocks. They don’t last long.
Most asset managers flip back and forth. At times they buy overvalued stocks and sell undervalued stocks and at other times buy undervalued stocks and sell overvalued stocks. The value they give away with the former offsets the value they give up with the latter. Reams of asset managers with average or below average performance fall in this category. Performance is a crap shoot for them. Sometimes they win. Sometimes they lose. Their long-term return relative to the averages boils down to luck, both good and bad.
Then there are the asset managers who somehow find a way to buy under-valued stocks and sell over-valued stocks more frequently than the reverse. No one bats a thousand in the asset management business, but there are those managers that over long periods of time swipe more value than they give up. Those are the managers that put together superior and enviable long-term records.
Buffett set himself up for good long-term returns the moment he bought GEICO at a steep discount to value. The seller meanwhile, remains a faceless counterparty to the trade, one that most likely was relegated to the long list of underperforming managers that find themselves on the wrong side of too many trades. The seller didn’t really understand the investment. Buffett, in the end, knew the investment far better than his counterparty.
Managers that put together superior track records, as a rule, are aware of who might be taking the other side of their trade and, importantly, why they might be either selling or buying at prices outside the range of fair value. Good investors work every day to ensure they understand the investment better than their counterparty. Only then can they be sure they are swiping more value than is being swiped from them.
It is shocking how few asset managers view the asset management business as a competitive zero-sum game. The ones that don’t, generally fall into one of the first two categories of managers just described. They either don’t last long or they limp along with below-average performances that don’t justify the fees they charge.
Under-performing managers typically don’t see the zero-sum-game aspect of the asset management business; they blindly let more enlightened investors swipe value from them. They are sadly unaware it is even happening. Without even knowing it, they get outmaneuvered.
At KP7, we do our best to make sure we are on the right side of more than our fair share of trades. We study our competition. We try to know our investments better than the person taking the other side of our trade. We do all we can to swipe value and make sure our competition are the ones being outmaneuvered.
