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The Real Reasons Why Buffett Wants You in Index Funds

publication date: May 3, 2021
 | 
author/source: Brian Nelson, CFA

Image Shown: Since mid-June 2015, on a price-only basis, the S&P 500 (SPY) has nearly doubled, while shares of Kinder Morgan have nearly halved.

In Morgan Housel’s The Psychology of Money, chapter 16 leads in with “Beware taking financial cues from people playing a different game than you are.” The people on CNBC are playing a different game than you, and so is Warren Buffett. Buffett’s principles of stock selection are golden, but you must understand that he is near the top of the Forbes’ Billionaires List. He absolutely should be taking his own advice and indexing! With the threat of long-term inflation and price-agnostic trading, the everyday investor, even with a few million in the bank, is not so lucky. Keep your game sharp.

By Brian Nelson, CFA

The market is not terribly inefficient, but at times there are terrible inefficiencies. That’s what our team noticed in mid-June 2015 in a massive mispricing of Kinder Morgan (KMI) and the pipeline MLPs (AMLP), more generally. During the past six years or so, shares of the pipeline behemoth and its MLP brethren have collapsed -- with KMI falling ~56% while the S&P 500 (SPY) nearly doubled. This is probably the best call you have never heard about (sorry for beating a dead horse!).

If you’ve read my book Value Trap: Theory of Universal Valuation, you can read most of the story in the Preface, but there’s much more to it. It takes a tremendous amount of grit to go against the crowd and stick to your guns to help investors. We were so spot-on with our call on KMI and MLPs and focused on our research that we were even told to write about something else by the editor at YahooFinance. Even TheStreet gave us a boot as a contributor (well, I think they did). How can we have been so “right” and be treated so wrong?

Publishing is a tough game folks, and we can never know the motivations of others out there -- but that’s why Valuentum is so important to the marketplace. We’re not only trying to get things right, but we have the experience and know-how to back it up -- and it’s become very obvious during the past decade that fewer and fewer investors know the ins and outs of discounted cash-flow analysis. This has offered members looking to learn about valuation a huge advantage.

But there’s something else I want to tell you. 

Once a Resident of Graham and Doddsville, Why Has Warren Buffett Changed His Mind on Indexing?

You may have heard the media talk about how Warren Buffett says you should invest in index funds. You might wonder: How could someone that has made billions through individual stock selection say this? Well, let me explain my take on his perspective: Warren Buffett thinks you should invest in index funds, not because index funds are your only feasible investment option to long-term success, but rather more because he dislikes most all the other alternatives out there.

From my interpretation of his writings, Buffett believes that most of modern portfolio theory (MPT) and quant analysis is nonsense. He doesn’t believe standard deviation is a good measure of risk (a core component of MPT) and he doesn’t believe there are “growth” and “value” stocks (a core component of “factor” investing and most of money management these days). By promoting indexing, he’s helping investors from falling into the trap of such flawed thinking. But why then isn’t he promoting active management -- how he made his billions?

For starters, the prospect of finding a money manager (or a stock publishing service) that hasn’t been swept into the pitfalls of simple multiple analysis or “factor” investing (and much of its underperformance) is very close to nil these days -- and if not MPT or quant or active money management, then what? Well, indexing is all that’s pretty much left, save for basketball cards or cryptocurrencies and bonds (the latter Buffett believes “are not the place to be these days”). For most investors, indexing may truly be the best route to investing, but it’s our view that Buffett suggests indexing to others primarily because he’s terrified of the alternatives—and justifiably so!

Let’s ponder further.

First, it doesn’t seem like Buffett, when he's gone, wants Berkshire Hathaway (BRK.A) (BRK.B) to ever turn into the next Long Term Capital Management (LTCM), a quant hedge fund that went under in the 1990s. In choosing the heir to the CEO position at Berkshire Hathaway, Buffett has opted for Greg Abel. According to Seeking Alpha, the Oracle has said that Abel is a “first-class human being--There's a lot of smart people in this world but some of them do some very dumb things. He's a smart guy who will never do a dumb thing." Knowing what we know about what Buffett thinks of traditional "quant," this means he's picked someone that will avoid quant's pitfalls (and that pretty much eliminates most of active management these days). 

Second, as a multi-billionaire, Buffett seems extremely risk-averse these days. When he's gone, it doesn't seem like he would want his money to be lost on the next "hot" trend, as there will always be one and the temptation to take on too much leverage to gain exposure to it. According to reports, the trustee for his estate when he passes will invest 90% of his money into index funds. His support for index funds, in our view, seems to be fueled by the desire to not leave his money in the hands of a (quant) manager that will blow up his legacy. With the industry going all-out “quant," that doesn't leave many options for the future.

In truth, it’s hard to really know what drives an investor’s views, but in my opinion, Buffett believes indexing to be the least-worst option for others, all things considered--and he might be right. It may not be the best option, however, and that’s what matters when it comes to putting investors’ interests first. After all, the Oracle of Omaha, himself, didn’t make his fortune by investing in an S&P 500 index fund, but rather through prudent individual stock selection. It’s the classic “do what I say, not what I do.” There’s nothing wrong with Buffett’s stance and his shift in perspective, but it’s important we’ve parsed through the motivations behind it to better understand where he’s coming from.

What About Those Pipeline MLPs?

With that said, let’s briefly update our views on the pipeline MLPs to keep our articles value-added from an equity perspective. Following a few first-quarter 2021 reports from key pipeline bellwethers, we still see little reason to rush out to consider the group. Magellan Midstream Partners (MMP) and Enterprise Products Partners (EPD) are comparatively small weightings in the High Yield Dividend Newsletter portfolio, and for those willing to seek exposure to the space, we view these two as best-of-breed in this high-risk space.

Most pipeline MLPs remain capital-market dependent, and we continue to have big issues with the term distributable cash flow, not to be confused with discounted cash flow, though both are often shortened to ‘DCF.’ The structural characteristics of the midstream MLP space have not changed since we warned about them years ago, and while risk-seeking yield-chasers may be tempted to make a few well-placed bets for income, know the risks. Their payouts are far from safe.

Heeding our views on pipeline MLPs years ago was a wise one -- and perhaps today, taking our perspective on why Buffett likes indexing may be the right way of looking at things, too. Indexing and price-agnostic trading will continue to proliferate, and the markets will only become more and more distorted by such activity (e.g. GME, AMC). These conditions don’t speak to support for a passive approach, but rather support for one that stresses active risk management through active stock selection.  

In the past, I have talked about the underperformance of the 60/40 stock/bond portfolio relative to the SPY during the past three decades or so--and how being active in a market environment that could see shares of larger and larger companies go bonkers may be well worth the price. It’s never easy to go against conventional beliefs in MPT or “factor” investing, or even Mr. Buffett at times, but from where we stand, active stock selection is still the best tool in the kit. Stock prices and returns will always, in part, be based on future expectations of traditional free cash flow.

Concluding Thoughts

In Morgan Housel’s book The Psychology of Money, chapter 16 leads in with “Beware taking financial cues from people playing a different game than you are.” The people on CNBC are playing a different game than you, and so is Warren Buffett. Buffett’s principles of stock selection are golden, but you must understand that he is near the top of the Forbes’ Billionaires List. He absolutely should be taking his own advice and indexing! With the threat of long-term inflation and price-agnostic trading, the everyday investor, even with a few million in the bank, is not so lucky. Keep your game sharp.

Now read: The Best Years Are Ahead

Also tickerized for the top holdings in the AMLP.

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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, and IWM. Brian Nelson's household owns shares in HON, DIS, HAS. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

1 Comments Posted Leave a comment

Donald Johnson (Greenwood Village)
 

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