It takes a lot of chutzpah to bet against the greatest investor in history.
But much to my own surprise, that’s exactly the position I’ve found myself taking over the past few weeks.
Here’s how it happened…
In late February, I published an article on Marketwatch.com entitled “Has Warren Buffett Lost It?”
In that article, I casually mentioned that I didn’t think Warren Buffett would be willing to bet that Berkshire Hathaway (BRK-B) would outperform a U.S. small-cap index over the next 10 years.
I thought my bet was a no brainer.
After all, Buffett himself had recently recommended that his heirs invest their inheritance in an S&P 500 Index fund after he himself no longer holds the reins at Berkshire. And since U.S. small caps consistently outperform the S&P 500, it seemed like a slam dunk “Buffett-beating bet.”
Much to my surprise, my proposed bet was picked up as far afield as the Brazilian financial press.
Then I was contacted by longtime Berkshire investor David Rolfe, of Wedgewood Partners, who stepped in to take Buffett’s side of the bet.
Here are the terms of the bet as we set them out.
Rolfe invested $25,000 in Berkshire Hathaway (BRK-B) at the closing price on March 3, 2014, at $116.06.
I invested the same amount in the Vanguard Russell 2000 Index ETF (VTWO) on the same day — at $93.20.
A decade later — on March 3, 2024 — if Berkshire is ahead, I write a check to Rolfe’s designated charity for the amount by which Berkshire outperformed VTWO.
If VTWO ends up ahead, then Rolfe writes my designated charity a check for the amount by which VTWO outperformed Berkshire.
We agreed to look at Morningstar’s “total return” numbers — that is, which investment makes the most money — and ignore calculations of risk-adjusted returns.
Why I’m Betting against Berkshire…
In betting against Berkshire, I am not making a judgment on the company or the quality of its investments. After all, Berkshire remains a current recommendation in my monthly investment newsletter, The Alpha Investor Letter. Nor is it an issue related to the quality of Buffett’s eventual successors. And I will continue to hold Berkshire in my firm Global Guru Capital’s “American Alpha” Investment Program. Furthermore, I regularly generate income in my personal portfolio by selling put options on Berkshire, knowing that Buffett has said he will buy back the stock if it ever drops to 120% of book value.
Instead, mine is more of a bet that U.S. small-cap stocks will continue to outperform large-cap stocks over the coming 10 years — as they always have.
My bet also assumes implicitly, that, because of its size, Berkshire has essentially become a less volatile surrogate for the broader U.S. large-cap stock market.
… And on the Ever-Reliable ‘Small-Cap Effect’
The University of Chicago’s Nobel Prize-winning economist Eugene Fama and his colleague Kenneth French have long argued that small-cap stocks should generate higher returns than large-cap stocks. Indeed, their investment rule of thumb is one of the few that has stood the test of time. After all, small caps are more nimble and are quicker to react to changing market conditions, making them ultimately more profitable investments.
History bears this out. U.S. small-cap stocks have substantially outperformed large-cap stocks over history. David Swensen, head of the Yale University endowment, pointed out in this 2008 lecture that if he didn’t have to consider Yale’s ongoing funding requirements and the trustees’ tolerance for occasional big drawdowns in the value of its endowment, there would be little reason to invest in anything but U.S. small-cap stocks.
The statistics Swensen cites are compelling. Between the bottom of the U.S. stock market in June 1932 and the end of 2006, U.S. small caps rose 159,000-fold. According to my back-of-the-envelope calculations, that’s an Internal Rate of Return (IRR) of roughly 17.56% — far above Buffett’s returns over the past 15 years.
U.S. Small-Cap Stocks: Better than Buffett
So, how has Berkshire’s performance stacked up against small-cap stocks over the past decade and a half?
Not well, with the last five years being particularly rough for Berkshire.
Stretching back over the last 15 years, Berkshire has underperformed the Russell 2000 small-cap index by 2.76% each year. Over the past 10 years, it underperformed by 1.71%. And over the past five years, it underperformed by 8.62%.
Recent experience in the U.S. market confirms both the power and lockstep rigor of the “small-cap effect.” Since the U.S. market bottomed five years ago in March 2009, the Russell Top 50 index of the largest U.S. companies has risen 163%. The Russell 1000, covering the 1,000 largest stocks, has gained 210%. The Russell 2000, covering the next 2,000 stocks, is up 275%. The Russell Microcap index — the smallest of the small — is up 295%.
By way of comparison, Berkshire has risen 162% over that same time period — a performance essentially identical to the Russell Top 50 Index.
The “small-cap effect” strikes at the heart of Berkshire’s biggest weakness… its size.
Berkshire — as Buffett has admitted many times — has gotten too big for its investment britches.
Until about 2000, Berkshire’s annual returns approached an astonishing 30% per year. Since then, its performance has deteriorated remarkably (as has everybody’s!). Berkshire has now lagged the S&P 500 for a decade.
Had Berkshire been able to continue its streak of 30% annual returns since 2000, it would be trading at roughly $1,429 per share — and not around $122. And Berkshire’s market cap would be over $3.5 trillion — about the size of China’s currency reserves.
Inevitably, Berkshire is gradually morphing into a big-cap stock portfolio that is broadly running neck and neck with the S&P 500.
That’s why I am doubtful that Berkshire will be able to match the returns of a small-cap index that, over its long history, outperforms large-cap indices by 2% to 3% per year.
Why I Could Still Lose this Bet
Small caps tend to underperform large caps on an annual basis about one-third of the time. They also fall harder and faster than large caps. If we are in a bear market when the bet ends in 2024 — well, that’s bad news for me.
And you never know how much “Mr. Market” is willing to pay for the same level of earnings at any one time. If small caps are in investors’ doghouse for whatever reason in 2024, I could be out of luck.
In making such a long-term bet, all I can really do is play the odds.
And I’m simply betting that that the “small-cap effect” will continue, even as Berkshire’s share price will be held back by the millstone of its ever-increasing size.
In case you missed it, I encourage you to read my e-letter column from last week about how you can beat the market with share buybacks. I also invite you to comment in the space provided below.
NOTE: Global Guru Capital is a Securities and Exchange Commission-registered investment adviser, and is not affiliated with Eagle Products.