Don't Fall Into The Warren Buffett Trap

Type Warren Buffett into a search engine and you'll be bombarded with results. Just under 26 million results actually. It's easy to understand why.

A while back I sat through a marketing presentation. The presentation highlighted data which showed that by putting a photo of Arnold Schwarzenegger on the front of a sports magazine, you could almost double sales overnight.

I don't know the figures, but I assume the same is true for Buffett.

Just like Schwarzenegger was one of the best male actors/sports personalities of the last century, Buffett is the greatest investor of the last century and others want to replicate his style.

But the harsh reality is you are not Warren Buffett, and you never will be. Even by following his trades and investments, it's highly unlikely that you will ever be able to achieve returns similar to the Oracle of Omaha. Actually, you'll come nowhere close.

A number of financial institutions recently compiled some data on what sort of return the average investor was able to achieve. Over a twenty year period to 2013, the average investor has only produced a total return of 2.5% per annum. The only financial instrument that performed worse than the average investor over the period was the Japanese stock market. Some of the instruments that performed better than the average investor over the past 20 years include: cash (3% p.a.), bonds (3% – 8% p.a.), hedge funds (8% p.a.), REITS (10% p.a.) and all emerging markets (6% – 10% p.a.).

As many investors try to replicate Buffett's style by actively trading (and over-trading as a result), they are hurting their returns. Buffett himself has stated that the best investment for most investors is the index fund. But whatever you do, don't fall into the Buffett trap.

The Buffett trap

It is easy to read up on Buffett and try to replicate his style. There's so much content out there on Buffett and Berkshire it must be easy right?

Wrong.

A month or so ago I covered some of Buffett's earlier investments. These early investments, while deep-value in nature required shareholder activism to unlock value.

Buffett has never really been a strict buy-and-hold investor. In fact, the majority of his investments have involved activism, or some kind of interference on his part. This is something the average investor will never be able to achieve.

And it's not just interference with complacent management teams that's helped Buffett achieve his returns over the years. Inside information and idle corporate chatter has helped the billionaire avoid heavy losses.

Idle chatter

For example, during 1988 Buffett spent $108 million of Berkshire's cash building a stake in Freddie Mac, the giant government-backed mortgage insurance firm. Buffett paid $4 per share for Freddie. By 1998 Freddie was valued at $70 per share. That's a compound annual growth rate of around 33%, a total return of 1,650%.

Then, during 2000 Buffett had a series of meetings with Freddie's CEO. The CEO was jubilant, he believed he could grow Freddie's earnings at a double-digit clip every year for the foreseeable future.

Any analyst, or private investor would have been extremely excited by this news and outlook, but Buffett, after meeting management noticed rifts across the board of directors and became concerned. Berkshire was out within a year. By 2003 it was revealed that Freddie Mac had regularly misreported its earnings, then the company was bailed out by the government during the financial crisis. At time of writing, Freddie's common stock trades at $2.36.

With a holding period return of 1,525% over 13 years, Freddie is considered to be one of Buffett's greatest investments.

Complex deals

As well as corporate inside information, Buffett is able to make deals few others are able to put together.

The financial crisis was actually a highly profitable time for Buffett. He was able to use cash, as well as debt instruments to invest $25.20 billion in six key deals that have returned in excess of 40% so far. Starting at the top, one of the deals involved the $24 billion purchase of Wm. Wrigley Jr. Co. by Mars Inc.. Buffett loaned Mars $4.4 billion and purchased a minority interest in Wrigley for $2.1 billion at a discount to the buyout price. In total, including the Wrigley stake, Buffett invested $6.5 billion and has received $3.8 billion in interest and dividends.

Next, for a total investment of $10 billion, Buffett helped shore up the finances of Goldman Sachs and Bank of America after the financial crisis. But unlike private, or even institutional investors, who are limited to investing in preferred stock and other debt securities issued by banks, Buffett told Goldman he would make a loan in exchange for preferred stock, which paid out a handsome dividend (10% p.a.). Additionally, Buffett demanded warrants to buy $5 billion worth of common stock at $115 per share anytime in the following five years. That purchase would work out to over 43 million Goldman shares — roughly a 10% stake in the company.

Buffett's deal with Bank of America was made along similar lines. Other preferred stock, debt, warrant and equity agreements were made with Dow Chemical, Swiss Re and General Electric during the financial crisis.

Reputation

These are only a small selection of trades Buffett has made over the years but they illustrate a point. Buffett is able to achieve returns other can't because he has built up a strong reputation, bank balance and network of informants over the years. Now even the Berkshire name is being sold as a hallmark of quality.

And if you believe you can replicate these qualities when investing, there's one you might not be able to copy; Buffett's time horizon.

Buffett invests forever, he is not interested in what happens to the company over his lifetime, he's interested in returns over the next century or so. Many investors just think about the next twelve months with no long-term outlook.

Stockopedia tracks the performance of investing strategies that are inspired by the approach of Warren Buffett - you can click here to see them.

Warren Buffett is a master at finding stock market diamonds - you can read more about his approach here. If you want find out more about hunting for big winners in the stock market, a free investment guide from Stockopedia could make a big difference. Stockopedia's Guides to Making Money in Value & Dividend Stocks can help you become a more successful investor in 2015 and beyond. They are simple and straightforward reports on what works in the stock market and explain how to find shares that can enhance your returns.

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