Mebane Faber, Forbes.comPicking stocks is hard. Academic research has shown that most individuals and professionals underperform their benchmark indexes. That is not surprising given new research from Blackstar Funds that shows that roughly two-thirds of all stocks underperform their index over their lifetime, 40% are unprofitable investments and nearly a fifth lose at least 75% of their value.That being said, would anyone deny that there are some managers who are very good at stock picking? Warren Buffett is certainly good at it; so are David Einhorn, Seth Klarman and David Tepper--all elite money managers that have proven they can pick winning stocks consistently. Just like any other profession, there are people who are experts in their field and these top professionals get paid handsomely for what they do.Top 10 Buffett StocksBuffett Wit And WisdomIn Pictures: Seven Ken Fisher Super StocksIn Pictures: Biggest Billionaire GainersHomes Of The BillionairesBy reviewing the publicly available SEC form "13F," you can see the holdings of these and any other professional money manager with assets under management of more than $100 million. The data is uploaded to the SEC Web site no more than 45 days after the quarter's end, and an investor can view the holdings free of charge. By reviewing the 13Fs, you can view and understand the holdings of every manager from George Soros and Carl Icahn to T. Boone Pickens and Warren Buffett.Typically, the best investors to choose for this analysis are managers who employ long-term holding periods (in Buffett's case he has stated that his favorite holding period is "forever"). This will minimize the effects high turnover would have on the portfolio, and the 45-day delay in reporting times should not be a major factor in performance.Here are potential benefits of using a 13F strategy versus allocating to a hedge fund manager:Access: Many of the best hedge funds are not open to new investment capital, and if they are many have high minimum requirements (in excess of $ 10 million in many cases). As Mark Yusko, owner of Morgan Creek Capital, said in Foundations and Endowment Investing, "We don't want to give money to people that want our money. We want to give it to people that don't want it."Fraud & Transparency: The investor controls and is aware of the exact holdings at all times, thus eliminating fraud risk.Liquidity: The investor can trade out of the positions at any time, vs. monthly, quarterly or longer lockup periods at hedge funds.Fees: Most funds charge high fees, the standard is 2% management and 20% performance fees. Fund-of-funds layer on an additional 1% and 10%. These fees would require a portfolio to generate 17% gross returns to deliver a 10% return to an investor. The fees associated with managing a 13F portfolio are simply the investor's routine brokerage expenses.Risk targeting: The investor can control the hedging and leverage to suit his risk tolerances. Blow-up risk from leverage or derivatives is eliminated.Below I take a look at a single manager--Warren Buffett--as a case study in how the cloning process looks in action.Warren Buffett is one of the most celebrated investors of all time. Buffett learned his craft from his mentor, Benjamin Graham, author of the legendary tomes Security Analysis and The Intelligent Investor. Graham ran his own investment partnership for years, grounded on the concept of buying stocks that were cheap compared to their intrinsic value. He preached about buying securities that had a "margin of safety." After a lifetime spent studying stocks, Graham stated the following in the Financial Analysts Journal (1976):"In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook Graham and Dodd was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors."And Graham came to this conclusion prior to the advent of the Internet, Bloomberg and other modern research tools. The efficient market hypothesis (EMT) was certainly making the rounds through academia and the investing public at the time. However, Warren Buffett has famously dismissed the theory, stating, "I'd be a bum on the street with a tin cup if the markets were always efficient." Would the student be able to prove the teacher wrong?Buffett's chairman's letter in the 2009 Berkshire Hathaway annual report indicates that the per-share book value of Berkshire Hathaway has increased at a compounded annual rate of 20.03% since 1965. Compared to an average of 9.3% for the S&P 500 including dividends, the outperformance is astonishing.For Buffett's style of value investing to be successful, the efficient market theory must not be valid. Buffett himself has said, "the disservice done to students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us."While Warren Buffett has practiced some hedge fund techniques such as trading currencies and commodities, merger arbitrage, convertible arbitrage, PIPEs, and private equity, he is known mostly for his equity investments. There have been numerous books that have tried to divine exactly how Mr. Buffett goes about selecting his investments. The American Association of Individual Investors (AAII) has developed screens that are designed to find companies that Warren Buffett would buy based on criteria he has promoted in the decades of public speaking, annual reports, and prior transactions.Indeed, some investors simply buy Berkshire Hathaway stock, gaining access to his portfolio management skills, exposure to the operations of an insurance conglomerate, and entree into the Berkshire Hathaway annual shareholder meeting.An investor who wants exposure to Buffett's investing acumen can invest in any of the mutual funds that share the Buffett investment style. When Warren Buffett closed his investment partnership in 1969, he advised his investors to place their money in the Sequoia Fund, managed by Ruane, Cuniff & Goldfarb (which reopened in 2008 for the first time since 1985). The Tweedy Browne family of funds is another good example, in fact, the firm was founded by several employees of the Graham-Newman partnership.But why not just buy what Warren buys? I set out in this writing to examine whether following Berkshire Hathaway's investments utilizing Form 13Fs could offer the investor the opportunity to piggyback on Buffett's stock picks, and consequently, achieve outsized excess returns.Buffett's current clone portfolio would be: Coca-Cola Company, Wells Fargo, American Express, Procter & Gamble, Kraft Foods, Wal-Mart Stores, Wesco Financial, ConocoPhillips, Johnson & Johnson, and U.S. Bancorp.The results for the period from 2000 to 4/15/2010 are found below. The Buffett portfolio with 10 long holdings equal-weighted and rebalanced quarterly is compared to the returns to the broad U.S. market (S&P 500).The first observation is how dismal the returns have been for stocks this decade. Zero return with a near 50% drawdown is depressing indeed. (The drawdown figures are currently at a monthly resolution, daily data would result in a larger drawdown.)Buffett S&P 500 Annualized return 8.9% 0.0% Volatility 15.4% 16.0% MaxDD* -43.0% -50.9% *maximum peak to valley drawdown, measured monthly Source: AlphaCloneBuffett returns more than 8% a year, which doesn't sound that spectacular but $100,000 invested in the Buffett portfolio would be worth approximately $240,000 today vs. about $100,000 invested in the S&P500. About 85% of Buffet's portfolio is concentrated in his top ten holdings. Volatility was low, surprising given that the portfolio contained only 10 holdings.If you ran a mutual fund with these numbers you would be one of the best performing mangers in the U.S. over the time period. A recent academic paper has examined the strategy for Buffett all the way back to 1976 and found results consistent with mine. From the abstract: Contrary to popular belief, we find Berkshire Hathaway invests primarily in large-cap growth rather than "value" stocks.Over the period the portfolio beat the benchmarks in 27 out of 31 years, on average exceeding the S&P 500 Index by 11.14%. We find that Berkshire Hathaway's portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value. While increased volatility is normally associated with higher concentration we show the volatility of the portfolio is driven by large positive returns and not downside risk.Tomorrow, I will review the strategy of a group of superstar long-term investors that I call tiger cubs because their funds were all spawned by Julian Robertson's Tiger hedge fund.Mebane Faber is a portfolio manager at Cambria Investment Management and a cofounder of AlphaClone. He recently published the book The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.News posted by www.newsinfoline.com
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