"Buffett buys control of companies. He is not a stock picker."
-- Dan Solin
Wait, what? Come again?
The preceding is a comment from investment writer Dan Solin responding to a reader of his recent post "Foolish Advice From the Motley Fool." The advice that he's referring to came from yours truly.
Now let's get something straight right up front here: I actually agree on the big picture with Solin. He directs the masses toward investing in low-cost index funds, and that's the right place for them to be. For the great majority of people out there that are saving for retirement or hoping to put children through college, index funds are a great way to capture the market's returns without getting burned by half-baked stock picks or scalped by high fees.
But it's the "why" of Solin's fervor for index funds -- and, more specifically, his use of some Warren Buffett quotes to back his position -- where we differ. Originally, I chided Solin for misconstruing Warren Buffett's advice regarding investments in low-cost index funds. In his follow-up, he fired back with some Buffett quips that he thinks back up his position, but I think he's still a bit off target.
Warren the stock picker
Solin implies that Buffett would agree with the efficient markets theory and concede that it's not worth trying to beat the market because all news and other information is already priced into stocks.
In reality, Buffett scoffs at that idea. In a possibly apocryphal quote, Buffett cracks, "I'd be a bum on the street with a tin cup if the markets were always efficient." While the veracity of those particular words might be questionable, anyone that's read Buffett's article "The Superinvestors of Graham-and-Doddsville" could easily picture that coming out of his mouth.
And Buffett certainly hasn't just talked the talk when it comes to beating the market. Though Solin asserted that Buffett is not actually a stock picker, his long career strongly suggests otherwise. Buffett began his career at Graham-Newman, a highly successful money management company and left to found his own market-crushing investment partnership. And during his long run at the head of Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) , Buffett has made his investors very significant amounts of money through his stock picking -- and that's whether we're talking about classic wins like picking up American Express (NYSE: AXP ) in the wake of the Allied Crude Vegetable Oil scandal or more recently sinking a significant amount of capital into Goldman Sachs (NYSE: GS ) right in the middle of the financial crisis.
Solin is correct in noting that Buffett buys control of entire companies, but that's simply something that he's increasingly done as Berkshire has grown in size. When you're throwing around hundreds of billions of dollars, it becomes a little tougher to move the needle without buying entire companies. But to characterize Buffett's career as such would be like saying that Lenny Dykstra was an options trader. Sure, Nails had a (ill-advised) foray into trading and other business ventures after his baseball career was over, but it was baseball that made him a great.
What Buffett really thinks
Buffett doesn't think markets are efficient and he's spent his entire career backing that up. He does, however, think that index funds are great for a wide swath of investors. Why? Because, as he points out in the "Gotrocks" parable in his 2005 letter to Berkshire shareholders, the cost of frenetic trading activity and mutual fund and other advisory fees can easily get out of hand and slash the returns that investors are actually pocketing. In the end, he sees it as better to simply own the entire market and pay little in fees.
What Fools think
As I noted above (and in my original article), for most people index funds are a great way to go. But at The Motley Fool I don't write for most people. My barber has never heard of The Fool, my dentist doesn't care about what I'm writing, and even my wife has to be cajoled to ever read my articles. I would recommend that these folks do anything but invest in index funds no more than I'd recommend a couch potato try to run a marathon.
The folks I write for see tickers when they walk down grocery aisles and know that "SEC filings" aren't college football schedules. They aren't in it for the "thrill of the chase" as Solin puts it -- they're investing time and effort to find companies that the market has mispriced below their true worth.
And interestingly, I have a sneaking suspicion that beneath his tough efficient markets exterior, Solin may actually be a bit Foolish himself. After all, though he quickly dismisses my use of valuation metrics in identifying potential outperforming stocks ("It is incorporated into the price of these (and all other) stocks, making the current price a fair price."), he notes that in his index fund advisory business he constructs portfolios with "a tilt toward small and value" in following the findings of Fama and French. Call me crazy, but I'm not sure that there's another way to determine "value" other than looking for value-like, um, valuations. So, like I said, maybe there's not as much of a gap between us after all.
Investor, know thyself
So, should you be trying to pick individual stocks? The answer lies in, as Benjamin Graham puts it in The Intelligent Investor, "the amount of intelligent effort the investor is willing and able to bring to bear on his task."
In my original article I quipped that many folks would rather "watch a Dharma and Greg rerun, reorganize their closet, or go to the dentist" than do the research required to invest in individual stocks. I meant this not to be demeaning to index fund investors, but rather highlight that most people don't find investment research particularly engaging. The index fund route is perfect for this group -- they can easily capture market returns, avoid massive fees, and get back to the more rewarding aspects of their lives (yes, even if that is Dharma and Greg).
But for those of us willing to invest time in research and diligence, well, let's just say I don't see a perfectly efficient market getting in our way.
You've heard my piece, now I want to hear what you think. Head down to the comments section and sound off!