It's Not Always a Good Idea to Follow Warren Buffett

Many investors look to Warren Buffett for monetary guidance, but it isn't always a great idea to follow the leader. 

In the video below, Motley Fool financial analyst Michael Douglass talks with senior banking specialist John Maxfield about Buffett's decision-making prowess and how some of his investment ideas aren't worth following for individual investors.

Michael Douglass: All about Warren Buffett, and the key to successful investing may not be what you think it is. This is Industry Focus.

[INTRO]

Hi, Fools, Michael Douglass here, financial analyst with The Motley Fool. I'm here with our senior banking specialist, John Maxfield from Portland. John, how's it going?

John Maxfield: Great. It's great. It's good to be with you, Michael.

Douglass: Fantastic. We're going to be talking about two articles that you've written recently, so I guess we'll just call ourselves The John Maxfield Show today -- which I'm OK with!

Let's start with Warren Buffett, superinvestor; everybody loves hearing what Buffett's got to say. You've titled this article, "Warren Buffett Does Things That You Shouldn't Try at Home." I encourage people to check it out on Fool.com.

It's an interesting article because it basically says, "Listen, a lot of people like to follow Buffett, but that's not always actually a great idea." Walk us through your reasoning here, John.

Maxfield: A lot of people look at Warren Buffett and they say, "This guy buys great companies, he pays reasonable prices." If you look at his portfolio, this has really been borne out over the years, that this has resulted in remarkable investment returns.

But here's the problem: If you look at any one individual investment, you can't just assume that he's buying a great company or, what he would say, "a wonderful company" at a reasonable price.

Here's the reason. Buffett applies a number of different investment philosophies to his own approach to investing the additional cash proceeds at Berkshire Hathaway (BRK.A 0.99%) (BRK.B 0.91%). There are really three main influences on his thought process.

There's Benjamin Graham, which is really his original mentor. Benjamin Graham is the author of The Intelligent Investor. I think he was mainly writing in the '30s. He had an investment fund starting in the late '20s, I think, through the '30s and '40s and '50s. He's also a professor at Columbia Business School, which is how Warren Buffett got to know him.

But he talked about, what you should do is focus on cheap companies, where there's a big difference between what you perceive to be the intrinsic value and what the market is valuing it at. The problem with that is that most of those companies aren't actually really good companies that you can hold over a very long time. That's one approach.

The second approach that he uses, he adopted from Philip Fisher. Philip Fisher was a growth stock guy. Basically he says, "What you do is just buy the most amazing companies that you can find, that you think have a lot of room to grow in the future, and you buy them really irrespective of price."

So, you have Graham on one side saying, "You focus on price, somewhat irrespective of quality." You have Fisher on the other side saying, "Quality, somewhat irrespective of price."

Then you have Charlie Munger, who is the vice chairman of Berkshire Hathaway. He's come in and influenced Buffett and said, "What you want is really good companies, but you pay a reasonable price for it." It's in the middle ground.

Any individual investment that Buffett goes into, if you're going to follow into it, you need to know which of these philosophies he's following, to know if that fits into your own portfolio.

Douglass: That makes perfect sense, particularly when you're talking about value. I just couldn't think of that quote about "cigar butt stocks," that might just have a couple puffs left in them, that maybe the market has left for dead.

Of course the problem with deep value like that is that unless you've really, really done your homework, you are going to get absolutely hammered on returns.

For me, I remember my very first stock was this Greek dry bulk shipper. I thought, "Oh man, deep value. There's a forward P/E of like 6." Of course, that was because they had serious cash flow problems. They've lost 85% of their value since then, and I just got creamed.

But it was a good lesson about the fact that if you really think that you're going to find that inefficiency in the market, that the market's missing, chances are remarkably good you can't actually find that inefficiency easily yourself unless you've done a lot of homework.

Maxfield: I agree with that. The other thing to keep in mind is that, when we're talking about individual investors, when we're out in the market buying and selling stocks, we have all these other competitors. The question is, what is our competitive advantage as individual investors?

The answer to that is time. We do not have to report our earnings or our investment results on a quarterly or annual basis, so we can hold things for a long time. We don't have to trade in and out of stocks to make things look better.

By holding things for a long time, that is our one competitive advantage. If you're going in and buying these cigar butt stocks, there is a potential that you're not going to be able to take advantage of your one competitive advantage -- that is time -- because these companies aren't going to live for that long.

Douglass: Yes. When you're talking about competitive advantages, that's the big competitive advantage we have on mutual funds. Mutual funds, a bunch of people decide to exit, the fund has to sell at whatever price. That's a really painful thing for them, and that really does give people opportunities to pick stocks up for perhaps less than they really are worth.

Another point that you made in the article, and I thought this was a really important point for people to know about, is that when you're looking at big investors; folks like your Buffetts, your Icahns, your Bill Ackmans, your George Soroses, they don't play exactly by the same rules we do.

They can negotiate for things to be a little bit different. Just because somebody picks the stock ... you really need to understand the background of that deal and what the fine print of that deal was.

Bank of America (BAC 2.06%) was one of your big examples of Buffett picking up a stock, but maybe not for reasons because he thinks this is a great company, and also because he hedged his bets. Let's talk about that a little bit.

Maxfield: To your point, when you look at Buffett's investment in Bank of America, he has these warrants to buy 700 million shares at $7.14 a share. If you convert that into actual common stock, it turns out that Bank of America is Warren Buffett's fifth largest holding at Berkshire Hathaway.

You look at that and you say, "Wow, Warren Buffett must think that Bank of America is just this remarkable company," particularly when you look at the other banks that he owns. He owns Wells Fargo (WFC 1.24%) , US Bancorp (USB 1.48%) , and M&T Bank (MTB 1.60%) , and those are categorically the best banks in the country, in terms of how they're run and the profitability and the return for investors.

Then when you dig into the details of that Bank of America deal for Buffett, you're talking about apples and oranges. This is just not an analogous thing.

This was in 2011, when he made the investment. He went in -- this was when Bank of America shares were trading like $6.00, $6.50, $7.00, in and around there -- and he said, "Look, Brian Moynihan ..."

He called the CEO of Bank of America, Brian Moynihan, and said, "Look, this is what we'll do. I'll invest $5 billion into preferred stock that yields 6% with Bank of America."

This is $5 billion worth, so he gives them $5 billion, and he gets $5 billion of preferred stock back. But on top of that, Buffett demanded that Bank of America give him warrants to purchase 700 million shares of Bank of America's common stock at $7.14 a share, so that basically he's already doubled his investment right there.

A typical investor just can't get a deal like that, so you can't look at Buffett going into a Bank of America and say, "That means that I should follow him into it," because you're just not going to get that premium.

To a point that you made earlier, before we were actually filming, Buffett took out all the risk of that deal for him by structuring in that way. You and I, or the other individual investors, simply can't do that when we just purchase common stock.

Douglass: Yes. As you noted before -- I guess we just had this separate conversation that was really helpful then -- Buffet basically set up a "Heads I win, tails I win" kind of thing.

We knew the government wasn't going to let Bank of America die, because this was in 2011, after that conversation has already occurred. The government was like, "No, we're really going to step in," so he had baked all of his downside out, so it was just potential upside for him.

So, blindly following Warren Buffett -- or any superinvestor, for that matter -- maybe not your best move, particularly if you're not reading the fine print, and particularly if you don't understand what different philosophies are at play there.

This actually brings me very nicely to the other article of yours we wanted to talk about, which was that the key to great investing isn't always what you think it is.

We always talk about that Warren Buffett quote, the 12 words. "Be greedy when others are fearful, and fearful when others are greedy," but not necessarily something that should be applied at all times.

Maxfield: That's true. Now, let's be clear Michael. If you want to succeed in the market, you've got to be a contrarian, which means that you're going against the crowd in the investments that you make.

However, and this is really where the nuance comes into play, if you read the great stock speculators, the great investors of the past, what you come away with is not that these guys are focused on being contrarians, because they're actually not. Being contrarian is rather a natural byproduct of their extreme intellectual independence.

It's no coincidence that Warren Buffett lives in Omaha, Nebraska. Let me be clear; I grew up in Wyoming, about seven miles away from the Nebraska border, so I'm very fond of Nebraska. That's where our family business was. But it is far from a financial hub in the global economy!

If you read back, all these other -- Jesse Livermore was a famous stock speculator in the past; Philip Fisher, which is one of Buffett's mentors, another famous and successful investor -- all of these guys say, "Look, you've got to be independent in your thought process."

That independence sometimes will lead to a contrarian investment, but contrarianism is not the end, in and of itself. Intellectual independence is.

Douglass: Again, bringing up that Greek dry bulk shipper -- my first investment; my first awful, awful individual investment in the stock market. I saw the price coming down and I thought, "This is a contrarian buying opportunity." But what I hadn't done was the research.

Being selectively contrarian is I think what I would call it. Some days when the market is selling out of something, it's because it's an awful investment and it's really so bad that you're not interested in that.

But the fact of the matter is that there are times when the stock market is mispricing something, and if you have done the research and really have the intellectual independence -- and let's also go ahead and throw it out there, the fortitude -- to stand on your own, then there can be tremendous opportunities.

I think it's self-serving for us to go into examples where this happened, because hindsight is 20/20. But the fact of the matter is that with strong research and a lot of work, we can identify some of these stocks that could be mispriced. That's something that we certainly try to do here at The Motley Fool all the time.

Maxfield: Again, just to pitch our own services, if you look at the results of our services, run by very capable investment professionals, they have consistently beaten the market over the short and the long term.

That goes to show that you can beat the market by acting independently and doing your homework and doing all those things. The question is, as an individual investor, is that a feasible objective that you should be actually going after or should you, say, use one of our ... of course we think you should use one of our services!

Douglass: We're a little biased that way, maybe!

Maxfield: We're a little bit biased! But they have tried-and-true track records. Then of course the other alternative is you can go with a mutual fund.

Or -- the third alternative is probably one of the most popular ones, even with investment professionals -- you can use a low-cost exchange-traded fund that tracks a broad market index, say the S&P 500 or even the world index. There are a number of great ones, particularly by Vanguard, which has probably some of the lowest expense ratios in the industry.

Douglass: Yes. Certainly Buffett's a big fan of the Vanguard funds. I think that's a long and separate conversation we definitely can have; and should have, by the way, because I think it really gets to the crucial issues of individual investing. Let's hold that conversation for another week.

John, as always, a real pleasure to talk to you. For The Motley Fool, I'm Michael Douglass. Thanks for watching and listening. Check in to Fool.com for all of your investing needs, and of course the Industry Focus podcast. It is, after all, where the money is. Fool on!