Why You Shouldn't Follow Warren Buffett

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Have you ever bought a stock because Warren Buffett bought a stock? You know, like American Express (NYSE: AXP) or Moody's (NYSE: MCO)?

If so, you're not alone. In fact, thousands of investors follow Buffett's every move, and that's such a hassle for the Oracle of Omaha that he has actually (and unsuccessfully) lobbied the SEC to give him a dispensation from disclosing his stock picks.

Heck, it got so bad that in 1999 Coca-Cola was trading for as much as 40 times earnings -- an unbelievably high number for a steady consumer staple that sells sugar water.

Yet if you believe Alice Schroeder's account in her Buffett biography The Snowball, Buffett wouldn't sell Coca-Cola even then because "the price of Coca-Cola could plunge as a result."

After all, if folks had mindlessly followed Buffett in, thereby driving up the price, they would just as surely follow him out.

This has a name
When investors follow other investors into and out of stocks or use another investor's decision to buy or sell to justify their own decision to buy or sell, you have a phenomenon called "herding."

While Buffett has been wary of passing along his stock ideas since the 1950s and '60s, it wasn't until 1990 or so that financial research established herding as a prevalent and powerful day-to-day force in the market's gyrations.

And recent research from professors Amil Dasgupta, Andrea Prat, and Michela Verardo of the London School of Economics allows us to quantify how herding affects stock prices over both the short and long terms.

We'll spoil the ending for you: Herding isn't much benefit to anyone.

Survey says ...
It turns out that institutional herding around a few supposedly great ideas ultimately leads to overvaluation and underperformance.

Money managers, in trying to avoid being outdone by their colleagues, flock to the same sets of stocks. In the words of the professors, "money managers tend to imitate past trades (i.e., herd) due to their reputational concerns, despite the fact that such herding behavior has a first-order impact on the prices of assets that they trade."

It's a broken system that punishes investors who aren't courageous enough to think on their own.

But wait!
Not everyone agrees that herding depresses the returns investors can look forward to. Just look at "Imitation Is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway."

The authors studied Berkshire Hathaway from 1976 to 2006 and found that "a hypothetical portfolio that mimics [Berkshire's] investments at the beginning of the following month after they are publicly disclosed also earns significantly positive abnormal returns of 10.75% over the S&P 500 index." Wow.

So we should all be poring over Berkshire's 13-F filings and buying what Buffett and team did, right? Not so fast.

Those findings are eye-opening and impressive, but in our view, they don't offer much for prospective investors for two reasons:

1. Berkshire circa 2009 is much different than the Berkshire of the 1970s, 1980s, and 1990s. For one, Berkshire is huge now and can only trade in megaliquid megacap stocks. More important, because of this herding behavior and its effect on stocks he likes, Buffett now favors private deals or full acquisitions over common stock purchases.
2. The Internet has revolutionized stock investing, making more information more readily available -- at a faster pace. In other words, informational advantages are likely lessened in the digital era.

It's this latter point that got us to thinking about one of our favorite Web resources, GuruFocus.

What now?
GuruFocus is a website that tracks "the buys, sells, and insights" of the world's "investment gurus." This is a list that includes long-term outperformers like Warren Buffett and Seth Klarman.

It's a neat website that sends out neat monthly emails, but we waver on this question: Is it a truly valuable service, or is it merely an interesting service?

After all, you shouldn't be buying or selling stocks because other investors are, and doing so may give you a false sense of security about your decision. As Ben Graham once said: "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right." And that's true even if it's a really smart crowd.

So what are the current "Consensus Picks of Gurus" (i.e., the stocks the most gurus are buying)? The list includes Adobe (Nasdaq: ADBE), Travelers (NYSE: TRV), Copart (Nasdaq: CPRT), and Heinz (NYSE: HNZ) -- a decent list of businesses, to be sure.

But are these sure winners over the next year, or five, or 10? No.

Who knows why these gurus bought them, or when or why they'll sell them? Was it macro opportunities/concerns? Bottoms-up fundamental insights? Something they saw during a meeting with management? Are they selling because of investor redemptions?

Heck, it may be that David Dreman bought Heinz because he saw that George Soros was adding to his position and figured he knew something.

Again, who knows?
The point is: Don't buy stocks because others are buying the same stocks. Don't simply follow Warren Buffett's publicly disclosed stock trades -- following the Oracle's moves, herd-like, is likely to lead you down an unprofitable road.

If you want to profit from Buffett's brain, you have two choices.

1. Buy shares of Berkshire Hathaway.
2. Study Buffett's shareholder letters, magazine articles, and body of work, and apply those lessons to your investing.

Both are good courses of action
While buying a share or two of Berkshire is a prudent course of action (Tim added to his position just a few months ago), it is worth noting that Berkshire today is very different from the more nimble version that bought shares in tiny companies such as Blue Chip Stamps, Associated Retail Stores, and Illinois National Bank.

Back then, Buffett was able to focus on good businesses at great prices regardless of size, industry, or geography -- and he thus got some great deals on the very small-cap end of the spectrum.

That's what we do each and every day at Motley Fool Global Gains. As co-advisor of Global Gains (Tim) and a contributing author to the international-investing chapter of our most recent book (Brian), we believe the good businesses at great prices are the small and foreign companies that American investors largely don't think are worth their time.

We have a scorecard full of these types of stocks that we believe will outperform over the long haul. You can see all our research and stock picks, including our top small-cap foreign stock ideas, free of charge with a 30-day free trial.

Click here to take us up on the offer.

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This article was first published April 30, 2009. It has been updated.

Tim Hanson owns shares of Berkshire Hathaway. Brian Richards does not own shares of any companies mentioned. Berkshire is a Motley Fool Stock Advisor and Inside Value recommendation. American Express and Coca-Cola are Inside Value selections. Moody's and Copart are also Stock Advisor choices. Heinz is an Income Investor pick. The Motley Fool owns shares of Berkshire Hathaway and American Express, and it would like you to meet its disclosure policy.