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Don't put all your eggs in Warren Buffett's basket

(MoneyWatch) No investor's portfolio should consist of just one company -- even if that company is Berkshire Hathaway (BRK.A) and its CEO, Warren Buffett, is donned an oracle. For those investors thinking I'm wrong, I hope you'll consider four logical reasons why you shouldn't create a portfolio consisting only of Berkshire shares, or even allocating more than a small percentage of your equity allocation to it.

The first is that investing in any single stock, even a company like Berkshire, is taking on what economists call unsystematic, idiosyncratic risks. An unsystematic risk is one that can be easily diversified away. And while the market provides compensation in the form of higher expected returns (risk premiums) for systematic risks (such as the risks of stocks compared to Treasury bills, or small stocks compared to large stocks, or emerging market stocks compared to developed market stocks), it doesn't provide any premium for risks that can be diversified away.

Prudent investors accept only those risks for which they are compensated for taking. Since you can easily diversify away the idiosyncratic risks of Berkshire's common stock, you're not compensated for owning it with a higher expected return.

A second reason is that Buffett, who's responsible for Berkshire's investment strategy, is now 83 years old. His long-time partner, Charlie Munger, is almost 90. As we discussed earlier, there are many who have tried to imitate Buffett, but very few have come close to succeeding. How much longer can Buffett run the company successfully? Will his successor do as well?

A third reason, also noted earlier, is that Buffett himself has warned that he can no longer generate the type of returns he did in the early years because of the huge amount of assets he must invest. The last 18 years make a pretty compelling case that Buffett was right.

And thanks to the research of Robert Novy-Marx, we now have a fourth reason to avoid the idiosyncratic risks associated with Berkshire's stock. Marx discovered Buffett's "secret sauce" -- and it's not stock picking.

A June 2012 study by University Rochester finance professor Robert Novy-Marx, "The Other Side of Value: The Gross Profitability Premium," provided investors with new insights into the cross-section of stock returns. His key finding was that profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios). Using this insight the authors of the study "Buffett's Alpha," found that Buffett's superior performance was mainly explained by two factors:

  • His use of cheap leverage provided by his companies (that explained about 4 percent of his excess return).
  • The companies Buffett acquires have the following characteristics: They are low risk, cheap and high quality. Companies that are high quality have the following characteristics: low earnings volatility, high margins, high asset turnover (indicating efficiency), low financial leverage and low operating leverage (indicating a strong balance sheet and low macroeconomic risk), and low specific stock risk (volatility unexplained by macroeconomic activity). Companies with these characteristics have historically provided higher returns, especially in down markets.

In other words, it's Buffett's strategy that generated the "alpha," not his stock selection skills. Once you accounted for the cheap leverage and Berkshire's exposure to the style factors of style factors (market, size, value, momentum, low volatility, and quality), Buffett's alpha was statistically indifferent from zero. That's important, because today there are low-cost, passively managed mutual funds that buy stocks with these same type characteristics. And that enables you to diversify away the idiosyncratic risks of Berkshire's stock for which you aren't compensated.

The bottom line is that given the performance of Berkshire's common share over the last 18 years, and the four reasons we have discussed, there doesn't seem to be much reason to consider owning the stock -- except perhaps for the entertainment value, and the passport it gets you to attend the annual meeting!

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