Bluematter.

A couple of weeks ago the NYT ran an interesting piece by Austan Goolsbee on Warren Buffet's plan for picking a successor. (gated NYT version, non-gated version at Economist's View). I tend to agree with Goolsbee's main point that Buffett's plan for picking a successor is a bad one (that is the plan as described in the article - there is some disagreement as to whether Goolsbee got his facts right to start with). What doesn't make sense is this:

A number of years ago, in a moment of professional weakness, I bought exactly one share of Warren Buffett’s Berkshire Hathaway....

For a brief moment, I thought his track record might disprove the economist’s mantra that no one can beat the market in the long term so it’s better to just invest in index funds like one that matches the S.& P. 500.

The mantra comes from the rather compelling evidence that actively managed mutual funds cost too much and don’t always act in the shareholders’ interests. They churn stocks, for example — raising fees while also generating capital gains taxes for the investors. Their high fees sharply cut into investment returns in the long run. ...

Berkshire Hathaway seemed like a mutual fund but without the bad incentives. Mr. Buffett doesn’t care about churning stocks to get bigger fees. He doesn’t do things at the expense of his shareholders. He is the Oracle of Omaha, for Pete’s sake. If anyone can beat the market, it’s him.

Well, I still own that share, but it hasn’t worked out as well as I had hoped. My share has underperformed the S.& P. 500... My colleagues have mocked me incessantly, but I have remained a closet romantic, hoping that Mr. Buffett would renew his secret formula and prove my colleagues wrong.

I have no choice but to be blunt: that's complete and utter nonsense. Furthermore, it seems that Goolsbee is not motivated by a desire to mislead the readers - he genuinely doesn't get it. The fact that his share did not outperform the market is no indication of whether or not Berkshire Hathaway's portfolio consistently does so.

For the sake of argument, let's say that Warren Buffett's portfolio consistently beats the market by 300% each year, and that he also has a certificate from God stating he will keep doing so in eternity. Should you expect to beat the market yourself by buying Berkshire Hathaway stock? The answer is a resounding no. The moment Buffett gets his holy certificate, the stock of Berkshire Hathaway will jump so that BH offers the exact same risk-weighed return to new investors as companies not similarly favoured by the Almighty.

Goolsbee's investment would have beat the market only if Warren Buffet had got unexpectedly better at generating investment returns sometime after the renowned University of Chicago economics professor and Obama's lead economic advisor purchased his BH share. If on the other hand Buffett unexpectedly went from generating (or being expected to generate) a 300% return on investment a year to 200%, BH's price would fall - and Goolsbee's own investment would not have proven to be such a good one.

To cut a long story short: You buy shares in a company if you believe other investors underestimate its potential. A company's profitability per se is neither here nor there.

Advertisement: An extensive post on the widely misunderstood efficient market hypothesis (as well as a couple of on-request posts and one on 'virtual' worlds) has been in the making for a while now, and should be appearing here soon.