Elliot's Twitter Feed

Subscribe to the RSS Feed:
Search
Compounding the Categories
13f aaron clauset after-tax return alan greenspan alchemy of finance alexander hamilton algo algorithmic trading allan mecham all-time highs alpha alvaro guzman de lazaro mateos amazon amsc anarchy antifragile antti ilmanen apple aqr capital architecture art of stock picking asset quality review asthma atlantic city austerity barry bonds baseball behavioral economics ben bernanke best buy bill maher biotech bitcoin black swan bobby orr bridgewater bruce bueno de mesquita bruce richards bubble buttonwood CAPE capital gains capitalism caravan cash cerberus cfa charles de vaulx charlie munger checklist checklist chicago booth china chord cutting cinecitta claude shannon Clayton Christensen clean energy commodities complex adaptive system compound interest constitution content cord cutting correlation cpi craft beer credit suisse cree cris moore crisis cybersecurity Dan Geer daniel kahneman darwin david doran david laibson david mccullough david wright debt ceiling defense department deficit deleveraging disruptive innovation diversification diversity dixie chicken don johnson economic machine economist edward thorp efficiency efficient market hypothesis elke weber eni enterprise eric sanderson eric schmidt euro european union eurozone Evgeni Malkin evolution facebook fat finger federalist 15 federalist papers ferdinand de lesseps flash crash flashboys forecasting fortune's formula fragility fred wilson gambling gene sequencing general electric genomics geoeye george soros global reserve currency gold gold standard google goose island gore-tex government budget grantham greece gregory berns grid parity guy spier hamiltonian path problem hans harvard business school henry blodgett henry kaufman hft hockey horizon kinetics housing howard marks hudson hudson river hussman iarpa ichiro iex imax implied growth incyte indexation indexing innovation innovator's dilemma internet investment commentary ipad ipo islanders italy j craig venter james gleick jets jim grant jim thome jjohn maynard keynes jk rowling jochen wermuth Joe Peta joel greenblatt john doyle john gilbert john malone john maynard keynes john rundle jonah lehrer juan enriquez justin fox kelly criterion kevin douglas kodak larry david legg mason lehman brothers linkedin liquidity little feat logical fallacies long term capital management louis ck malaria Manhattan manual of ideas marc andreesen marc lasry mark mahaney media mental model Michael Mauboussin millennials minsky mnst moat money mr. market multi-discipline murray stahl myth of the rational market nasdaq: aapl NASDAQ: GOOG nassim taleb natural gas net neutrality netflix new york NGA nicholas barberis Novus oaktree optimality optimization overfitting panama canal pat lafontaine performance personal philip tetlock Pittsburgh Penguins pixar preamble price earnings ratio price to book priceline profit margins prospect theory psychology punditry radioshack random walk ray dalio rebalancing reflexivity regeneron registered investment advisor reproduction value RGA Investment Advisors RGAIA risk risk aversion rob park robert shiller robotics robust ROE s&p 500 samsung santa fe institute satellite scarcity s-curve sectoral balance silk road silvio burlesconi solar space shuttle speculation steve bartman steve jobs stock market stock picking streaming subsidy synthetic genomics systems tax code ted talk the band the general theory the information tomas hertl Trading Bases tungsten twitter undefined van morrison vincent reinhart wall street walter isaacson warren buffet warren buffett william gorgas william poundstone woody johnson wprt yosemite valley youtube
Navigation
Tuesday
Oct082013

Buffett, Soros and Uncle Sam

 I recently came across an interesting piece comparing the returns of Warren Buffett and George Soros (h/t @ReformedBroker). The post immediately caught my attention, for both Buffett and Soros are two of my favorite minds in investing.  I am oversimplifying greatly, but from Buffett, I learned much about the importance of patience, quality and management integrity, while from Soros, I learned the importance of identifying self-fulfilling cycles and reflexive processes in financial markets. While some like to contrast these two gentlemen as taking opposing views to markets, I think their approaches are not mutually exclusive.  In fact, combining the lessons from these two gentlemen has been a potent force in crafting my own, unique approach to investing.

In the piece comparing the relative performance of Buffett and Soros, the author includes the following chart:

The author then asks, if “George's track record is better but Warren is richer. Why?” while offering the following answer:

The snowball of POSITIVE compounding for longer. Both were born in August 1930 and Warren ran his hedge fund from 1957 but George didn't set up his until 1969. Warren was lucky to be in Omaha while Dzjchdzhe Shorash was in Budapest, more affected by WW2. Also Warren got into currency trading and philanthropy later. George's outperformance is due to stronger international diversification and because reflexivity is ignored. Value investing is copied more than reflexivity investing. The boom bust of Eurozone sovereign credits and subprime CDOs are quintessential examples of reflexivity. Crises are PREDICTABLE. And profitable if you have expertise.

Sure some of these factors certainly played a role in Buffett’s wealth relative to Soros, though this is largely misleading and the most crucial point is ignored entirely. Simply put, these return figures are not presented on an apples to apples basis.  Buffett’s returns are presented using the growth in Berkshire Hathaway’s book value, while Soros’ returns are presented using his hedge funds’ returns.  In this comparison, the author is therefore comparing Buffett’s after-tax returns, with Soros’ pre-tax returns. (There is a second key point missed that many Buffett followers will pick up on: book value does not reflect the true realizable value of many Berkshire assets, and therefore, is understated relative to the intrinsic value of the company. While important, my intent here is to focus simply on the tax consequences so beyond this mention, I will skip digging into the consequences of this reality).

We can re-plot the relative returns of Soros and Buffett in order to more closely portray what the comparative returns would look like on an after-tax basis.  For the purposes of this comparison, I assumed that each year, 20% of Soros’ returns would be paid out in taxes.  This is obviously a simplification, and not intended to be historically accurate, as everyone has their own unique tax profile, and long and short-term trades have different consequences.  I am merely cherry-picking a number that if anything, is probably favorable to Soros in light of the following factors: 1) capital gains tax rates were higher than today’s 15% during much of the time period covered in this analysis; 2) we know that Soros profited in capital markets subject to hybrid tax rates between long and short-term capital gains (like commodity and foreign exchange markets); and, 3) from Soros’ own journal in Alchemy of Finance (which I strongly recommend reading), we know that he engaged in many short-term, speculative trades that would be subject to ordinary income tax rates.

There is a second simplification I’ve made for the purposes of this comparison in assuming that returns were earned on a straight-line basis, rather than calculating each individual’s returns per year, adjusting for taxes and plotting those out.  Again, the purpose here is to demonstrate the impact of taxes on returns, and not to be perfectly precise with who is better than whom.  

As we can see below, the end result looks quite different when compared on an after-tax basis:

 

 

Plotted this way, Buffett’s compounded annual growth rate (CAGR) remains 21.4%, while Soros’ is 21.0%.  Now some might argue that an investor in Berkshire would still have to pay taxes on his or her investment, and this is true, but the clear intent in the article cited was to compare the performance track-record of each investor as stated by the author, and as evidenced by the author’s focus on the CAGR of Berkshire’s book value, rather than the performance of the stock itself. 
One of the biggest problems with performance generally speaking is how reporting systemically does not take into account tax consequences, yet there can be huge differences between two strategies with identical “returns.”  In reality, it’s only after-tax returns that matter.  Buffett’s partner, Charlie Munger offered the following important point on targeting after-tax, rather than pre-tax returns (from Munger's "On the Art of Stock Picking"):
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you're going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%.And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

I am a fan and student of Mr. Buffett and Mr. Soros and have no bone to pick in this race, though it should be clear to all that both men’s returns are about as good as they get over such a long time-frame.  To summarize, there are two key points here that I want to emphasize.  For individual investors, it’s extremely important to plan your investments in such a way as to maximize after-tax, not pre-tax returns.  Don’t be fooled simply by the appreciation in your portfolio.  Think about what portion of your gains you are paying to Uncle Sam (taxes) come April 15th each year.  For those who work with investment managers or invest via funds, when looking at performance reports, it’s extremely important to think about what the after-tax returns of a strategy look like.

 

Disclosure: Long shares of BRK.B in my own and client accounts.

 

PrintView Printer Friendly Version

EmailEmail Article to Friend

Reader Comments

There are no comments for this journal entry. To create a new comment, use the form below.

PostPost a New Comment

Enter your information below to add a new comment.

My response is on my own website »
Author Email (optional):
Author URL (optional):
Post:
 
Some HTML allowed: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <code> <em> <i> <strike> <strong>
« Links for Thought -- October 11th, 2013 | Main | Beware of Mistaking a Symptom for the Cause »