My $25,000 Bet against Warren Buffett Revisited

There’s no point in putting lipstick on a pig: March 2014 was a lousy time to bet on U.S. small caps.

It was exactly a year ago today that I bet investment manager David Rolfe that U.S. small caps would beat Berkshire Hathaway stock over the next 10 years.

Sure enough, the day we placed the bet, Berkshire leapt out of the starting gates.

Over the next nine months or so, Berkshire looked like a nimble Olympic sprinter competing against a sadly outclassed wannabe.

Berkshire — also a long-time recommendation in my newsletter The Alpha Investor Letter — went on to have a monster year in 2014 during which it absolutely crushed U.S. small caps. Chock full of large-cap names, as well as a slew of private investments, Berkshire soared 26.6% last year.

In contrast, U.S. small-cap stocks lagged badly, with the Vanguard Russell 2000 ETF eking out a 5.01% gain for all of 2014.

Even more impressively, Berkshire delivered its strong performance despite highly publicized flops in Tesco (TSCO) and IBM (IBM), as well as equally uninspiring performances in long-time stalwarts like The Coca-Cola Company (KO) and Exxon Mobil Corporation (XOM).

Looking for a Better 2015

2014 was not a typical year, neither for Berkshire nor for U.S. small caps.

Relative to the S&P 500, this was Berkshire’s strongest year since 2007.

Relative to U.S. large caps, U.S. small caps actually performed worse than they did even at the height of the 2008 financial crisis.

But extreme trends inevitably revert to the mean. And the more extreme the trend, the more pronounced the reversion.

In last week’s edition of the Global Guru, I pointed out why I expect U.S. small caps to soar in 2015.

First, after a year of nearly record-breaking underperformance, U.S. small caps now trade at far more attractive relative valuations than the large caps that populate Berkshire’s portfolio. The Russell 2000 trades at 19.82 times forward 2015 earnings. That’s well below the 84.68 level of a year ago.

In contrast, U.S. large-cap stocks have rarely been this expensive, especially when viewed through the lens of the long-term Cyclically Adjusted Price-Earnings (CAPE) ratio. In fact, the last times U.S. stocks were this expensive were in 1928 and 2007. And we all know what happened the following years.

Second, U.S. small caps are purely domestic businesses, which have few, if any, international operations. In contrast, large caps face the headwind of the stronger U.S. dollar. A stronger dollar has already hit the revenue of 70% of the top 50 companies in the S&P 500 — including several of Berkshire’s holdings.

Third, in 2015, U.S. small caps offer investors far better revenue growth prospects than their large-cap rivals. According to Bloomberg, sales per share are estimated to increase 6.6% this year for the small-cap stocks in the S&P 600. In contrast, Bank of America Merrill Lynch forecasts overall S&P 500 earnings growth to be flat in 2015.

Why I’m Not Eating Crow, Just Quite Yet

There are several more reasons why I am not ready to eat crow, even after such a lousy start to my long-term bet.

First, U.S. small caps’ volatile performance cuts both ways. One out of three years, small caps tend to have a lousy year, and 2014 was clearly one of those. But as with many asset classes, lousy years are often followed by blow-out ones. That’s also why I’ve been increasing my own personal exposure to U.S. small caps.

Indeed, U.S. small caps already are clawing their way back. Over the past three months — admittedly a short period — small caps have outperformed Berkshire by an impressive three-to-one, gaining 6.61% versus 2.02% for Berkshire.

In fact, Berkshire is actually in the red this year, even as major market indices are hitting record highs.

Second, Berkshire’s track record over the past decade is nowhere near 2014’s market-busting performance. No matter how you slice and dice it, Berkshire’s returns have been waning over the past decade and a half. Up until the year 2000, Buffett’s average annual return approached a remarkable 30%. Since then, these returns have shrunk to an annual average of 10.4%.

Size — that is, huge investments in large-cap stocks — is becoming Berkshire’s enemy. Recall that during a five-year period, year-end 2008 to year-end 2013, the S&P 500 beat Berkshire’s gain in book value per share. That was the first such period in Berkshire’s history.

No wonder Buffett himself has advised his own heirs to invest in a low-cost S&P 500 Index Fund, rather than keep the money in Berkshire itself.

That’s not exactly betting against yourself. But it is pretty close.

Despite 2014’s strong performance, I don’t expect that trend to improve over the next nine years.

Third, it’s important to remember that our bet is over a long-term horizon. And despite a lousy 2014, U.S. small caps are holding up better than you’d think.

Over the past five years, the iShares Russell 2000 has returned 15.47% compared to Berkshire’s 13.56%. The Vanguard Small Cap ETF — a slightly different index — returned 16.83%. Both indexes beat Berkshire by a comfortable margin.

Over the past 10 years, Berkshire’s return of 9.49% beat the iShares Russell 2000 (IWM). At the same time, Berkshire trails the Vanguard Small Cap ETF, which returned 9.69% over the same period.

So small caps aren’t exactly out of the running, even after Berkshire’s monster 2014.

The bottom line?

March 2014 was a terrible time to place a 10-year bet on U.S. small caps. And with the benefit of 20:20 hindsight, I’d have much rather put the bet on today than a year ago.

But I’m still sticking to my guns and betting on U.S. small caps to outperform Berkshire between now and 2024.

In case you missed it, I encourage you to read my e-letter column from last week about the performance of small-cap stocks versus large caps. I also invite you to comment in the space provided below.