Today Warren Buffet appeared on CNBC for 3 hours answering a multitude of questions from Becky Quick, Joe Kernen
and a slew of emailers. One emailer from Cincinatti asked “How do we know that you are not another Bernie Madoff?” In response Buffett said:
“Well, that’s a good question. I would say this. I–it is a problem with investment advisers. I mean, it–there are going to be a certain number of crooks in the world. And sometimes they’re smooth-talking, and the best ones are the ones that kind of don’t look like crooks… it is a problem who you put your trust in.”
He then later agreed with Joe Kernen that an investor cannot rely totally on government regulation to catch these crooks. So what is an investor trying to protect herself to do?
I wrote a post (Part 1) back in September of last year with the intention of answering this question. This was before the Bernie Madoff or the R. Allen Stanford stories broke. In the post I promised 10 red flags which might alert an investor that his advisor is not on the up and up. I’m finally getting around to listing them. Today I’ll do just a couple and get to the rest at a later date.
As a side note, The Wall Street Journal reports that the client list of Bernie Madoff became available to the public. The list contains well known and not so well known folks running the wealth spectrum. The one thing they all have in common is they are all considered sophisticated investors. The list should once and for all prove that “sophisticated” means little in the investment world and underscores my personal pet peeve with the restrictive accredited investor law. I digress.
1. Returns that (nearly) always go up:
If your advisor is reporting returns that always seem to go up, then you should regard his numbers with great skepticism. The markets are controlled by unpredictable human emotion and its movements simply can’t be predicted. Madoff’s firm produced returns of positive 1% to 2% in gains per month with only five negative months covering a period of 12 years. These types of returns are so improbable that an investor can almost stop here and safely speculate that they’ve encountered a ponzi scheme or at least an investment manager that is not telling the truth about his returns. But we’ll go on.
2. Complex strategies that cannot be duplicated:
When and an advisor has to start using greek letters in formulas to explain his investment strategy, it’s time to be concerned. Madoff used an investment strategy consisting of purchasing blue-chip stocks and then taking options contracts on them – a split-strike conversion or a collar. The strategy itself is not complicated. In fact, it’s pretty plain vanilla. What was extraordinary are returns Madoff reportedly received with the strategy.
A few individuals attempted to perform due diligence but were unable to replicate the Madoff’s past returns. Harry Markopolos was among those that tried. In an interview with 60 Minutes he said:
“As we know, markets go up and down, and his only went up. He had very few down months. Only four percent of the months were down months. And that would be equivalent to a baseball player in the major leagues batting .960 for a year. Clearly impossible. You would suspect cheating immediately… No one’s that good.”
The above represents a stark contrast to the investment approach employed by Mr. Buffett – value investing. Unlike the method employed by Mr. Madoff, it is niether complex nor does it produce returns that are always favorable. In fact, sometimes years go by without positive results. That’s why it is so important to have a long term view as Buffett reiterated today in his interview with CNBC.
BECKY: Yeah. And on a serious note, there are people who look at the stock market and wonder how do they know the whole thing’s not a Ponzi scheme?
BUFFETT: Well, the whole thing’s not a Ponzi scheme.
BECKY: What–how do they know who to trust?
BUFFETT: We’re talking about, you know–we’re talking about American businesses that employ, just the ones on the stock market, tens and tens and tens of millions of people. They’re real companies… in the 20th century, the Dow went from 66 to 11,000, you know, 400. And we had all kinds of problems during that period. Business works overall. It doesn’t work every day or every week or every month, and sometimes it really gets gummed up. And then you need government invention sometimes to get the machines back working smoothly. But the machine works.
BUFFETT: And equities, over time, are the way to do it.