In Alice Schroeder’s biography of Warren Buffett, The Snowball: Warren Buffett and the Business of Life, Buffett admits that much of his early success was the result of “coat-tailing.” He followed the activities of top fund managers – like Graham – whose ideas could make him a lot of money.
When we start, in anything, it is natural to find gurus or mentors to follow. It is comforting to see that investors of such stature as Warren Buffett used coat-tailing to form his early investing structure.
So what is copy-cat investing or cloning? As the name implies, cloning refers to the strategy of replicating the ideas of famous investors or investment fund managers.
The big question is, is it a viable investment strategy? While there are differing opinions on this, and we will be discussing that and more. There are certain techniques you can use to increase your chances of becoming successful in utilizing this technique.
Multiple very famous investors have utilized this source of investing for ideas; investors such as Warren Buffett, Charlie Munger, and Mohnish Pabrai have extolled the benefits of cloning.
In my mind, if these very successful investors have taken ideas from this strategy, why can’t we?
Let’s dive in and see what is entailed in copy-cat investing and how we can use this to our investing success
Top Fund Manager Mohnish Pabrai on Cloning
For those of you not familiar with Mohnish Pabrai, he is one of the more successful investors out there. He runs an extremely concentrated fund; he currently has three investments in his portfolio.
He is also the author of one of my favorite investing books out there, The Dhando Investor. Mohnish is a shameless cloner and follower of Warren Buffett and Charlie Munger.
If you listen to any of his talks or read his writing, you will find an extremely smart, thoughtful investor who is very practical in his ideas and thoughts.
Pabrai has a great read, called the 10 Commandments of Investing. Mohnish spent years compiling this list of rules based on the work of Warren Buffett and Charlie Munger. He’s constructed these rules after studying the way the two billionaires approach investing. He’s drawn from their experience and lessons, as well as his education, to compile a short checklist for investing success.
Pabrai’s commandment number 10 is: “Thou shall be a shameless cloner.” Which is the idea that I would like to explore more because it could be helpful and a bit misleading.
Keep in mind that buying a stock just because someone you admire is dangerous; without understanding the reasons behind the purchase, you could set yourself up for trouble.
What Pabrai is advising here, however, is using the actions of highly successful investors as a sort of investment screen, and then doing your research on top of that. Speaking as part of a webcast question-and-answer session with students at London Business School back in June,
Pabrai said just that. He told the students that other investors’ portfolios should be “just a starting point for further research” because these ideas have “already been through a screen,” which means they’re likely to be safer than other holdings you might have picked yourself. Pabrai didn’t add much detail in the Q&A session, but this topic is something he’s talked about many times before. In a 2012 lecture, he gave a bit more detail:
“When you only basically buy ideas that other great investors have already bought after studying them, the error rate you will have will be a small fraction of what you would have if you went out on the prairie on your own. If you go out on your own and look at 10,000 stocks and pick 10 – trust me – your error rate will be off the charts. But if you pick 10 out of the 40 that great investors have bought and you have looked into why they bought them, it’s like bowling with bumpers…Never bowl without bumpers when they offer you bowling with bumpers.”
And when the ideas have been through this first screen, you can take each one and put it through your screen, discarding the ones you don’t understand and sticking with the ones you’re most comfortable with:
“[You can invest by] simply only taking ideas from great investors, studying them on your own … discarding the ones you don’t understand, take the ones that you understand, take the ones that are absolutely no brainers, and buy those. And that will be enough to get you going for a while. So I think the big message I wanted to meet with you here is that cloning is extremely powerful. If you look at what I did with Pabrai Funds, the structure, the setup of Pabrai Funds – completely clone the model – and then on top of it when I’m buying stocks, very few of the ideas – and remember this is just between us girls here – very few of the ideas are things that I have generated on my own.”
The beauty of this process is there’s no limit to how many ideas you can look at and chuck out.
The key to the whole idea is to stay within our circle of competence, another Buffett idea by the way. By staying within our circle of competence, we can avoid investing in companies we just don’t understand.
Plus Side of Cloning
The plus side of cloning an investment portfolio is obvious; you get in on the investing genius of some of the best investors of all time. A recent study looked at cloning the Berkshire Hathaway portfolio by buying each of their investments a month after the public disclosure via 13F filings.
The study found that those investments would have outperformed the S&P 500 by an annual average of 10.75% from 1976 to 2006.
Meb Faber also conducted a similar study that showed an outperformance of Berkshire Hathaway from 2000 to 2014 of 10.53% versus 4.31% for the S&P 500 during the same period.
In this day and age of no-fee trading, it is much cheaper to practice this strategy because it affords you more liquidity than in the past; in other words, you don’t have to build in additional loss of any particular position.
With the access afforded us via 13F filings we can see what companies Buffett is buying and how much capital he is allocating to that purchase. This transparency allows us the ability to balance our portfolio based on the allocations we desire.
This strategy also allows us the opportunity to manage our positions concerning the tax implications and our tax statuses. The impact of tax management is often minimized because it is not sexy.
The underreported story is that taxes have a significant impact on returns and must be addressed when investing.
The best fund managers to follow when copy-cat investing are typically value investors because of their propensity to hold their investments for longer periods. Buy and hold investors are better to follow because the time lag between an actual trade and its reporting may be a detriment to effective trade replication. Some managers such as Carl Icahn, who uses quite a lot of different strategies to invest such as hedging, shorting, and leverage, among others, lead to difficulty in tracking his portfolio.
It’s much better to follow someone like Buffett, who likes to say, “his favorite holding period is forever.”
Top fund managers such as Buffett, Munger, Pabrai, Seth Klarmann, Guy Spier, and Prem Watsa are some of the better investors to follow when utilizing this strategy.
Negative Side of Cloning
However, there are also some potential negatives to cloning because, of course, not every investment strategy is perfect.
Number one, success is not guaranteed. No investment strategy is a sure-fire winner. For example, a copycat investor may have to stick with the strategy for many years because if you are following a value-based investor, it can take many years for the stocks to blossom. In this case, losing patience and abandoning the strategy early may result in substantial losses.
Another negative is an obvious one. The stock may have already moved significantly between the time it was acquired and the time it was announced. This harms the stocks’ risk-reward profile for the cloner.
The last disadvantage is a differing investment time horizon or objectives of the investor that you are cloning. You may have a much shorter time horizon, while the investor you are cloning might be in it for the long haul. The different time horizon leads to a much different risk-tolerance and can lead to underperformance or a desire to exit early, risking substantial losses.
We have talked about the pros and cons of cloning our guru’s portfolios, let’s talk a little about how to do it and what some of the results could be for us.
Examples of Cloning Portfolios
First up has to be Warren Buffett, who is arguably one of the world’s greatest investors and most followed investors out there. His words and deeds have been covered by many, much more talented than I to describe. However, for this post, we are going to look at what would happen if we just followed his investments.
Let’s set up the ground rules to follow, by the way, these rules come from Meb Faber’s great book “Invest With The House,” which is free by the way!
Rule Number One: Equal weight the top ten holdings with a 10 percent weight for each stock. In reality, if there are more than ten holdings, we will use the ten largest holdings, as his largest holdings should drive the majority of a managers performance.
Rule Number Two: Rebalance, add/delete holdings quarterly, and calculate performance as of the twentieth day of the month to allow for all filings to arrive.
For the test, Faber uses the years 2000 to 2014 for his backtest, which includes two market drawdowns, so it is a good period to test based on some big fluctuations in the market.
If you take the ten largest holdings in Buffett’s portfolio as of 2014:
- Wells Fargo (WFC)
- Kraft Heinz (KHC)
- Coca-Cola (KO)
- American Express (AXP)
- Phillips 66 (PSX)
- Protctor & Gamble (PG)
- Walmart (WMT)
- U.S. Bancorp (USB)
- DaVita HealthCare Partners (DVA)
An interesting list and as you can see not all of them have been home runs, IBM and Kraft Heinz and have not worked out as well as he would have hoped. So take solace in the fact that even the great Warren Buffett can have misses!
Taking this portfolio and equal weighting to 10% each over the 14 year time period that Faber backtested you get these results:
- Clone 10.53%
- S&P 500 4.31%
That is great news and is an outperformance of 4-5 percentage points per year. And a note to be observed, this outperformance occurred while Buffett and Berkshire have underperformed the S&P 500 since the bottom in 2009.
Buffett often gains much of his outperformance during bear markets. Another bonus is that because Buffett is the classic buy and hold investor there is not much turnover in his portfolio, therefore the need to rebalance or add/delete positions will be much lower, than say Ray Dalio who is quite a bit more active.
Another investor to investigate would be Seth Klarman of the Baupost Group. He of the “Margin of Safety” fame and one heck of a great investor himself. Klarman credits a lot of his success to following the Graham-Dodd model and developing a margin of safety in every investment he makes.
Klarman focuses on other holdings besides stocks, such as real estate, bonds, and other distressed debt. But for our purposes here we are looking at his equity holdings and their returns versus the S&P.
Klarman’s holdings during the backtest:
- Cheniere Energy (LNG)
- ViaSat Inc (VSAT)
- Alcoa (AA)
- Pioneer Mutual Resources (PXD)
- Antero Resources Corp (AR)
- PayPal Holdings (PYPL)
- PBF Energy Inc Class A (PBF)
- eBay EBAY
- Twenty-First Century Fox Inc Class I (FOX)
- Atara Biotherapuetics (ATRA)
Not a lot of household names in there but that is not important to us, results are.
Klarman’s return during the test years, 2000 to 2014:
- Clone 13.66%
- S&P 500 4.31%
That is quite the outperformance during that period.
Let’s take a look at one more, Mohnish Pabrai and his performance for Dalal Street Funds.
Pabrai’s fund since it was inception in 2000 has returned 517% over the 19 years, versus the S&P 500’s return of 43% over the same period. That is 27.2% CAGR over that time versus 2.26% for the S&P 500 during the same period. That is a serious outperformance!
Pabrai’s fund is extremely concentrated; he has only three holdings.
- Fiat Chrysler (FCAU)
- Micron (MU)
- GrafTech (EAF)
If you were to follow him, it would be extremely easy to do. I have copied his Fiat Chrysler investment and it has done extremely well for me.
Pabrai is an investor that has certainly taken the advice of Munger/Buffett to heart. When he finds an investment, he likes he goes all-in on the company, which helps contribute to his great success.
Cloning can be a fantastic source of great investment ideas; it can also be a wonderful way to develop a portfolio based on the guru’s portfolio.
Even though Warren Buffett has been reporting his stock picks for decades now, we don’t know of many investors like Mohnish Pabrai, who have cloned Buffett to tremendous success.
The reason is not far to fetch. Many people like to refer to themselves as long-term investors. But when it comes down to it, most investors – even the ones cloning Buffett – want to see results in the first 6 to 12 months of owning a stock. And if that does not happen with the cloned idea, the one who was cloned is questioned for his analysis and investment.
People often fail to look within, at their own mistakes. They also fail to differentiate between their investment horizon and that of the one being cloned.
An additional problem with blind cloning is that investors fail to assess the interests of the one being cloned. Again, authority and recency biases (recent success of the cloned) are at play.
This may not be the case when you clone someone like Warren Buffett. But when you clone unscrupulous people – Twitter and various stock forums are great breeding grounds for such people – with hidden agendas – like those looking for greater fools.
These are the greatest risks to cloning, and we need to be aware of these ideas and guard ourselves for them. Knowing who you are following is just as important as what you follow. Someone like Buffett, who is well-known and has scruples, is worthy of our attention. But be sure to guard yourself against someone trying to take advantage of their situation to their benefit.
But the upsides to this strategy are there as well. The outperformance of all the managers listed above can be of great encouragement. And as Mohnish stated earlier, your error rate following one of your heroes is likely to be far lower than if we mere mortals tried our hand at stock picking.
After all, stock picking is hard.
As always, thank you for taking the time to read this post and I hope you find something of value that you can use for your investing success.
If I can be of any further assistance or have any questions, please don’t hesitate to reach out.