A reader offered this observation that frames the entire discussion:

“I thought you could add a comment to your Buffett page about the total irrelevance of his method to ordinary investors. Buffett does not make his money on the markets. He takes control of companies and sets performance targets. He then uses their cash reserves for more acquisitions. This is why he buys insurance firms (which have free cash) and ignores tech stocks (which only have burn rates). Obviously this has nothing to do with trading. Masses of people have been misled by all the hype claiming they can use his methods.” — Paul B.

Buy and hold is toast as an investment strategy.

Warren Buffett seems to make the buy and hold illusion look smart, but let’s take a look at why this strategy is dangerous to your portfolio. Below are excerpts from Warren Buffett and Charles Munger’s remarks at their annual shareholder meeting for Berkshire Hathaway. TurtleTrader editorial comments about their remarks follow each quote.

On Technology and Predictability

Warren Buffett: We understand technology products and what they do for people. But we don’t understand the economics ten years out — the predictability of it. Is it comprehensible? We do think about it, but we don’t get anyplace. We would be skeptical of anyone who says they can. Even my friend Bill Gates would agree.

TurtleTrader® comment: How can the trends (up and down) of Microsoft, Cisco and Sun be ignored? Buffett bought Dairy Queen, Gillette and Coke 30 years ago. That alone must not warrant blind following. If you trade from a trend following perspective you don’t need to know anything about tech companies’ fundamentals to trade them long or short.

This is the core distinction. Buffett’s framework requires understanding what a business will earn in ten years. Trend following requires no such forecast. The price of Microsoft, Cisco, or any other tech company reflects what every participant in the market believes about its future. A trend following system reads that price, identifies a directional movement with sufficient strength, and enters a position. No fundamental analysis required. No decade-long earnings forecast. Just price. The entry is triggered by what the market is doing, not by what the trader believes the company is worth. Tech stocks trend up and down with enormous momentum. Missing those trends entirely because you cannot predict ten-year earnings is a significant opportunity cost, measured in both directions.

On Holding Forever

Charles Munger: If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you buy a few great companies, then you can sit on your $%@. That’s a good thing.

Warren Buffett: We want to buy stocks to hold forever.

TurtleTrader® comment: Nothing is forever. The best companies go belly up. Trading is not about buying into companies. Trading is about making money. You must rethink your central objective if all you do is buy and hold.

The list of companies once considered permanent, too big and too important to fail, that subsequently lost most or all of their value is long and well documented. General Electric. Eastman Kodak. Sears. Enron. WorldCom. The buy-and-hold forever philosophy works when you pick the right companies and hold them through the decades. It is catastrophic when the company turns out not to be one of the forever ones. Trend following has no such vulnerability. A position is held as long as the trend supports it and exited when the rules say to exit. The drawdown on any single position is defined and limited. There is no holding forever through a 90% decline in hopes of eventual recovery.

On Market Caps and Valuations

Warren Buffett: Think about a company with a market cap of $500 billion. To justify paying this price, you would have to earn $50 billion every year until perpetuity, assuming a 10% discount rate. And if the business doesn’t begin this payout for a year, the figure rises to $55 billion annually, and if you wait three years, $66.5 billion. Think about how many businesses today earn $50 billion, or $40 billion, or $30 billion. It would require a rather extraordinary change in profitability to justify that price.

TurtleTrader® comment: If your trading technique is designed to ride a trend then firm earnings are not important, nor is any other fundamental data point for that matter. You don’t have to be a financial analyst or accountant to make money in the market. See Microstrategy (MSTR) example.

Buffett’s valuation framework is internally consistent. For a fundamental investor buying to hold, a rigorous analysis of what earnings must be to justify the current price is exactly the right question. But for a trend follower, that entire framework is irrelevant. The question is not whether the price is justified by fundamentals. The question is whether the price is moving in a direction with sufficient force to hold a position. A stock trading at a price no fundamental model can justify can still trend powerfully for months or years. Trend followers capture that move. Fundamental analysts wait on the sidelines for the valuation to normalize. More on why fundamentals are not needed in trend following.

On Finding Value Today

Warren Buffett: We’ve seen companies with market caps of tens of billions of dollars that are worthless, and seen other companies that trade at 20-25% of their true value. It eventually gets sorted out. But the speculative mania in one area is not creating equivalent discounts elsewhere. We’re not finding businesses at half their real value today. Forty-five years ago, I had lots of ideas and no money. Today, I have a lot of money but no ideas.

TurtleTrader® comment: There have been and will continue to be trends everywhere, where you can make money long and short.

When Buffett says he has no ideas, he means he cannot find businesses trading at a significant discount to his estimate of intrinsic value. A trend follower operating the same day would have had no shortage of opportunities. Currencies trending. Commodities trending. Bond markets moving. International equity indices diverging. The trend follower does not need a business to be undervalued. They need a price to be moving. Those conditions exist somewhere in the global market on nearly every trading day regardless of what the broad equity index is doing. The constraint of a single style, buy undervalued businesses and hold, creates blind spots that a multi-market, direction-agnostic approach does not have.

Reader Feedback

This page makes Buffett followers angry. Here are some comments:

“Why not look at the trend of Buffett’s stocks and see why no one comes close to the discipline he possesses in holding onto a trending situation.” — Web Visitor

“The fact that he didn’t buy Intel or Microsoft is just nitpicking.” — Web Visitor

The fallacy of the Buffett legend is the buy and hold mantra he helped promote, which is not exactly what he did to get rich. As Paul B. noted at the top of this page, Buffett’s actual method involves taking control of companies, setting performance targets, and using their cash flows for acquisitions. That is not what retail investors do when they “follow Buffett.” They buy stocks and hold them, hoping the story plays out. That is a fundamentally different activity.

Buy and hold is not the panacea Wall Street and Buffett proclaim.

More Feedback

The Buffett page continues to provoke feedback from some readers:

“Whilst I recognize and can appreciate your different trading philosophy to Mr. Buffett I am appalled at your presumption to criticize a man that has become reputably the second richest man by employing his techniques. Maybe in 40 years time when you have achieved the same success you will have earned the right to offer such sharp criticism. No I am not an investor in his company/s nor have I followed his lead but I do respect and admire the man for what he has achieved, through his philosophy of investment and maybe if the corporate raiders followed his example the market place would be healthier. By the way IT stocks are not doing too well are they?” — Web Visitor

We consider the last sentence to be the only comment worth responding to. The reader does not understand the nature of trend following. We hope it is clear to you that trend following garners profits in both up and down markets. Trend followers don’t fall in love with any one market or sector. They take opportunity as it comes and simply make money. Up or down, it doesn’t matter whether it’s a tech stock or not.

Note: The TurtleTrader® site will continue to offer a well-rounded slate of positive reinforcement articles along with critique articles. The combination of the two styles helps the learning process.

Frequently Asked Questions

Is Warren Buffett a trend follower?

No. Buffett is a fundamental value investor who takes controlling stakes in businesses he believes are trading below their intrinsic value and holds them for decades. His method requires understanding a business’s competitive position and earnings power far into the future. Trend following requires none of that. It uses only price and volatility to make decisions, without any forecast of a company’s fundamental value.

What is wrong with buy and hold as a strategy?

Nothing is forever. The best companies in any given decade have frequently declined to near zero in subsequent decades. Buy and hold works if you pick the right companies and hold them through decades of compounding. It produces catastrophic losses if the company turns out not to be one of the forever ones. Trend following limits any single position’s loss through predefined exit rules, preventing a permanent capital impairment.

Why don’t trend followers need to understand a company’s fundamentals?

Because price already incorporates all fundamental information that every participant in the market holds. The trend follower reads the price, not the earnings report. If the market is pricing Microsoft higher each week, the trend follower is long, regardless of whether they can predict ten-year earnings. If it reverses, they exit. No accounting degree required.

Why is there always opportunity for trend followers even when Buffett says he has no ideas?

Because trend following is not limited to undervalued equities. It operates across currencies, bonds, commodities, energy, metals, and global equity indices in both directions. When Buffett cannot find an undervalued business to buy, trends are still developing somewhere in the global market. A direction-agnostic, multi-market approach has no off-season.

What did Buffett actually do to get rich versus what retail investors think he did?

Buffett took controlling positions in businesses, set performance targets, used their cash flows for further acquisitions, and specifically targeted insurance companies for their float capital. Retail investors who try to “follow Buffett” buy minority stock positions and hold them, hoping the story plays out. That is a fundamentally different activity with a fundamentally different risk profile.

Trend Following Systems
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