Temporary Underperformance—A Feature, Not a Flaw of Quality Investing
“To be blunt, Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passe. Buffett, Berkshire’s chairman and chief executive, may be the world’s greatest investor, but he hasn’t anticipated or capitalised on the boom in technology stocks in the past few years.” –?Barrons’s article ‘What’s Wrong, Warren’, Dec 27, 1999
If there’s one investor who has been repeatedly written off by new, adrenaline filled young upstarts it’s probably the Oracle of Omaha – Warren Buffett. Almost every decade features a phase where his investing philosophy is termed as –?conservative, passe?and?archaic?among other things.
Yet, year after year, Buffett sticks to his principles, choosing to invest in companies that exhibit three key attributes:
Why Underperformance is a Feature of Quality Investing
Most of the criticism aimed at Buffett over the years has come during periods of underperformance. These periods become more frequent when looking at shorter time frames.?
What many fail to realise is that these temporary setbacks are a natural part of long-term value investing. Since Buffett began publishing his returns in 1965/66, there have been several such periods of underperformance, often in the context of broader market trends
Take, for example, the three major periods of extended underperformance for Berkshire Hathaway’s shares:
Case Study: 1999-2000 Dot-Com Boom
One notable period of underperformance occurred from March 1999 to August 2000 during the height of the dot-com bubble. As the technology and internet sectors boomed, the market narrative shifted against Buffett’s investing style. His refusal to join the tech stock frenzy led many to predict the demise of his approach.
Despite this, from December 1993 to December 2003, Berkshire Hathaway’s Book Value Per Share (BVPS) compounded at an impressive rate of 19% annually. [—which is a measure of the company’s net assets divided by the number of shares—grew at a solid rate of 19% annually from December 1993 to December 2003. This means that the company's intrinsic value (or its financial health) was improving significantly during that time.]?
Despite this strong growth in BVPS, the P/B ratio (the ratio of the market price of the stock to its book value) of Berkshire's stock dropped in the late 1990s. When this ratio compresses, it means that the stock price isn't rising as fast as the company’s intrinsic value.
In other words, even though Berkshire was getting more valuable based on its fundamentals (its assets and earnings), the stock price wasn't reflecting that value during the tech boom, as investors were chasing tech stocks instead of value stocks like Berkshire.
This set the stage for a significant comeback once the tech bubble burst.
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In the aftermath of the crash, Berkshire delivered the kind of outperformance that cemented Buffett’s legendary status. An investor who ignored the prevailing pessimism and invested in Berkshire at the peak of its underperformance reaped the rewards over the next five years.
Berkshire Returns 2004-2010
An investor who purchased Berkshire Hathaway A shares on 1st?November 2004 would have lived through the following returns (these returns are cumulative NOT CAGR):
Why Does This Happen?
How is it possible that investors experience short-term underperformance but eventually beat the market over the long term? The answer lies in the fundamental compounding of Berkshire’s business. Despite periods of price-to-book (P/B) multiple compression, Berkshire’s Book Value consistently grows at a robust rate. Over time, this underlying strength outweighs the short-term damage inflicted by market sentiment.
The Importance of Sticking to Quality Investing
Buffett’s philosophy emphasises the importance of focusing on high-quality businesses. In the heat of market manias, such as the tech bubble, investors often chase sky-high returns from speculative stocks. While this may lead to temporary outperformance, the risk of getting in too late and suffering significant losses is high.
In the long run, it is the strong fundamentals of businesses like those in Berkshire Hathaway’s portfolio that drive consistent, satisfactory returns. As Buffett himself wrote in his 1994 shareholder letter, “Stock prices will continue to fluctuate—sometimes sharply—and the economy will have its ups and downs. Over time, however, we believe it highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.”
Temporary Underperformance is the Price of Long-Term Success
For investors following the principles of quality investing, temporary periods of underperformance are not to be feared but embraced. As history has shown with Berkshire Hathaway, sticking to sound investing principles—regardless of market noise—will ultimately lead to superior long-term results. While the market may fluctuate, businesses that exhibit strong governance, competitive advantages, and intelligent capital allocation will continue to thrive over time.