Dear Mrs. Buffett, About That Index Fund

June 04, 2014

Recommending an index fund isn’t the same as understanding indexing.

Dear Mrs. Buffett,

I am writing in response to your husband’s well-penned advice to you for investing your inheritance. Warren made waves by recommending you invest 90 percent of your cash in Vanguard’s S&P 500 ETF (VOO | A-96).

Warren likes VOO because it’s broad-based and cheap. VOO costs a measly 0.05 percent per year, or just $5 for each $10,000 invested; replicating a basket of U.S. large-cap stocks doesn’t take many resources these days. But VOO comes with opportunity cost, because it omits midcaps, small-caps, foreign companies and firms that have short-term earnings struggles.

Warren is the world’s most respected investor, and he should direct you to Vanguard’s most complete index fund. Vanguard’s Total World Stock ETF (VT | B-100) delivers the whole world to your portfolio, for just 0.18 percent a year.

I hope Warren has many more years upon this earth, for your sake and for the sake of investors everywhere. I am particularly grateful for his recent support of index investing, as he reminded us that a healthy dose of humility is a key ingredient to successful lifelong investing.

“The goal of the non-professional should not be to pick winners—neither he nor his “helpers” can do that—but should rather be to own a cross-section of businesses that in aggregate are bound to do well.” —Berkshire Hathaway Annual Report, 2013

Your husband has spent a lifetime understanding businesses and estimating their worth.

He has earned the right to be snarky about picking winners.

“Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.”

He has famously insisted on staying within his “circle of competence”—focusing on businesses that he understands, buying them at bargain prices. Warren sticks with what he knows.

He recommended you invest your inheritance in the world’s most recognizable index—the very one that most American investors cite. The S&P 500 Index is as familiar as Cherry Coke.

But if you and Warren apply the famous Buffett scrutiny to the S&P 500 Index, you might be surprised by what you find.

What’s Not In The S&P 500

For starters, the S&P 500 is a U.S. large-cap index. The S&P 500 misses out on midcaps and small-caps, and on many of the world’s best businesses.

Moreover, the 500 securities that it does hold are not, as most assume, the top 500 U.S. stocks by market cap. They’re actually a curated subset of the top 1000 stocks, more or less. The S&P 500 Index rules require that a company post positive earnings for the most recent quarter, and, in the aggregate, the past 12 months. The S&P index committee then chooses its 500 firms from among those companies that pass all its screens.

Warren knows all about choosing stocks. But he does things differently.

According to Berkshire Hathaway’s March 31, 2014 13-F regulatory filings, more than 25 percent of Berkshire’s portfolio of 45 publicly traded companies—12 stocks, to be exact—are not in the S&P 500.

Company Market Value of Berkshire's Stake ($M) Berkshire Ownership Percentage Market Cap ($M) Earnings Per Share  ($TTM) Reason for S&P 500 Exclusion
Sanofi SA 207.5 0.2% 138,135 3.04 Non-US
Suncor Energy Inc. 500.9 0.9% 51,462 1.90 Non-US
Liberty Global plc - Class A 330.7 3.4% 32,232 -3.39 Negative earnings
Liberty Global plc - Class C 315.0 1.3% 32,232 -3.39 Negative earnings
Liberty Media Corp 678.6 4.6% 14,945 68.97
Verisk Analytics Inc. 94.9 0.9% 10,003 2.09
Chicago Bridge & Iron Company 774.9 8.8% 9,407 3.35 Non-US
Media General Inc. 85.3 5.2% 7,533 -0.18 Non-US, Negative earnings
WABCO Holdings Inc. 436.0 6.7% 6,473 4.65
USG Corp. 1,302.1 31.5% 4,497 -0.19 Negative earnings, Midcap
Starz 59.0 1.8% 3,547 2.13 Midcap
Lee Enterprises Inc. 0.4 0.2% 239 -1.52 Negative earnings


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