Don’t Play Billionaire Squares

Several years ago I read an article that gave what I felt was terrible investment advice. At a time I thought ethanol companies were deep into bubble territory, that article (which due to the nature of the Internet is still out there to the author’s chagrin) touted ethanol companies.

The real kicker in the article was the appeal to authority — an argument I see people make every week. You knew ethanol was a good investment because Bill Gates was investing in Pacific Ethanol (NASDAQ: PEIX). If “some of the richest and most successful people in the world” were investing in ethanol, you knew it had to be a good deal.

I wrote a rebuttal arguing that ethanol companies were overvalued, and unsurprisingly I got more than a few responses along the lines of this actual comment: “Unlike you, Bill Gates has the ability to see into the future. You are very, very stupid if you think Pacific Ethanol will continue to decline.”

But the share price did continue to fall as the ethanol bubble popped, and was down 40% less than three months after I wrote that article. The U.S. government would ultimately step up with increased ethanol mandates in a bid to keep the industry from collapsing. Pacific Ethanol’s share price fell from nearly $40 at its peak to less than $2, with Gates selling at a loss in the neighborhood of 50% on the way down. (Not to pick on Gates, but he also invested in advanced biofuel company KiOR in 2013, one year before it went bankrupt.)   

I am not trying to pat myself on the back here, but rather to make a point. Bill Gates got very rich because he saw an opportunity in the developing personal computer industry. Had it not been for that, he may have very well made his fortune in another field. But he didn’t make his fortune in the energy business. Appealing to Bill Gates’ authority on an energy investment is like preferring his recommendation on the best way to change the brakes on a car or the proper way to perform brain surgery.

(And that’s assuming Bill Gates actually makes most or all of the decisions on where to invest his billions, which tells you a lot about someone’s financial sophistication right there.)

An authority often appealed to in the energy business is Warren Buffett. Certainly Buffett knows a thing or two about investing. There are few investments that can rival the long-term track record of Buffett’s Berkshire Hathaway (NYSE: BRK.A). So Buffett is certainly an authority. He has made quite a few investments that have performed extraordinarily well. An example is his acquisition of the BNSF railroad, which has seen rapid growth in the transport of crude oil out of North Dakota’s Bakken formation.  

So the appeal to authority in the case of Buffet is understandable, but the problem with this argument is that it fails to acknowledge that people like Buffett, or Bill Gates, or Elon Musk, or choose any other billionaire you wish to emulate — are often wrong, and sometimes spectacularly so, even if they’re the actual decision makers. Thus, if you choose to invest because an authority has invested, you can get badly burned. You won’t get in as early as they got in (shares will often move as soon as their investment becomes public), and you likely won’t get out as early if things are going badly.

Buffett has acknowledged some of his blunders in the energy space. One was loading up on ConocoPhillips (NYSE: COP) as oil prices were nearing their peak in 2008. The subsequent correction sharply reduced share prices across the energy sector, and Buffett subsequently told investors that even though be believed that “the odds are good that oil sells far higher in the future than the current $40-$50 price” it was a decision that “cost Berkshire several billion dollars.”

More recently, in 2013, with oil above $100/bbl, Buffett bought 41.1 million shares of ExxonMobil (NYSE: XOM). His purchase was followed by a number of articles in various financial publications arguing that investors should follow Buffett’s lead. For some, ExxonMobil became the “must own” oil company, since it was endorsed by Buffett. Fast forward to 2014 and Berkshire sold the entire ExxonMobil stake during the fourth quarter as oil prices were sliding steeply (although ExxonMobil held up better than most).

The point is that every investor makes bad calls. Those with the greatest success — like Warren Buffett — get it right more than they get it wrong, but they do still get it wrong. So those who appeal to authority will sometimes lose money, and sometimes they will end up eating some big losses. You would probably be better off copying someone’s investment not because that someone is rich but rather because of demonstrated expertise in relevant subject matter.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)