Is Buffett’s investment success a matter of skill or luck? Two analysts at AQR Capital Management, one of the most sophisticated and largest hedge funds in the world, coupled with a New York University professor, teamed up to answer this question once and for all.
The answer they came up with… Buffett’s skill is legitimate and his extraordinary performance over the years is deserved, but more importantly than that, the average investor can also replicate his investing methods.
The Classic Debate and Its Origins
Clearly, this debate has been raging for a while – as far back as 1984 – when Warren Buffett went toe to toe with economist Michael Jensen in 1984 at the Columbus Business School conference where David Dodd and Benjamin Graham’s book Securities Analysis was commemorated for the 50th anniversary.
Jensen, a believer in the efficient market school, which currently holds that no profit can be earned systematically from going over the public information about a stock, made his argument that Buffett’s success was just luck. “If I survey a field of untalented analysts all of whom are doing nothing but flipping coins, I expect to see some who have tossed two heads in a row and even some who have tossed 10 heads in a row,” reasoned Jensen.
Buffett’s reply… What if the analysts that continued to flip heads all came from the same school of thought – in particular, the value investing methods of Graham and Dodd? Could there be more to the outcome than just random chance? The obvious answer in Buffett’s mind was “yes.”
You may have thought that the debate ended there, but you’d be wrong. Even though Buffett gave a convincing performance, the question remained in the minds of many investors and market analysts because rock solid proof was not provided either way. That is until right now.
Discovering Warren Buffett’s Alpha
In a paper that was recently published titled Buffett’s Alpha, David Kabiller and Andrea Frazzini of AQR Capital Management and Lasse Pedersen of New York University believes that they have solved the puzzle:
“We show that Buffett’s performance can be largely explained by exposures to value, low risk and quality factors. This finding is consistent with the idea that investors from Graham and Doddsville follow similar strategies to achieve similar results and inconsistent with stocks being chosen based on coin flips. Hence, Buffett’s success appears not to be luck.”
After closely analyzing a wide variety of stocks that were publicly traded for about 30 years between the years 1929 in 2011, the authors came to the conclusion that under Warren Buffett’s stewardship, Berkshire Hathaway had the highest Sharpe ratio (a measurement of risk-adjusted performance) out of everyone. And above all else, the authors of the study discovered that Buffett had a much higher Sharpe ratio than “all US mutual funds that have been around for more than 30 years.”
The authors also recognized that the Buffett strategy is implementable and straightforward for the average investor – which is something that he has always claimed. Many have argued that Berkshire Hathaway’s major success comes from its ability to buy large private companies as opposed to Buffett selecting publicly traded stocks on an individual basis.
There’s simply no truth to this rumor, according to the authors. “We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performs the best, suggesting that Buffett’s skill is mostly in stock selection.”
The authors even figured out many of the specific variables that Buffett uses to lead to his ultimate success in stock picking.
How does Warren Buffett choose stocks as a way to achieve attractive returns that he can leverage? We’ve recognized several general features in his portfolio: He only buys safe stocks with low volatility and low beta, he buys value stocks at low price-to-book ratios, and the companies are always high quality, which means that they are growing, stable, profitable and have high payout ratios.
Does This Hold up under Examination?
In order to test this theory, we’ve taken a look at Berkshire Hathaway’s reasons for purchasing Wells Fargo, there now largest publicly traded holding. “Generally, Buffett did not like banks,” mentions Roger Lowenstein in his Warren Buffett biography. “But he had been pining for this bank for years. Wells Fargo had a strong franchise in California and one of the highest profit margins of any big bank in the country.”
But not until 1990, right in the middle of banking’s single worst year prior to the 1930s, did Wells Fargo become cheap enough for Berkshire Hathaway to own more than just a marginal position that it had began just the year previous. At the time, Buffett explained it in his letter to shareholders:
“Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled – often on the heels of managerial assurances that all was well – investors understandably concluded that no bank’s numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pretax earnings.”
Here’s the point… Every one of the three identifiable variables was there. Wells Fargo was safe even though the industry itself was in complete chaos. Buffett recognized and estimated that the worst-case scenario for Wells Fargo was a performance that would break even the following year. It was cheap to purchase, since the stock price dropped 50% starting in the beginning of 1990. And it’s a high-quality company. Buffett even noted at the time, “With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen.”
What can you take away from this as an individual investor?
Let’s be really clear about this study’s implications… or on the other hand, the message that you need to take away from this. The more that you learn about investing, the more it’s easy to realize that people fail due to impatience and their willingness to look for short-term volatility on highly speculative stocks.
This study clearly demonstrates, however, that Warren Buffett’s success was earned exactly for the opposite reasons, and that’s why he is so wealthy today. He buys real businesses for the long-term and waits for the stock price to trade at a very steep discount to their historical value. You do not need to be a genius to do this. Anyone can do it. But you have to have patience, a long-term timeline and serious discipline.