David Peartree, The Daily Record Newswire
Warren Buffett has been the investor par excellence for nearly four decades. The question is whether he offers a model that other investors can or should emulate. He does, but not in the way commonly supposed.
Buffett is widely regarded as the consummate stock picker, but the explanation for his success is not so straightforward. A study published by three economists in November 2013, “Buffett’s Alpha,” is one of the few empirical studies to peal back his approach and deconstruct his performance.
Buffett’s performance over the 35 years covered by the study, 1976-2011, has been undeniably superior. His company, Berkshire Hathaway, handily beat the S&P 500 over that period. Berkshire Hathaway realized an average annual excess return of 19 percent over the T-bill, a common measure of the risk-free return. By comparison, the U.S. stock market only achieved an average annual excess return of 6 percent. Berkshire Hathaway’s returns were also better on a risk-adjusted basis than any other stock or mutual fund that has been around for more than thirty years.
Any way you look at it, Buffett’s performance has been impressive. No surprises here. The more interesting part of the study concerns how Buffett was able to do this and the lessons this holds for other investors. The study attributes Buffett’s success to three factors: his approach to picking stocks, the use of leverage, and discipline.
Conventional thinking is that Buffett’s stock picking skills are the source of his superior returns. According to the study, though, the type of stocks he selects better explains his performance than the particular stocks he selects. His success lies in the approach he takes, not in his stock picking per se.
Buffett look for stocks that are safe, cheap and high quality. For Buffett, “safe” means stocks with low volatility relative to the overall market, “cheap” means value stocks with a low price-to-book ratio, and “high quality” means stocks that are profitable, stable and have higher payout ratios. The study concluded that stocks with those characteristics do better in general, not just the ones that Buffett buys.
This finding in no way diminishes Buffett’s brilliance. He was smart enough to figure out what to look for decades before most other investors did.
A second major factor in Buffett’s success has been his ability to take advantage of cheap financing to fund his investments. The study looked at Buffett’s use of “leverage,” or borrowing, to magnify his investment returns. Most significantly, he has been able to take advantage of the insurance float from his holdings of insurance companies. “Insurance float” refers to insurance premiums that are collected in the present against claims that may be paid out many years later, if at all.
By borrowing against this insurance float, Buffett has been able to tap into a very cheap source of financing for many of his investment purchases. The study estimates that Buffett’s annual cost of borrowing against his insurance float was approximately 2.2 percent, less than the average T-bill rate over the period studied.
In addition, Berkshire Hathaway has enjoyed a top credit rating for many years, providing another source of low cost funds as needed. Finally, the study noted two other sources of cheap financing tapped by Buffett, his aggressive use of tax deductions for accelerated depreciation and income from the sale of derivative contracts.
Finally, Buffett has been the epitome of a disciplined, long-term investor. He is not swayed by short-term trends. Few recall, for example, that Berkshire Hathaway was down 44 percent from June 1998 through February 2000, a period during which the market gained 32 percent.
A shortfall of 76 percent will test anyone’s mettle, but Buffett refused to buy into the hype of the late 1990s market that eventually became a tech stock bubble. He has shown the discipline to maintain his investment strategy even during periods of significant underperformance.
The lessons Buffett offers for other investors may challenge conventional thinking. First, pure stock picking skill appears not to be the essential ingredient to his success.
Second, to the extent his success is based on buying stocks with particular characteristics — safe, cheap and high quality — investors can try to copy that strategy. Indeed, there are now mutual funds and ETFs that try to do just that.
But it is interesting to note that Buffett’s outperformance relative to the U.S. stock market has been steadily declining. During the late 1970s through the mid-1990s, he vastly outperformed the overall stock market. From 1976 through 1980, he outperformed by 34 percent.
Since 1996, however, the margin of outperformance has narrowed considerably. From 2001-2005 he outperformed the market by 1.6 percent and from 2006-2011 he outperformed by 2.5 percent. This is still outstanding performance but it is no longer otherworldly as in his heyday. In fact, over the last five years Berkshire Hathaway has underperformed the total U.S. market by about 3 percent.
William Bernstein, a noted financial theorist and author, has observed that market beating strategies only seem to work for the few who adopt them early and before the rest of the market piles in. The future success of the “Buffett approach” is far from certain.
Third, most investors — and that includes even most large institutional investors — will never have access to the kind of low-cost leverage that Buffett has been able to exploit to magnify his returns.
You begin to wonder why Warren Buffett keeps saying that most investors, including institutional investors and his heirs, would be better off building their portfolios around low-cost index funds. The best lesson offered by Warren Buffett may be to do as he says, not as he does.
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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
