How the Best Investor in the World beats the Market
For good reason, Warren Buffett has long been considered one of the most judicious investors of his generation. In fact, his firm Berkshire Hathaway has the highest risk-adjusted returns of any listed U.S stock or managed fund with a history of more than 30 years.
Which begs the question: What’s the source of Buffett’s above market returns?
The “conventional wisdom” has always conveniently been that his success is explained by his stock-picking skills and his discipline. However, a new study1 provides some very interesting and unconventional answers.
The following is a summary of the study’s findings:
- From November 1976 through December 2011 (a 35 year period), Berkshire realised an average return of 19.0% pa over and above the risk free asset (being U.S Treasury bills). In comparison, the S&P 500 (or the 500 largest listed stocks in the U.S) returned 6.1% above the risk free asset. That is an incredible result over such a long time period.
(It’s important to remember that Standard & Poor’s research comprehensively demonstrates that most investors don’t even get the market return – or in this case the S&P 500 return – over 5 years or longer. This is entirely due to ill-disciplined behaviour in volatile markets).
- As risk and return are related, you would expect Berkshire to have been exposed to more risk than the overall market to achieve this result. And indeed it was, with one measure being that Berkshire’s share price was 58% more volatile than the overall market. So only investors who remained disciplined and held onto their Berkshire stock would have enjoyed the long term performance.
- Berkshire had to endure periods of substantial losses compared to the overall market and significant drawdowns to achieve its results. For example, over the 20 month period to February 2000 (during the IT boom), Berkshire shares lost 44% of its market value, while the overall stock market gained 32%.
Not many fund managers could survive a 76% underperformance over a two year period! And no doubt there were many media commentators desperate to fill their column space each day who wrote off Berkshire shares during this time.
Buffett is clearly a proponent of our mantra “It’s not timing the market that counts, it’s time in the market that matters.”
- Buffett has boosted returns through the use of low cost debt to invest.
- Buffett has stuck with his strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or allowed emotion to interfere with the disciplined process of investing.
- Buffett’s approach is to buy large stakes in operating businesses and, in certain cases, provide strategic advice to management. He tends to nurture and support management more than other investors.
The study concluded that it is Buffett’s strategy that generated the alpha or above market returns, not his stock selection or market timing skills.
Our approach of targeting the dimensions of higher expected returns focuses on the factors that drive returns and deliver a premium:
Cash & Fixed Interest
- Credit & Term – only take credit risk and term risk where the bond portfolio is widely diversified and investors are adequately rewarded.
- Market – over time the stockmarket provides higher expected returns than cash and bonds because risk and return are related.
- Small – a well-diversified portfolio of small companies provides a higher expected return than large ‘blue chip’ stocks because small companies are riskier assets to own and tend to have a higher cost of capital. A higher cost of capital over the mid to long term results in a higher expected return.
- Value – a diverse portfolio of ‘cheap’ stocks as measured by book to market ratios provides higher expected returns than large, established ‘growth’ companies because these value companies are riskier assets to own.
It is the ones relating to the stock market – plus some additional elements like low cost borrowing – that the report concluded were the foundation of Buffett’s success.
Buffett’s genius thus appears to be in recognizing long ago that “these factors work… and sticking to his principles,” the study finds. It notes that it was Buffett himself who stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
When the study considered all the factors that Buffett targets in his investment approach, it found that only 0.1% pa of Berkshire’s stock price outperformance compared to the market could not be explained. In other words, whilst 0.1% could be attributed to skill or luck, the remaining outperformance could be quantified by academically accepted investment strategies employed by Buffett.
So we know that Buffett doesn’t have a special gift, he is just disciplined and buys primarily value stocks and then applies low cost debt.
Whilst the average high net worth investor cannot access the type of low cost leverage available to Buffett, you can access the other factors that contributed to his market-beating results.
Our Asset Class investment approach already captures the academically accepted factors that drive returns, plus ‘momentum’.
The academics we work with in the U.S have, after extensive research, uncovered a sixth factor that is currently being tested. This may be another evolution in our investment approach that is helping to provide our clients with the greatest probability that their lifestyle and financial goals will be achieved.
So in our own way, we are capturing the nous of Buffett through our evidence based approach to investment. However instead of our clients spending their time like Buffett studying the market for opportunities, we hope our clients are instead enjoying full and meaningful lives that don’t involve the day to day worries of investing.
Adapted from Larry Swedroe, Money Watch, 2 October 2012, with thanks.
1. ‘Buffett’s Alpha’, by Andrea Frazzini and David Kabiller of AQR Capital Management, and Lasse Pedersen of New York University and the Copenhagen Business School, 29 August 2012
Author: Rick Walker
Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.