Warren Buffett’s Secret

As of September 2012, Warren Buffett is listed as the 2nd richest man in the world with a value of $46 billion. Warren Buffett started investing in 1956 and by 1969 closed his first investment fund after having made $25 million for himself. He eventually formed a new company that was called Berkshire Hathaway (the name of a textile company he had bought in the past). His investment performance with Berkshire Hathaway has been truly amazing. From 1976 to 2011, Berkshire Hathaway’s Sharpe ratio (0.76) was higher than any individual stock that existed for at least a 30-year period between 1926 and 2011. It is the highest ratio of any mutual fund that existed between 1926 and 2011 and had at least a 30-year history. Over this period, Berkshire outperformed Treasury Bills by 19% per year and the stock market by 6.1% per year. If you had invested $1,000 with Berkshire in 1976, it would be worth $1.5 million by 2011. This is great performance, but it wasn’t all smooth. There was a time, during the internet bubble, when people began to doubt Buffett and say that he was too old. From June 30, 1998 to February 29, 2000, Berkshire lost 44% of its market value while the overall stock market gained 32%. However you look at it though, there is a reason Warren Buffett is the 2nd richest man in the world—he knows how to pick stocks.

Investors want to know Buffett’s secret recipe. Is there a way to replicate his behavior using basic investment rules. A very good book on how to do this is Quantitative Equity Portfolio Management. Some new research suggests that Buffett’s success can be explained. So here’s the secret recipe for Buffett’s success:

1. Buy companies that have high quality characteristics. That is, historically high profit margins, historically high return-on-equity, historically high return-on-assets, low accruals, and high payout ratios.

2. Among those companies, choose those that have low market beta. That is, choose companies with market beta less than 1. Avoid companies with beta greater than 1.

3. Leverage your portfolio by about 1.6 to 1. Most brokerages in the United States allow leverage of up to 2. Thus, this falls within that framework. Remember though, with leverage comes increased risk and the possibility that a margin call may take place.

4. Be able to cheaply borrow for this leverage. If possible, 3 percentage points less than Treasury bills. This would not have been feasible for most investors in the past and certainly is not feasible today with interest rates near 0. Buffett was able to do this because of his ownership of insurance businesses, which help him borrow money cheaply in the past.

Most retail investors will be able to do three of these steps, but not the final step, because margin rates at brokerage houses are typically high. However, doing 3 of the 4 may be provide value-add as well.

As exciting as this new research is, there are certain reasons it might not be so applicable today. First, the study did not consider transaction costs, which were much higher in the early part of Buffett’s investing career. Second, the U.S. markets are much more efficient today. There are so many clever quants and portfolio managers chasing good stocks that such simple strategies may not do as well. For example, an entire class of fundamental indices have been created that weight companies on variables such as profitability, rather than market capitalization. In fact, since January 2008, the Berkshire Hathaway fund has underperformed the S&P 500 by about 1/2 percent per annum. Third, a back-tested strategy is always subject to possible data mining and so only time will tell if these new factors really have the secret sauce or not.

If you do follow a strategy similar to this one, be aware that the Bush tax cuts may expire in 2013 and this could lead to a selling of high-dividend paying stocks (or high payout ratio) stocks, which could cause you some discomfort in 2013.