- Was Buffett% 27s success, luck or% 3F skill
- The performance of Buffett% 27 can be largely explained by low risk exposure% 2C% 2C and quality factors.
- Buffett’s skill lies primarily in stock picking.
Is Warren Buffett’s success as an investor the result of luck or skill? Two analysts from AQR Capital Management, one of the largest and most sophisticated hedge funds in the world, and a professor from New York University have answered this question once and for all.
Your answer? Berkshire Hathaways (NYSE: BRK-A) (NYSE: BRK-B) exceptional performance over the years is not only the result of Buffett’s skill, but can be reproduced by the ordinary investor.
The origins of a classic debate
To be clear, this is an old question that dates back to at least 1984 when Buffett at the infamous Columbia Business School conference in 1984 commemorating the 50th anniversary of Benjamin Graham and David Dodd’s seminal book Securities Analysis vs. Economist Michael Jensen took over.
Jensen, a follower of the Efficient Markets School, which believes that analyzing public information about stocks does not produce systematic profit, argued that Buffett’s success was just luck. “When I look at a field of untalented analysts who all do nothing but toss coins, I expect to see some who have tossed two heads in a row and even some who have thrown 10 heads in a row,” argued Jensen.
Buffett’s reply? What if every head-turning analyst came from the same school of thought – Graham and Dodd’s school of value investing? Could the result be more than just a coincidence? Obviously the answer to Buffett’s mind was “yes”.
That must have marked the end of the debate, right? Not nearly. Despite Buffett’s compelling performance, that question has stayed on the minds of investors and analysts as it bypassed rock-solid statistical evidence in both cases. Until now it has been like that.
Revealing Buffett’s Alpha
In a recent paper appropriately titled Buffett’s Alpha (link opens a PDF), Andrea Frazzini and David Kabiller of AQR Capital Management and Lasse Pedersen of New York University claim to have solved the puzzle (emphasis added):
We show that Buffett’s performance can largely be explained by exposure to value, low risk and quality factors. This finding is consistent with the notion that Graham-and-Doddsville investors follow similar strategies to achieve similar results and contradicts stock selection based on coin toss. Hence, Buffett’s success doesn’t seem like luck.
After analyzing the universe of stocks, which were publicly traded for at least 30 years between 1926 and 2011, the authors concluded that Berkshire Hathaway, under Buffett’s leadership, had the highest Sharpe ratio (which measures risk-adjusted performance) of all. In addition, the authors found that Buffett had a higher Sharpe ratio than “any US mutual fund that has been around for more than 30 years”.
The authors also found that Buffett’s strategy is simple and actionable by the average investor – both of which, by the way, always maintained. For example, there has been an argument that Berkshire Hathaway’s success was due to its ability to buy private companies as a whole, rather than Buffett’s selection of individual publicly traded stocks.
That’s just not true, say the study’s authors. “We find that both public and private companies are contributing to Buffett’s performance, but the public equity portfolio does the best, suggesting that Buffett’s skill is primarily stock picking.”
In addition, the authors identified the exact variables that led to Buffett’s success in stock picking.
How does Buffett select stocks to get that attractive return that can be leveraged? We identify several general characteristics of his portfolio: he buys stocks that are safe (with low beta and low volatility), cheap (value stocks with low price-to-book ratios), and good quality (i.e. profitable and stable), growing and with high payout ratios).
Does it stand up to an examination?
To test this, I went back and looked at the reason for Berkshire Hathaway’s biggest public turnout now: Wells Fargo (WFC). “In general, Buffett didn’t like banks,” explained Roger Lowenstein in his Buffett biography. “But he had longed for this bank for years. Wells Fargo had a strong franchise in California and one of the highest profit margins of any major bank in the country.”
But it wasn’t until 1990, the worst year for banking since the 1930s crisis, that Wells Fargo got cheap enough for Berkshire Hathaway to consider holding more than the somewhat marginal position it had occupied the previous year. As Buffett stated in his letter to shareholders at the time:
Our 1990 Wells Fargo purchases were fueled by a chaotic market for bank stocks. The mess was appropriate: month after month, the foolish lending decisions of once respected banks were publicly displayed. When one huge loss after another became known – often after management reassurances that everything would be fine – investors understandably came to the conclusion that a bank’s numbers could not be trusted. Aided by their flight from bank stocks, we bought our 10% stake in Wells Fargo for $ 290 million, less than five times after-tax income and less than three times pre-tax income.
The point is that all three of the variables identified were present. While the industry was in chaos, Wells Fargo was safe. Buffett estimated that the worst-case scenario for the bank was break-even performance the following year. It was cheap as its inventory had fallen 50% since early 1990. And it was high quality. As Buffett stated at the time, “We believe we have won Wells Fargo with the best managers in the industry, Carl Reichardt and Paul Hazen.”
So what can you take away from it as an individual investor?
I want to make the implications of this study very clear – or rather, the message that you should take away from it. The more I learn about investing, the more it becomes clear that people fail because of impatience and an irrational willingness to make short-term flyers with speculative stocks.
However, as this study shows, this is the exact opposite of what made Warren Buffett so rich and successful. He buys reputable companies in the long run and waits until they trade at a sufficiently large discount to historical value. It doesn’t take a genius. You can do it too. It takes patience, discipline and a long-term time horizon.
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