Readers will know that this column buys into the notion that diversification is the only free lunch out there and it thus advocates buying stocks mostly via low cost passive and actively managed funds. For an advisor this strategy has the added advantages that it is pretty easy to implement and is less likely to get you offside with the FMA. The downside is that advisors can probably make more money recommending clients buy and sell individual stocks, in the short term anyway.
Despite the intrinsic advantages of diversity and the countless academic papers demonstrating that doing as well as the index is a hard act to follow you can be certain that, whenever a column advocating this approach appears online, within 30 seconds or so any number of comments appear from "buy individual stocks" devotees. Many of these views are of course anonymously authored by financial planners and stockbrokers waiting for Mighty River. However one common denominator stands out and that is that many of the believers of the "you can do you own research, find great stocks and be an alpha male" approach cite as evidence the remarkable and undeniable success of the Sage of Omaha, Warren Buffett.
Since December 1976 Buffet's company, Berkshire Hathaway (BRKA on the NYSE and USD$152,750 per share no silly share splits for Warren) has returned 22.9 per cent pa. In the same period the S&P500 has returned 10.5 per cent pa. This is all well and good but what Warren's groupies conveniently forget is that, statistically, Warren is an outlier, i.e. for every Warren there are a million or so try-hards whose retirement has been permanently postponed by the impact of their attempt to pick winners.
The good news is that we are not going to rehearse the attractions of diversification again today (sigh of relief from readers). Instead let's throw caution to the wind and take a look at some interesting new research from two people at AQR Capital Management (run by Cliff Asness) and a guy at New York University which attempts to explain how Warren did it. We will then consider if it's possible to copy his strategy so that we can all become filthy rich. The research decomposes Mr Buffet's success into three main areas;
The biggest factor in determining the Sage's outperformance has been the fact that he recognized early in his career that high quality, growth stocks were undervalued relative to the market. This factor is probably the most valuable piece of information for retail investors because it is pretty easy to copy. Mr Buffett alludes to this strategy in various annual reports when he says "whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down" and "I try to buy stock in businesses that are so wonderful that an idiot can run them because sooner or later, one will".
The research looked at whether Berkshire Hathaway's success was idiosyncratic or if it could be simply explained by these characteristics. Using various statistical analyses which we won't go into the authors conclude "accounting for the general tendency of high quality, safe and cheap stocks to outperform can explain much of Buffett's performance".
Earlier in his career Mr Buffett was able to buy stocks cheaply then more recently he bought opportunistically at the time of market crashes but markets have become much more efficient in the last twenty years so the potential to buy things at bargain prices has reduced. Note that in the ten years ended February 28 2013 Mr Buffett's company has returned 9.5 per cent pa which is ahead of the 8.2 per cent pa of the S&P500, but not really shooting the lights out either. The absence of bargains is further illustrated by his recent purchase of Heinz as its valuation measures were higher than the market average even before Mr Buffett made his takeover bid.
Another big part of the Buffet's success has been due to his willingness to borrow to invest and his ability to do so cheaply and maintain high levels of leverage even when things go bad. This latter point is quite critical because when things go bad for hedge fund managers the banks frequently withdraw funding and, in the same way, when things go bad for Mr retail investor their wives quite sensibly shut things down. The authors estimate that Buffett's average leverage has been about 1.6 to 1 which is high and that it relies on unusually low cost and stable sources of financing.
So there you go. That is how Warren does it but before we all race out and attempt to become alpha males there are a couple of cautions we should observe. Firstly the history of academic research uncovering profitable investment strategy is characterized by one sad fact and that is as soon as a strategy which makes money is widely identified it usually goes sharply into reverse for ten years or so until all the new money has lost faith and then start anew, albeit from a lower base. I am thinking here in particular of some research twenty or so years ago which highlighted the fact that small companies outperformed.
Virtually as soon as this report made the Financial Analysts Journal small companies underperformed larger stocks for about ten years. There are lots of other examples but I can't think of them at the moment. Secondly leverage is scary and you tend to lose your nerve when things get really bad and if you don't lose your nerve the person funding you may. Lastly .... Warren's early years were his best and, in recent times, his outperformance hasn't been nearly so great so maybe "Mr Market" is catching up to WB.
Now before we get a stream of complaints from Buffett-ites the authors of the study stress that their work does not in any way diminish Mr Buffett's outstanding accomplishments. They write that he decided to invest based on these principles fifty years ago, found a way to apply cheap leverage, stuck to his principles and continued to operate at high risk even after experiencing some setbacks that would have caused many other investors, not to mention their financiers and wives, to rethink and retreat from their original strategies.
Space has meant that we haven't been able to go into much detail on the secret of Warren Buffett's success so interested readers should google "Buffett's Alpha" to read the whole paper.