The Real Secret to Warren Buffett’s Success

Fair warning, gentle reader… the next two DailyWealth essays are, in all likelihood, a waste of your time.

Unless, that is, you’d like to know the real secret to Warren Buffett’s almost unbelievable investment track record over the last 50 years. In my view, understanding this secret is bar none the most valuable thing you can ever learn as a common-stock investor.

As some of you may know, I’m currently writing a book about Buffett, titled Warren’s Mistakes. I know… the world doesn’t need another book about Buffett.

[ad#Google Adsense 336×280-IA]There are dozens of good books out already.

(The two best are The Snowball by Alice Schroeder and Buffett: The Making of an American Capitalist by Roger Lowenstein.)

I’m writing my book because the mainstream media and most of the financial community fail to realize how much Buffett’s investment style has changed since 2000.

And not for the better, either.

In the next two essays, I’d like to show you what lies at the center of Buffett’s incredible results… and exactly why his more recent results have been lackluster.

AQR Capital Management is one of the world’s largest and best quantitative hedge funds. Its founder, Cliff Asness, got a PhD at the University of Chicago. He studied alongside the “market is perfectly efficient” crowd… the guys who think it’s impossible to beat the market consistently. But when he studied the market carefully, he found patterns – thousands of anomalies – that could be exploited for profits.

If you read Steve Sjuggerud’s work, you’ll recognize the strategy that Asness discovered. He found that both value strategies (buying stocks when they are significantly underpriced relative to their assets or earnings) and momentum strategies (buying stocks that are going up or selling stocks that are going down) worked.

But the best strategy was combining the two approaches, buying cheap stocks after they began to go up. Or, as Steve puts it, Asness found that buying stocks that were “cheap, hated, and in uptrend” was the best way to beat the market.

While Asness wasn’t the first market analyst to adopt this approach, he was the first researcher who took the time to assemble enough high-quality data to prove it worked empirically. By the mid-2000s, Asness was managing almost $40 billion in capital, utilizing various computerized strategies that distributed investments among hundreds of stocks that met his criteria. (Likewise, Sjuggerud has also built computer systems to aid his investing. His True Wealth Systems track record outperforms his own human-selected recommendations in True Wealth.)

I bring up Asness because you need to understand there’s probably nobody in the world more qualified to pass judgment on Buffett’s track record.

Asness has been the world’s leading market empiricist since the early 1990s, when he built investment bank Goldman Sachs’ first quantitative investment fund before founding AQR in 1997. Asness is a genius at studying how the market actually works, instead of simply describing how it ought to work.

In 2013, Asness sponsored a “deep dive” into understanding how Buffett was able to produce such outstanding results over such a long period of time.
They looked at all the stocks and mutual funds that have traded since 1926 and found that nothing beat Berkshire Hathaway. That is, Berkshire has the highest “Sharpe ratio” among all possible publicly traded equity investments.

For those of you who aren’t finance geeks, the Sharpe ratio is a simple measure of a stock’s annual return over its volatility. Put simply, Buffett has earned roughly twice the returns he should have been able to make given the volatility of Berkshire’s stock.

While that’s incredibly impressive – the best record in the entire stock market – it’s still not enough. Doubling the return of the stock market only gets you to about 16% annualized returns… not the 20% annualized Buffett has earned at Berkshire. So how did he do it?

The real secret Asness discovered is leverage. What? How is that possible? Berkshire is rightly famous for being a fortress of financial stability. The company currently holds around $250 billion in cash. It has no net debt. Over the long term, the company has averaged total debt (short- and long-term) of around 20% of book value.

Nevertheless, Asness’ team reports, “We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.”

This leverage was created by using the “float” from his insurance companies. That’s the money that was paid in insurance premiums but not yet paid out in claims. Berkshire currently holds $84 billion in float. Berkshire’s insurance subsidiaries have a 12-year record of profitable underwriting, so Buffett has used all of this capital for free. It’s this leverage that explains the rest of Berkshire’s “alpha” – of the excess returns Buffett has earned.

Buffett isn’t the only investor who figured out that leveraging safe stocks can produce outstanding results. In the 1940s, while serving as an insurance regulator for the state of New York, Shelby Davis figured out that some insurance companies could compound their book value at market-beating rates. These rare firms, with exceptional underwriting skills, proved that they could increase their net worth, year after year, regardless of the economy.

In 1947, Davis quit his job. Starting with just $25,000, he set to work as a private investor, exclusively buying high-quality insurance stocks. Within 15 years, he was a millionaire. At his death in 1994, he was worth nearly $1 billion. His average annualized gain was 24% – matching Buffett’s. Davis produced this result without the benefit of controlling an insurance company. He was merely an investor in the common stock. But he used full margin at all times. This greatly amplified his returns and greatly increased the volatility of his portfolio. It nearly wiped him out in the 1974 bear market.

The Asness team saw the same kind of volatility in Berkshire’s shares. Berkshire fell 51% from peak to trough in the 2008-2009 financial crisis. It saw a 49% decline in the bear market of 2000. It fell 37% during the “Black Monday” stock meltdown in 1987. So the Asness researchers asked the key question: What kind of stocks are good enough and safe enough to be leveraged successfully over long periods?

What they discovered won’t surprise you. Here’s how they described Buffett’s picks: “He buys stocks that are safe, cheap, and high-quality (meaning stocks that profitable, stable, growing, and with high payout ratios).” Pay special attention to the last criterion (high payout ratios). We’ll come back to this attribute in tomorrow’s essay… By using this description, the Asness team is withholding something critical.

Using this information, the Asness researchers programmed their computers to run simulations “buying” large numbers of companies that matched Buffett’s criteria. By doing this, they were able to build portfolios that were highly correlated to Buffett’s portfolio. Using leverage on these portfolios, they were able to produce results that matched Buffett’s, even though their portfolios were far more diversified and made up of different stocks. As the Asness team concluded…

We find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.

In tomorrow’s essay, I’ll explain the key to finding companies that are good enough and safe enough to leverage like Buffett has. I’ll also show you how Buffett’s strategy has drastically changed since around 2000… and why these fundamental changes have doomed Buffett, and Berkshire Hathaway, to underperformance in the years ahead.

Regards,

Porter Stansberry

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Source: Daily Wealth