DO YOU WANT TO KNOW THE SECRET to Warren Buffett’s remarkable investment success?
First, some background. Buffett partially owns a company called Berkshire Hathaway and he uses this as his vehicle for making investments in other companies. So, when people say Buffett is a great investor, they’re looking at the performance of Berkshire Hathaway stock which, in turn, tends to reflect the performance of the companies Berkshire owns.
Further, a recent academic paper by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen, titled Buffett’s Alpha, said, “Buffett’s performance is outstanding as the best among all stocks and mutual funds that have existed for at least 30 years.”
Now, here’s the secret to Buffett’s spectacular returns according to the paper’s authors:
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
Let’s look at each of those components:
1) Cheap: defined as value stocks with low price-to-book ratios
2) Safe: defined as stocks with low beta and low volatility
3) High-quality: defined as stocks of companies that are profitable, stable, growing, and have high dividend payout ratios
4) Leverage: perhaps shockingly, the authors discovered that Berkshire magnified its returns by leveraging its capital by 60 percent financed partly using insurance float with a low financing rate Source: Buffett’s Alpha paper
This is not a buy or sell recommendation on Berkshire Hathaway stock, rather, it shows Buffett latched on to a good strategy early in his career, used leverage to magnify his returns, and stuck to the strategy even when it suffered large declines.
Now that we know “how” Buffett achieved his outstanding return (including the surprising leverage), does this in any way diminish his results? No. In fact, it’s probably just the opposite. Buffett figured this strategy out more than 30 years ago and researchers are just now catching up with him!
The rest of the commentary can be found here.
Please be sure to visit the Parks Wealth Management website at www.parkswm.com.
James T. Parks, CFP®, AEP, AIF
President and Wealth Advisor