Wednesday, October 3, 2012

Investing LIke Warren

Probably no investor in the history of Wall Street has been more widely followed and analyzed than Warren Buffett.

If you go to Amazon, for example, and type in "Warren Buffett" in a book search, you will find 1,117 paperback books, and 832 hardcover books, that have sufficient reference to Mr. Buffett that they are included in the search results.

Buffett's influence has been pervasive. News that Buffett might be buying a stock is usually cause for that stock to soar.

Buffett's views have been cited in dividend payouts (Berkshire Hathaway does not pay a dividend); tax policy (President Obama calls his proposal to increase tax rates on annual earnings of more than $1 million "the Buffett rule"); and philanthropy (Buffett famously is giving away most of his money, as is his good friend Bill Gates of Microsoft).

I think that one of the reasons that Buffett is so widely followed is that his investment style seems to be so easily duplicated.  Buying shares in companies like Coca-Cola; American Express; and Wells Fargo is not an actively limited to billionaires - anyone with capital and access to a brokerage account could buy the same stock.

Buffett is also famously very open about how he invests.  The letters in his annual reports are very readable, and he often appears in the business media.

Yet few, if any, have the investment track record over the past 50 years that Warren Buffett has been able to compile.

The Economist's Buttonwood column recently covered the latest research reports trying to figure out why Buffett is so good.

You can read the whole piece by following the link, but basically researchers at New York University and AQR Capital Management believe that Buffett's success boils down to two factors:  investing in low beta stocks, and an aggressive use of financial leverage.

Low beta stocks typically offer superior risk-adjusted returns to higher beta stocks, but market investors often will gravitate to higher beta stocks in an effort to produce superior returns. This means that "boring"stocks are often mispriced relative to their more volatile brethren.

According to the researchers, Buffett has combined leverage with low beta stocks with leverage (derived from the float in Berkshire's reinsurance business) to give him the best of both worlds, and deliver spectacular returns.

Here's an excerpt from the piece:

Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Better still, the firm has been able to borrow at a low cost; its debt was AAA-rated from 1989 to 2009....

These two factors—the low-beta nature of the portfolio and leverage—pretty much explain all of Mr Buffett’s superior returns, the authors find. Of course, that is quite a different thing from saying that such a long-term performance could be easily replicated. As the authors admit, Mr Buffett recognised these principles, and started applying them, half a century before they wrote their paper.

I am not sure I totally buy into this latest research. I think there are other factors included in Buffett's DNA that has allowed him to invest in the way that he has.

For example, one big factor, it seems to me, is his incredibly long time frame in managing his investment portfolio.  This is a concept he took from growth stock giant Phillip Fisher, who used to say that his optimal holding period for a stock is "forever".

Buffett's partner Charlie Munger was interviewed recently by the BBC.  Munger was asked whether he and Buffett were concerned about the recent share price drop of Berkshire Stock.

Not only did Munger immediately dismiss any concerns about the share price drop, he went on to say that Berkshire has experienced price declines of up to -50% over the course of their management, and it was never a cause for concern.

Moreover, Munger says, anyone who invests in stocks should be prepared for large price declines. If they can't handle a decline, they should be prepared for the "mediocre results that they will almost certainly earn".

Here's the interview in total.  The most important comments occur at the start: