Is Warren Buffett's success as an investor the result of luck or skill? That's the question two analysts at AQR Capital Management, one of the world's largest and most sophisticated hedge funds, and a professor at New York University teamed up to answer once and for all.
Their answer? Not only is Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) extraordinary performance over the years the result of Buffett's skill, but it can also be replicated by the ordinary investor.
The origins of a classic debate
To be clear, this is an old question, dating back to at least 1984, when Buffett squared off against economist Michael Jensen at the infamous 1984 Columbia Business School conference commemorating the 50th anniversary of Benjamin Graham and David Dodd's landmark book Securities Analysis.
Jensen, an adherent of the efficient-markets school, which holds that no profit can be systematically earned from analyzing public information about stocks, argued that Buffett's success was no more than luck. "If I survey a field of untalented analysts all of whom are doing nothing but flipping coins, I expect to see some who have tossed two heads in a row and even some who have tossed 10 heads in a row," Jensen reasoned.
Buffett's retort? What if every analyst who flipped heads time after time came from the same school of thought -- namely, Graham and Dodd's school of value investing? Might there be something more to the outcome than simply random chance? Obviously, in Buffett's mind, the answer was "yes."
This must have marked the end of the debate, right? Not even close. Despite Buffett's convincing performance, this question has lingered in the minds of investors and analysts because of its evasion of rock-solid statistical proof either way. Until now, that is.
Uncovering Buffett's alpha
In a recent paper appropriately titled Buffett's Alpha (link opens a PDF), Andrea Frazzini and David Kabiller from AQR Capital Management and Lasse Pedersen from New York University claim to have solved the puzzle (emphasis added):
We show that Buffett's performance can be largely explained by exposures to value, low-risk, and quality factors. This finding is consistent with the idea that investors from Graham-and-Doddsville follow similar strategies to achieve similar results and inconsistent with stocks being chosen based on coin flips. Hence, Buffett's success appears not to be luck.
After analyzing the universe of stocks that traded publicly for at least 30 years between 1926 and 2011, the authors concluded that Berkshire Hathaway, under Buffett's stewardship, had the highest Sharpe ratio (which measures risk-adjusted performance) of them all. On top of this, the authors found that Buffett had a higher Sharpe ratio than "all U.S. mutual funds that have been around for more than 30 years."
The authors also found that Buffett's strategy is straightforward and implementable by the average investor -- both of which, by the way, he's always claimed. There's been the argument, for instance, that Berkshire Hathaway's success stems more from its ability to purchase private companies in total versus Buffett's selection of individual publicly traded stocks.
This simply isn't true, say the study's authors. "We find that both public and private companies contribute to Buffett's performance, but the portfolio of public stocks performs the best, suggesting that Buffett's skill is mostly in stock selection."
Beyond this, the authors ferreted out the precise variables that led to Buffett's success at picking stocks.
How does Buffett pick stocks to achieve this attractive return stream that can be leveraged? We identify several general features 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 high-quality (meaning stocks that are profitable, stable, growing, and with high payout ratios).
Does this stand up under examination?
To test this, I went back and looked at the reasoning behind Berkshire Hathaway's now-largest public holding: Wells Fargo (NYSE: WFC) . "Generally, Buffett did not like banks," explained Roger Lowenstein in his biography of Buffett. "But he had been pining for this bank for years. Wells Fargo had a strong franchise in California and one of the highest profit margins of any big bank in the country."
But it wasn't until 1990, the single worst year for banking since the crisis of the 1930s, that Wells Fargo became cheap enough for Berkshire Hathaway to consider owning more than the somewhat marginal position it had staked the previous year. As Buffett explained in his letter to shareholders at the time:
Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled -- often on the heels of managerial assurances that all was well -- investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
The point being, all three of the identified variables were present. While the industry was in chaos, Wells Fargo was safe. Buffett estimated that the worst-case scenario for the bank was a break-even performance the following year. It was cheap, as its stock had fallen by 50% since the beginning of 1990. And it was high-quality. As Buffett noted at the time, "With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen."
So, what can you, as an individual investor take away from this?
I want to be very clear about the implications of this study -- or, rather, the message that you should take away from it. The more that I learn about investing, the more it becomes apparent that people fail at it because of impatience and an irrational willingness to take short-term fliers on speculative stocks.
As this study demonstrates, however, this is the polar opposite of what's made Warren Buffett so rich and successful. He buys bona fide businesses for the long run and he waits to do so until they're trading for a sufficiently large discount to historical value. It doesn't take a genius to do this. You can do it as well. What it takes is patience, discipline, and a long-term time horizon.