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Warren Buffett's Secrets Uncovered by New Study

Source: Wikimedia Commons.

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.

The wisdom of Warren
To learn more about what's made Warren Buffett such an exceptional investor, check out our popular free report, "Warren Buffett's Greatest Wisdom." You can access it instantly and for free by simply clicking here now

Read/Post Comments (13) | Recommend This Article (41)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 09, 2013, at 6:58 PM, cmalek wrote:

    In the United States the perception of every successful person is that they are either lucky or they have a some kind of a "secret". Furthermore, if they would only share that "secret" with the rest of us, we too will become successful (rich). However, the bitter irony is that we refuse to believe the eveidence before our eyes. Warren Buffet never made a secret of his methods. On the contrary, he repeatedly explained them to any who would listen. I would be willing to bet that in spite of this study, people will still insist that Buffet is lucky or that he has a "special secret."

    "people fail at it because of impatience and an irrational willingness to take short-term fliers on speculative stocks."

    We take irrational risks on short term fliers because we want instant gratification and we are greedy. We don't want to wait 20, 30 years for our ship to come in when there is a flier coming by every couple of days. We follow the flier all the way up, and because of our greed, we refuse to believe that, when the flier goes into a death spiral, it will never recover.

  • Report this Comment On December 10, 2013, at 7:54 AM, pbass003 wrote:

    I hope no grant money was wasted on this "study". There is nothing new here that Buffet himself has not said many times.

  • Report this Comment On December 10, 2013, at 3:21 PM, atkinskd wrote:

    I wish I had followed the Fool a number of years ago and turned a $30k gift into $800k. Investing was unfamiliar territory at that time - so I invested in a 'Redbox' type Franchise - turned $30k into a 900# Italian Paperweight from Riello once the FTC tidied things up.

    In the past 3.5 years I have a scorecard of 16.4, (despite picking some real losers based on public sentiment) Time, patience, go with what you KNOW, pick weak, sell strong. Still Learning:)

  • Report this Comment On December 10, 2013, at 3:46 PM, SkepikI wrote:

    ^ I predict you will go far. Discipline nearly always pays well. And take heart....some of US, yes yours truly included took more than one painful lesson to come about.

  • Report this Comment On December 10, 2013, at 8:25 PM, Megatron916 wrote:

    "New Study"... Lol

  • Report this Comment On December 10, 2013, at 10:09 PM, constructive wrote:

    "However, we find that the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors."

    I thought the high wizards of EMT determined that there were only 3 "risk" factors ... no wait 4, or maybe 5 or 6 or 7 ... or maybe there are lots of return factors unassociated with risk and EMT is completely bogus.

  • Report this Comment On December 10, 2013, at 11:22 PM, sagitarius84 wrote:

    Any study that claims to have uncovered the secret to Buffett's success, and mentions words such as Alpha, Beta, probably does not fully understand his strategy.

    I would strongly recommend reading all resources available about Buffett, and learning for yourself how he made it:

  • Report this Comment On December 11, 2013, at 1:02 AM, grahamsway wrote:

    Always an interesting topic. In my opinion and experience it isn't the mechanics. It's easy enough to figure what's safe, what's cheap etc. The real "secret" is being able to psychologically buy-low and sell-high.

    Sounds easy but as, I think it was Buffett who said it, you have to buy when just thinking about it makes your stomach ache.

    For instance, it might have been more helpful if all those experts saying how great the market is now and will be in the future said the same in 2009.

  • Report this Comment On December 11, 2013, at 8:50 AM, CAPSnGAIN wrote:

    I've tried a bunch of strategies, and have found trying to buy low and sell high to be quite difficult. Quite often buy low ends up being hold as it goes lower.

    For me, a more successful approach has been GARP... find those stocks hitting new highs, that have a successful 10 year return and low current valuations, and if fundamental analysis suggests such growth can continue, then I buy high, hold, and sell higher!

    True, I don't have the wealth of Warren Buffett, but then again, I'm only half his age! The one thing I do follow from Warren that's been a successful strategy, is to buy when others say sell, and vice versa. Having a contrarian point of view, in my case has been much more successful, than following the analysts from major brokerages, that in almost all cases perform well in trending markets, but almost never call the tops or bottoms. Case in point, in my old company, the stock hit a low in 1998, of $15, when a well known analyst downgraded it to a sell. In early 2000, with the stock over $150 per share, the same analyst, along with many from other major brokerages, upgraded it to a buy. When it peaked at $255 per share in the summer of 2000, 90% of analysts covering the stock upgraded it to a strong buy. Eventually between 2001 and early 2003, when it dipped below $30, and eventually bottomed at $2.50 these same analysts downgraded it to a sell. LOL! So much for the smart analysts... the ones with high SAT scores, graduating from America's top business schools.

    So, in my opinion, I'm not as sold on Warren's ability to buy value stuff low, so much as his willingness to be contrarian, and buy when most are panic selling, and sell, when almost everyone says it's going to the moon!

  • Report this Comment On December 13, 2013, at 1:22 PM, bretcomar wrote:

    How did Buffet know he could trust Wells Fargo's numbers? Did he have access to information the general public didn't have access to that told him he could trust the numbers Wells Fargo published?

    As the article itself says, quoting Buffet, other banks were suffering "one huge loss after another...often on the heels of managerial assurances that all was well."

    I don't know, but if I had to guess, Buffet has better information than most or he is exceptionally good at reading between the lines or both.

  • Report this Comment On December 13, 2013, at 4:36 PM, The1MAGE wrote:


    How can Buffett trust those numbers? Because the accountant(s) will go to jail if they are fabricated.

    He doesn't have any "secret" information, but you need to realize he spends 40+ hours a week studying companies, and he has done this for half a century. It isn't hard to think that he has learned a few things as a result, so yes he can read "between the lines".

    Talking about secrets, inside information, or any other "underhanded" reason is nothing but an excuse. It is so much easier to point at others and accuse them of something then to look at yourself and see the flaws. (And we all have flaws.)

  • Report this Comment On December 17, 2013, at 12:47 PM, bretcomar wrote:


    I hope I didn't sound like I was attacking Buffett. Didn't mean to. He's had great success and my question is an attempt to better understand why, in hopes of more successfully emulating.

    That said, information is not equally available to everyone--even if everyone were to take the time to look for it. Some people have better access than most. I've had it myself on occasion (but not acted on it). If I've had it, it's reasonable to assume Warren has (along with Jamie Dimon and Lloyd Blankfein and their peers).

    I've also seen, first hand, both very misleading accounting and outright fraudulent accounting. People have been burned by it. Ask Enron investors. It's fair to ask how widespread the problem is. My suspicion is pretty widespread. I can't point to any studies supporting that suspicion, but Warren's partner Charlie Munger seems to agree:

    "“I would argue that a majority of the horrors we faced would not have happened if the accounting profession were organized properly.

    “In other words, [the accountants] have a position from which, if they behaved intelligently and correctly, they could prevent a huge amount of all that’s wrong with the system. And they fail utterly, time after time, after time.

    “And they are way too liberal in providing the kind of accounting the financial promoters want. They have sold out and they do not even realise that they’ve sold out … Compared to what could reasonably be with intelligence and honour, the accounting profession is a sewer.”

    Here's a link to the interview in which he says this:

    Again, look at what Warren himself said: banks were suffering "one huge loss after another...often on the heels of managerial assurances that all was well."

  • Report this Comment On January 14, 2015, at 1:48 AM, SCMessina wrote:

    Great article. If you are truly trying to replicate Warren Buffett's strategy, it's more than just about picking the right investments.

    Most of us focus on the INVESTMENT strategy, but the FUNDING strategy of Berkshire Hathaway is even more important. Where does Buffett get the money to invest? Does he borrow? Is it all his? This touches on it a little bit:

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