News Flash: Academics Prove Buffett Talented Investor!

For years, finance academics scoffed at the notion of investment skill, preferring to adopt the efficient market hypothesis (EMH). According to EMH, stock picking is a waste of time because a security's price reflects all relevant information at any given moment. In this framework, consistently beating the market is an anomaly attributed to a string of luck that is bound to happen with enough participants.

A recent paper, however, undermines that theory. The authors used the quantitative tools of finance academics to show that Warren Buffett's investing record, perhaps the greatest "anomaly" of all (and a real thorn in the side of the theoreticians), can't be explained by luck or risk, but rather is the product of skill.

"I'd be a bum ...
... on the street with a tin cup if the markets were always efficient," Warren Buffett told Fortune magazine in 1995. So while Buffett would agree that the market is mostly efficient, that still leaves him room to earn his keep.

He does this by taking action only when a great business becomes temporarily undervalued. "Mostly efficient" and "always efficient": the distinction makes all the difference in the world.

Hitting the 99.99th percentile
Buffett is the best-known practitioner of value investing, the strategy pioneered by his mentor Benjamin Graham, and his track record is a wonderful illustration of value investing's efficacy over time. Between 1976 and 2006, Berkshire Hathaway's stock portfolio beat the market 28 out of 31 years -- consistency that puts it in the 99.99th percentile. Yet it's the combination of consistency and his margin of outperformance -- 14.65 points per year over the S&P 500! -- that led the authors of the afore-linked study to conclude that neither risk nor luck can explain these extraordinary numbers.

Usefully, the paper also debunks the myth that value investing means systematically buying low price-to-earnings or low price-to-book value stocks. In analyzing Berkshire Hathaway's stock holdings, the authors found that they are best characterized as large-cap growth. The Berkshire portfolio contains companies with consistent growth profiles that span decades, such as Procter & Gamble (NYSE: PG  )  and Bank of America (NYSE: BAC  ) .

To emulate Buffett, look for large companies with high returns on capital (an indication that they have a competitive advantage) and low debt at a reasonable price. The following stocks are part of the results of a screen I created along these criteria:

Return on Equity

Return on Capital

Market Capitalization (in billions)

Accenture (NYSE: ACN  )

73%

64%

$21.5

Coach (NYSE: COH  )

42%

41%

$10.6

Legg Mason (NYSE: LM  )

11%

9%

$9.7

Novartis (NYSE: NVS  )

17%

10%

$135.5

PepsiCo (NYSE: PEP  )

39%

23%

$128.1

Two of the stocks on this list -- Accenture and Legg Mason -- happen to be current Motley Fool Inside Value recommendations. They lend weight to the screen, but the converse isn't true. After all, showing up on a screen would be no more than the first step in a long vetting process before a stock becomes a recommendation (I know, because I work on this newsletter).

It's simple, but it isn't easy
With stock market volatility at or near a multiyear high, this is a period in which some outstanding companies are going on sale. That doesn't happen very often, and investors who follow value investing principles can take advantage of these opportunities. The principles are:

  1. Stocks are fractional ownership interests in businesses.
  2. Businesses have a value.
  3. The value of entrenched, predictable businesses can be estimated with reasonable confidence.
  4. Purchasing a stock at a price that equates to buying the business at less than its value will produce superior returns.

I have adopted this approach because of those I understand, it is the only one that I find practicable. Still, it requires a combination of knowledge, hard work, and hard thinking. It's no easy task putting these simple principles into practice. At Inside Value, that's what we do all day long.

If those principles make sense to you too, click here to join us free for 30 days. There is no obligation to purchase and you can find out more about value investing and see our latest picks.

Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway, Accenture, and Legg Mason are Inside Value recommendations. Berkshire is also a Stock Advisor pick. Bank of America is an Income Investor recommendation. The Motley Fool owns shares of Berkshire Hathaway and fully discloses all such interests.


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