For years, finance academics scoffed at the notion of investment skill, preferring to adopt the efficient market hypothesis. 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's 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 theoreticians' side), can't be explained by luck or risk. Instead, it's 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. The distinction between "mostly efficient" and "always efficient" 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 years out of 31 -- consistency that puts it in the 99.99th percentile. This combination of consistency and Buffett's margin of outperformance -- 14.65 points per year over the S&P 500! -- led the authors of the paper 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 Comcast
To invest like Warren 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. When I screened for these criteria, I found stocks like these:
|
|
Return on Equity |
Return on Capital |
Market Capitalization |
|---|---|---|---|
|
Autodesk |
31% |
24% |
$8.8 |
|
BJ Services |
23% |
18% |
$9.5 |
|
Gap |
19% |
17% |
$13.1 |
|
NetApp |
17% |
9% |
$8.2 |
|
Turkcell |
32% |
21% |
$15.7 |
Source: Capital IQ
One of the stocks on this list -- Gap -- happens to be a current Motley Fool Inside Value recommendation. The fact that it is on the screen lends weight to it, but the converse isn't true. After all, showing up on a screen would be no more than a first step in a long vetting process before a stock became a recommendation.
It's simple, but it isn't easy
With stock market volatility at or near a multiyear high, some outstanding companies are currently on sale. That doesn't happen very often, and investors who stick to the following truisms stand to profit:
- Stocks are fractional ownership interests in businesses.
- Each business has a value.
- The value of entrenched, predictable businesses can be estimated with reasonable confidence.
- Purchasing a stock at a price below the business's true value will produce superior returns.
Of all the investing strategies I understand, this is the one I find most practical. Still, it requires a combination of knowledge, hard work, and hard thinking -- no easy task to carry out. At Inside Value, that's what they do all day long.
If those principles make sense to you, too, click here to join Inside Value free for 30 days. There is no obligation to purchase, and you can find out more about value investing and see the latest picks.
This article was first published Jan. 11, 2008. It has been updated.
Alex Dumortier , CFA, has no beneficial interest in any of the companies mentioned in this article. Gap, Berkshire Hathaway, and Home Depot are Motley Fool Inside Value recommendations. Gap and Berkshire are also Stock Advisor recommendations. Turkcell is a Global Gains selection. The Motley Fool owns shares of Berkshire Hathaway and fully discloses all such interests.
