Warren Buffett is a legendary and successful investor, but his approach might not be the right one for everyone. Many have tried to emulate him over the years, but the results have been mixed.
Warren Buffett's value investing approach was based on the philosophy and work of influential financial academics such as Benjamin Graham. Graham and his followers contend that every stock has an intrinsic value based on the future cash flows that the company will generate. Owners of the company are eventually entitled to the financial surplus of the company, which is generally distributed through dividends at a certain point of its maturation.
Many value investors use metrics such as discounted cash flow (DCF), dividend discount, and residual earnings to predict future financial results and calculate a fair present value for each share. By accurately forecasting those metrics, investors can identify mispriced stocks and buy those that trade at a discount to intrinsic value. Unlike the common belief that value investors solely focus on buying stocks with low price-to-earnings, price-to-book, or price-to-free-cash-flow ratios, Buffett could conceivably still identify stocks that look expensive by those standards but that are nevertheless at a discount to intrinsic value.
Yet Buffett has a few clear and important advantages over the average person dabbling in the stock market. There are other proven strategies that could be better alternatives for typical investors to consider.
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1. Most investors can't match Buffett's capabilities and scale
While the approach is completely sound in theory, the methodology can be a complicated process. Most non-professionals lack the expertise or time to execute effectively. There's a huge margin of error in most DCF models, so managing the associated risks is extremely difficult. Buffett employs a team of the best analysts, traders, and portfolio managers in the world, and they still get it wrong sometimes.
The glut of financial data, news, and investment tools have reduced information asymmetries, meaning that there are fewer opportunities for individuals to legally access information that other market participants lack. There are simply fewer stocks that can be confidently identified as mispriced, and the opportunities tend to be smaller. Worse for individuals, information advantages tend to require large and expensive tech resources that are dominated by banks, hedge funds, and other institutions with deep pockets.
Buffett's scale is a major advantage. It is very time consuming to use Buffett's process to produce and monitor a full portfolio of stocks with significant intrinsic upside, but he has a large team of analysts and managers at his disposal. He has enough capital and clout to influence boards and executive management teams, while the average investor is just a passenger.
2. Warren Buffett is not a growth investor
Investors looking for rapid growth potential may want to break away from Buffett's approach. He prioritizes stable growth with quality companies, and by design overlooks speculative moon shots. Value investing methodology is difficult to apply to unprofitable companies, those with limited operating history, and businesses that are expanding very quickly.
Buffett is generally disinterested in exciting new IPOs and growth names with lofty valuations. Many of the most popular stocks of the past decade fall into those categories. Growth investing is by no means inherently better than value investing, but they often have mutually exclusive tactics that should lead to different types of outcomes. As such, neither is going to be suitable for every investor. If your goals include the massive upside of riskier high-growth stocks, then Buffett's approach is a mismatch with your desired outcome.
3. There are other proven alternatives to value investing
Investors can easily implement several strategies that have demonstrated track records of success. Indexing is popular for the efficient markets hypothesis crowd. Most active portfolio managers have deployed Buffett-inspired methods but failed to consistently exceed total market performance net of fees. There are numerous index ETFs and mutual funds that can deliver simple and inexpensive returns.
Factor investing has also made waves after the work of French & Fama showed that certain characteristics of stocks could explain future market performance more reliably than intrinsic valuation models. For example, some academic studies have shown that, on average, the majority of a stock's long-term performance can be explained by characteristics such as company size, valuation ratios, momentum, and quality. Strategies have been developed as a result that allocate disproportionately to stocks that score favorably on these qualities, with no regard to intrinsic valuation or growth outlook. Factor and smart beta ETFs are an efficient way to gain access to factor investing strategies.
Investors need to realistically consider their goals and capabilities before trying to invest like Warren Buffett. There's no reason to disparage his legendary work and accomplishments, but there might be better choices out there for anyone who isn't a financial professional.
