Widely regarded as one of the greatest investors of all time, if not the greatest investor of all time, Warren Buffett is rightfully studied. The reason to study Buffett is to find clues about how he has delivered such extraordinary results. But, the answers have been elusive until now.

Studying greatness is a popular pursuit. But, the purpose of the study has not always been to emulate the success of the individual. For example, many have studied George Washington. The goal is not to become a president necessarily but to understand the leadership and civility which marked his career.

In the case of Buffett, the pursuit seems to be aimed at understanding how to invest like Buffett with the hope of duplicating his success. The truth is it will not be possible to fully duplicate his success.

In part, his success derives from his access to low cost capital and his reputation, factors that will be impossible for an individual investor to duplicate. But, there are still lessons to be learned from Buffett and there are important steps to take that can help improve an investor’s performance.

Buffett’s Performance: By the Numbers

One recent paper summarized important aspects of Buffett’s performance. “A dollar invested in Berkshire Hathaway in October 1976 (when our data sample starts) would have been worth more than $3,685 in March 2017 (when our data sample ends).” Of course, that needs context.

The authors provided that, “Over this time period, Berkshire realized an average annual return of 18.6% in excess of the T-Bill rate, significantly outperforming the general stock market’s average excess return of 7.5%.”

But, we know that high rewards generally come with higher than average risks so it is important to consider the risk of an investment with Buffett. “Berkshire stock also entailed more risk, realized a volatility of 23.5%, higher than the market volatility of 15.3%.” And, again, context is needed.

“However, Berkshire’s excess return was high even relative to its risk, earning a Sharpe ratio of 18.6%/23.5% = 0.79, 1.6 times higher than the market’s Sharpe ratio of 0.49.”

The Sharpe ratio is defined by Investopedia as “the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be isolated.

One intuition of this calculation is that a portfolio engaging in “zero risk” investment, such as the purchase of U.S. Treasury bills (for which the expected return is the risk-free rate), has a Sharpe ratio of exactly zero.

Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.”

Clearly, an investment in Berkshire Hathaway has been more attractive than an investment in the broad stock market. But, there are other ways to measure performance. Beta, for example, compares the volatility of an investment to the volatility of the broad market.

“Berkshire realized a market beta of only 0.69…[and] adjusting Berkshire’s performance for market exposure, we compute its Information ratio to be 0.64.”

The beta of 0.69 indicates that Berkshire Hathaway has had just 69% of the volatility of the broad market. This is generally a positive factor since volatility can cause investors to panic and sell at times when the investment isn’t performing well.

The information ratio is a measure of the risk-adjusted return of a financial security (or asset or portfolio). It is defined as expected active return divided by tracking error, where active return is the difference between the return of the security and the return of a selected benchmark index, and tracking error is the standard deviation of the active return.

It’s a more complex measure of risk adjusted performance than the Sharpe ratio and to understand it, we could use some context. The chart below shows Buffett’s information ratio compared to all funds with a track record of at least 40 years.

Source: Buffett’s Alpha

What Explains the Performance?

So far, the research has conformed that Buffett is unusually good at investing. The authors also used statistical techniques to search for an explanation of why Buffett has been so successful. These techniques look at various factors and isolate the important components of return.

Not surprisingly, they find that Buffett buys low beta (less volatile stocks) that are high quality stocks. Now, the quality of the company is defined in a specific way.

To define quality stocks, the authors used four broad characteristics that are indicative of safer companies which define the quality to junk factor:

• Profitability: Measured by such metrics as return on equity, return on assets, margins and cash flows
• Growth: Measured by the prior five-year growth in the profitability measures.
• Safety: Measured by both market beta and volatility, as well as by fundamental-based measures such as leverage, volatility of profitability, and credit risk
• Payout: Management’s agency problems are diminished if free cash flows are reduced through higher net payouts (including dividends and buybacks offset by new share issuance).

Using these tools, the authors found a portfolio could even outperform Buffett.

Now, an investor could buy and hold the same companies Buffett owns but that will not beat Berkshire Hathaway. The chart below shows the companies in his portfolio do beat the market, but not as much as a portfolio of the stocks that pass the quality to junk and low beta tests.

Source: Buffett’s Alpha

To truly duplicate Buffett, an investor would need to use leverage. The authors estimate that Buffett’s leverage is about 1.7-to-1 on average. And, his leverage is less expensive than anyone else would pay at least in part because of his reputation.

The next chart shows that Buffett is able to borrow money and access funds at an extraordinarily low cost.

Source: Buffett’s Alpha

That is a portion of the performance that individuals cannot duplicate. But, individuals can buy good companies that have below average volatility (or beta) and approximate Buffett’s style. They don’t need to find the best tech stock or small caps since Buffett has shown large cap stocks can work well.

An investor could obtain leverage with margin but the cost will be greater than Buffett’s cost of funds. However, if the investor is truly focused on the long run, that is a risk that could be worth considering. Although margin is often frowned upon, the results show that leverage can boost returns.

That assumes the leverage is moderate. Excessive leverage, even with a value approach can lead to large risks. But, returns like Buffett will require accepting some risks.

 

Value investing is simple in theory. The general idea is to buy stocks that are undervalued. They are held and eventually sold when they become overvalued. That is certainly a simple theory. But, the implementation of that simple theory can be a problem.

First, the value investor must define value. Then, definitions of undervalued and overvalued are needed. This can, of course, all be done with precise formulas. However, precision can actually be little more than false comfort to value investors.

In the stock market, prices that seem to be undervalued can become more undervalued. Overvalued stocks and markets can become more overvalued. This is why it can be better to consider broad guidelines when developing a value investing framework.

Defining Value

The first problem of the value investor is to select a measure of value. There are many possibilities. One, for determining the value of the stock market is the Shiller CAPE ratio.

This metric is the cyclically adjusted price-earnings (or CAPE) ratio developed by Nobel Prize winning economist Robert Shiller. It compares current prices to average earnings over the past 10 years adjusted for inflation. It’s intended to measure earnings over the course of an entire business cycle.

The current reading of the CAPE and its history back to the 1800’s is shown below.

Source: multpl.com

It’s important to note that the CAPE ratio can also be applied to individual stocks. That is actually the measure of value that Ben Graham, Warren Buffett’s business school professor, advocated using in his book, The Intelligent Investor.

Graham thought it was important to consider earnings of a company over an entire business cycle, a thought process that is similar to the logic underlying Shiller’s model for the stock market as a whole.

From the chart above, we can see that this metric indicates the stock market is overvalued.

But, a less inclusive look, the P/E ratio using just one year’s worth of earnings, is not quite as overvalued.

Source: multpl.com

This illustrates one of the problems a value investor faces. The different measures of value can provide conflicting information.

Why Valuation Matters

Valuation measures are important because they are a significant component of market returns. One analyst notes, “the trend in P/Es is the most significant determinant of stock market returns.

There are only three sources of returns from the stock market: earnings growth, dividend yield, and the change in P/E (the overall level of valuation in the market). To illustrate the impact of the P/E cycle, we can assess stock market returns over the past century by breaking the long-term into relevant periods for most investors—decades rather than centuries.

Since 1900, there have been 97 ten-year periods (i.e. 1900-1909, 1901-1910, etc.). As most investors know, the average long-term return from the stock market has been 10%; and that is the average of all 97 decade-long periods.

It is striking, however, that average rarely happens. None of the 97 periods were exactly 10%—all were either above-average or below-average. So the only wrong answer for investors is to assume the long-term average.

A wiser choice is to decide that it is more likely from today either to be an above-average decade or one that will be below-average. For insights into which is more likely, we can [consider] the three components of stock market return: earnings growth, dividend yield, and the change in P/E.

Figure 4 is enlightening: our hero, the P/E, is the major driver of whether returns are above or below average. The generally more stable combination of earnings growth (blue) and dividend yield (brown) is pulled in both directions by the trend in P/E.

When the P/E was trending upward, the green-shaded addition to the bars provides above average returns; whereas, when the P/E was trending downward, the red-shaded pull mutes returns into a below-average result.”

Source: Crestmont Research

This means that value matters in the long run. And long-term gains are likelier when the P/E ratio is low than when it is high. The next chart illustrates this relationship.

Source: Business Insider

Notice that with the P/E ratio currently above 20, the stock market is likely to deliver below average returns. But, the chart also shows that high returns are also possible.

The chart above shows both an average and a median value for returns. The average is a calculation many investors are familiar with. It is found by summing the individual returns and dividing by the number of returns in the sample.

The median is the middle value. If there are eleven values, for example, the median is the sixth value when they are ranked from high to low. There are five values above that level and five that lie below the median value in this case.

Notice in the chart above that when the P/E ratio is above 20, the average return is negative while the median value is positive, at 4.43%. This indicates the average is skewed by at least one very negative value that is bringing the average significantly below the median value.

That is an important insight for value investors to keep in mind. It is also important that no individual year is likely to be average. In fact, every year is likely to be either above average or below average.

In a market such as this one, where the valuation metrics of the market and of many individual stocks are higher than average, selectivity becomes key. In the words of some traders, this is a market of stocks rather than a stock market.

There are values in the market, but they will require research. There could be more value among smaller cap stocks because smaller stocks are generally less widely followed than large cap stocks. Investors can benefit from, in effect, where few other investors are looking.

However, investors should be cautious about becoming too defensive in this environment. As the average value in the final chart above shows, there are at least some years when significant returns occur even when the stock market is at an overvalued extreme.

 

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