What would you be willing to do to obtain the investment secrets of the world’s most successful investor? Over 40,000 people travelled to the 50th annual conference of Warren Buffett in Omaha, Nebraska in 2015 to harvest his wisdom. Fans of Buffettology drive millions of dollars in book sales each year. If you thought all of Buffett’s secrets had been disclosed, read on for a few more.
Warren Buffett : Not Just Luck
The conservative value investor is more successful than even the investment experts had imagined, according to finance professors at New York hedge fund AQR Capital Management. While it seemed as if everything that could be written about this investor has been, they have discovered new information about the investment habits behind his success. Here is what you need to know to invest like Warren Buffett.
Buffet’s Alphabet Soup
In Buffett’s Alpha, the authors show that Warren Buffett is not only one of, but the world’s most successful investor. Through financial analysis, they provide new evidence that Warren Buffett’s famous investment rules (listed below Conservative = Low Risk Strategy) are indeed a low risk strategy. This low risk value investment strategy has outperformed all stocks and mutual funds.
They use a measurement of risk-adjusted returns called the Sharpe ratio to prove that Buffett outperformed stocks and active investors for 30 years, to 2011. Buffett’s Sharpe ratio of 0.76 is double that of the overall market over the same period.
What is the Sharpe Ratio?
Risk reflects the volatility of an investment. The more a stock price fluctuates, the higher the risk. An investor is paid a higher return for this higher risk. The Sharpe ratio strips out risk and returns to compare investments on an apples-to-apples basis. Government treasury bills have very low risk, and also low yields, and thus the US T-Bill is used as the risk-free rate of return.
Sharpe Ratio of 1 = Good
Sharpe Ratio of 2 = Very Good
Sharpe Ratio of 3 = Excellent
So at 0.76, Buffett’s Sharpe ratio is fairly good. Avon Products, in contrast, the popular seller of women’s personal products, is considered a volatile stock. The company’s stock performance has fallen sharply and is at a 2-year low as investors punish it for weak financial performance. Avon’s Sharpe Ratio is -6.2%.
We have assembled AQR’s list of how to invest like Buffett – their picks of his famous investment rules (3-8), and three new metrics (1,2 and 9).
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- Low Beta = Boring and Safe
Betting-Against-Beta is the arbitrage strategy of taking a short position in stocks with a high beta and a long position in stocks with a low beta. Beta is a measure of the risk of a stock versus that of the whole market. Warren Buffett does not actually short stocks. Here’s how the conservative investor plays the strategy. Buffett buys low beta stocks that rise and fall with the market but to a smaller degree. Over time, these less volatile stocks provide more consistent and higher returns.
Another key factor in Buffett’s investment success is his emphasis on high quality, safe and cheap stocks. In another popular study, the folks at AQR have determined that quality stocks outperform higher yielding junk stocks longer term. Buffett places his money on the quality stocks, consistently betting that they will outperform the market.
In summary, Warren Buffett’s conservative, boring, safe, dull investment strategy is a low-risk strategy that has outperformed the market for 30 years.
Conservative = Low Risk Strategy
The findings of Buffett’s low risk strategy should not be surprising. The well-known Buffett investment rules listed below are also part of AQR’s list of the secrets of Buffett’s success. The main attributes Buffett famously looks for in stocks are all associated with low risk.
- High quality stocks – Buffett looks for companies with low debt-to-equity ratio (total liabilities/shareholder’s equity) and high interest coverage. A high ratio means the company is financing its assets with debt instead of equity. The company should have a fairly consistent earnings and dividends payment history, although a few bad years could be overlooked. He likes large companies with over $100 million in sales (Coca-Cola, Wal-Mart, Wells Fargo are some of the stalwarts of his portfolio).
- Stable – The company should have steady earnings per share (EPS) growth and good profit margins (net income divided by sales), generally above 20%. Increasing profit margins shows the management is holding down expenses while growing sales.
- Profitable – Buffett compares the return on equity (ROE) (net income/shareholder’s equity) to that of peers to see if the company has consistently performed well over the past five to 10 years. He also looks for a high earnings yield – annual earnings divided by share price – compared to a company’s peers. The lower the share price compared to its earnings, the more undervalued the stock is.
- Growing – Price earnings growth is used as a predictor of future earnings growth. Calculate the average earnings per share (EPS) growth over the past five or 10 years. Using today’s EPS as a starting point, project EPS growth out over the next five or 10 years at a compounded average rate of, for example, 2.29% (in the Coca-Cola example below). Multiplying the 5-year average EPS growth rate by the estimated EPS in any given year will provide the estimated future share price.
Coca-Cola has grown at an average 5-year EPS of 2.29%. The EPS today is $2.05. In 2020, the EPS of Coca-Cola is forecasted to be $5.73.
Year 0 – 2.05
Year 1 – 2.51
Year 2 – 3.08
Year 3 – 3.79
Year 4 – 4.66
Year 5 – 5.73
- Low book-to-price ratios – This metric determines Buffett’s famous Margin of Safety. The P/B ratio is the stock market price divided by the book value (equity divided by the number of shares outstanding). He likes to see P/B ratios of 15 or higher.
- High payout ratios – The value investor chooses stocks with high dividend yields. The secret to his success is reinvesting those dividend yields. High dividends, though, should not come at the expense of intrinsic growth. Buffett is also a fan of companies that reinvest earnings back into the company to drive future growth.
Supporting Buffett’s stock picking prowess, the authors also found that his public stock picks outperformed his private companies.
- Low Cost of Capital and Leverage
The New York financial managers cite two other reasons for Buffett’s investment success that have been generally overlooked. Buffett has access to low cost capital and leverage. He borrows money to take a larger position in a stock. The astute investor borrows money from his insurance company Berkshire Hathaway at below market rates. If his investments only make average market returns, he will profit.
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