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Being Warren Buffett

Buffett’s phenomenal performance has long been somewhat of a mystery. He’s clearly a once-in-a-generation talent. But what if his incredible results stem from a few simple rules he intuited early on and then stuck with for 50 years? Even so, that would not detract from his remarkable accomplishments.

Buffett’s Alpha, the award-winning 2018 paper*, analyzes Buffett’s record. In short, “Buffett’s returns appear to be neither luck nor magic but, rather, a reward for leveraging cheap, safe, high-quality stocks.”

Buffett has followed a few simple rules:

1) Invest in companies that are safe, high quality, and relatively cheap. In factor terms, he tilted towards low beta (low volatility), quality (profitable, stable, growing), and value (relatively low price-to-book).

2) Apply modest low-cost leverage to magnify already strong excess returns. About 1/3 of this is from insurance float, which provided a cheap source of funding, but the rest is from debt and other liabilities.

Buffett’s “many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades.” 

3) Stick with the strategy for 40-50+ years. Don’t change approach, especially when underperforming and everyone says you are “washed up” (as in the late 1990’s U.S. TMT bubble).

Anyone can stick with a strategy when it is working. The hard part is sticking with a strategy when it isn’t. For example, Berkshire declined 44% in the late 1990’s while the stock market was up 32%. Many fund managers would have shifted strategies, closed up shop, or been “fired” by their clients.

Buffett also has some structural advantages:

1) He can’t be fired (effectively).

2) Berkshire’s corporate structure (and modest leverage) protects from fire sales. Investors can sell their Berkshire shares but that doesn’t force Berkshire to liquidate the underlying investments.

3) Buffett has been willing to stomach high volatility. “Berkshire realized a volatility of 23.5%, higher than the market volatility of 15.3%.” Berkshire has had “down years and drawdown periods.”

He’s been lucky as well. His rejection by HBS led him to Columbia and the chance to learn from Graham and Dodd. He also had the right “sequence of returns.” If every great investor gets 10 good years, 10 so-so years, and 10 bad years, you want the good years first. That way you’ll have the track record and reputation to make it through tougher times. And early success leads to later success – e.g., Buffett was uniquely positioned in 2008-09 to offer his “imprimatur” in exchange for special deals. If the bad years happen first, you won’t get a chance to make it to the good years. You’ll be out of the investing business.

What does this mean for investors today?

Investors can follow Buffett’s first rule on investment selection through factor tilts (e.g., with funds from DFA). Returns to these factors – now better understood by the market – will probably be lower in the future than in the past. However, most investors should NOT lever up; Berkshire has some rare characteristics that let it maintain modest leverage.

That leaves us with rule #3. I think that’s the hardest part – the conviction and discipline to stick with a strategy for decades. We now know Buffett’s discipline in the late 1990’s was rewarded…in the end. Conviction can also be a way to stick with a bad strategy (or what worked for only a while) – if you do that too long, you’ll go broke.

Buffett started investing in the 1950’s. There’s no question the game has changed a lot in the last 50-60 years.

*for the full paper, see Buffett’s Alpha.

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