December 9, 2013

‘Secrets’ of Warren Buffett’s Success Revealed in New Research

Berkshire Hathaway uses leverage to buy ‘safe,’ ‘cheap,’ high-quality stocks

Berkshire Hathaway Chairman Warren Buffett. (Photo: AP) Berkshire Hathaway Chairman Warren Buffett. (Photo: AP)

Warren Buffett has been showered with encomiums during his storied investment career.

Now, a new study by researchers at AQR Capital Management and the Copenhagen Business School calls his investment performance the best among all stock and mutual funds that have existed for at least three decades.

Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, the study found that between 1976 and 2011, Buffett’s Berkshire Hathaway generated a Sharpe ratio of 0.76, compared with the stock market’s 0.39.

The Sharpe ratio measures risk-adjusted returns.

In a similar vein, Buffett’s Sharpe ratio was higher than the median ratio of 0.37 for the 196 U.S. mutual funds in existence for more than 30 years.

The study’s authors noted that Buffett’s Sharpe ratio was lower than many investors might have imagined. Moreover, adjusting for the market exposure, his information ratio was 0.66.

“This Sharpe ratio reflects high average returns, but also significant risk and periods of losses and significant drawdowns,” they wrote.

Given Buffett’s “very good but not superhuman” Sharpe ratio, they explain that his success over the years has come from boosting his returns through use of leverage and adhering to a good strategy through good times and lean.

They estimate his leverage at about 1.6 to 1, enhancing both risk and excess return in that proportion.

“Thus, his many accomplishments include having the conviction, wherewithal and skill to operate with leverage and significant risk over a number of decades,” they write.

The authors identified several general features of Buffett’s portfolio to reveal how he picks stocks to achieve a strong return stream that can be leveraged.

He buys stocks that are “safe,” “cheap” and of high quality. The stocks he buys have low beta and low volatility. They are value stocks with low price-to-book ratios. And they are profitable, stable and growing, and have high payout ratios.

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Check out Buffett’s Bank Bets Are on the Money: Report on ThinkAdvisor.

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