After all, it took decades for modern financial theory to catch up with Buffett and discover his “secret sauce.” As my friend and fellow author Bill Bernstein points out, being the first, or among the first, to discover a strategy that beats the market is what buys you the yachts, not copying the strategy after it’s already well known and all the low-hanging fruit has been picked.
However, the findings do provide us with insight into why Buffett was so successful—it was strategy, not stock picking. Buffett’s genius thus appears to be in recognizing long ago that “these factors work, applying leverage without ever having to fire sale, and sticking to his principles.”
The authors noted it was Buffett himself who stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
The authors also considered “whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO.” To address this, they decomposed Berkshire’s returns into a part due to investments in publicly traded stocks and another part due to private companies run within Berkshire.
The idea is that the return of the public stocks is mainly driven by Buffett’s stock selection skill, whereas the private companies could also have a larger element of management skill. They found that the public companies performed better. So it’s not his skill as a manager that is responsible for his alpha.
However, they did find that the companies Berkshire owns provide a steady source of financing at a very low cost, allowing him to leverage his stock selection ability—36 percent of Buffett’s liabilities consist of insurance float with an average cost below the Treasury-bill rate.
Another advantage, though a less important one, is that: “Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment.” Accelerated depreciation acts just like an interest-free loan.
Once the authors accounted for all the style factors (market; size; value; momentum; betting against beta BAB; and quality) and the leverage, the alpha of Berkshire’s public stock portfolio drops to a statistically insignificant annualized 0.1 percent.
In other words, these factors almost completely explain the performance of Buffett’s public portfolio. The bottom line is that we now know that Buffett’s secret sauce is that he buys safe, high-quality, value stocks and applies low-cost leverage.
Finally, I would add that while you don’t have access to the type of low-cost leverage to which Buffett has access, you can access the other factors that created his “alpha.”
For example, Dimensional Fund Advisors, Bridgeway and AQR Capital are three of the leading providers of mutual funds that use strategies that involve a systematic and highly disciplined approach to capturing or harvesting a particular return or style premium. (Full disclosure: My firm Buckingham recommends Dimensional and Bridgeway funds in constructing client portfolios.)
While not index funds, the funds these three firms offer do fall under the broader category of what I would consider to be relatively low cost, passively managed funds.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.