Swedroe: Unpacking Buffett’s Genius

March 10, 2014

A close look at Buffett is to understand factor-focused investing, Swedroe says.

If investors were asked, “Who do you think is the greatest investor of our generation?” an overwhelming majority would answer “Warren Buffett.” For decades, Buffett outperformed the market, as did others he called the “superstar investors of Graham and Doddsville.”

Their success could generally be attributed to the following:

  • Using a broad theme of investing in “value stocks” and then identifying the best individual stocks to buy.
  • While others panicked and sold during bear markets, they stayed disciplined, adhering to their strategy, avoiding “fire sales.”

Buffett’s performance, as well as the performance of the other superstars, presented a great challenge to the efficient markets hypothesis—if these superstar investors could persistently outperform, how could the market be efficient? To address this issue, we’ll take a brief walk through the history of modern financial thinking.

William Sharpe and John Lintner are typically given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). The CAPM provided the first precise definition of risk and how it drives expected returns. It looks at returns through a “one-factor” lens, meaning the risk and return of a portfolio is determined only by its exposure to “beta.”

Beta is the measure of the equity-type risk of a stock, mutual fund or portfolio relative to the risk of the overall market. The CAPM was the finance world’s operating model for about 30 years. However, like all models, by definition they are flawed, or wrong. If they were perfectly correct they would be laws, like we have in physics. Over time, anomalies that violated the CAPM began to surface. Among the more prominent ones were:

The 1992 paper “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French basically summarized the anomalies in one place. The essential conclusions from the paper were that the CAPM only explained about two-thirds of the differences in returns of diversified portfolios, and that a better model could be built using more than just the one factor, beta.

The Fama-French Three-Factor Model

One year later, Fama and French published “Common Risk Factors in the Returns on Stocks and Bonds.” This paper proposed a new asset pricing model, called the Fama-French Three-Factor model. This model proposes that along with the market factor of beta, exposure to the factors of size and value explain the cross section of expected stock returns.

The authors demonstrated that we lived not in a one-factor world, but in a three-factor world. They showed that the risk and expected return of a portfolio is explained by not only its exposure to beta, but also by its exposure to two other factors: size (small stocks); and price (stocks with low relative prices, or value stocks). Numerous studies have confirmed that the three-factor model explains an overwhelming majority of the differences in returns of diversified portfolios.

In fact, the Fama-French model improved the explanatory power from about two-thirds of the differences in returns between diversified portfolios to more than 90 percent.



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