Opinion: Following the Oracle’s stock-picking formula
By Mark Hulbert – Market Watch
The wait could be over.
A new study that claims to have uncovered this formula was published last month by the National Bureau of Economic Research in Cambridge, Mass. Its authors, all of whom have strong academic credentials, work for AQR Capital Management, a firm that manages several hedge funds and other investment offerings and has $90 billion in assets.
The study’s authors analyzed Buffett’s record since he acquired Berkshire Hathaway in 1964. Their formula, which has more than a dozen individual components, comes in two major parts.
The second part of the formula will raise eyebrows: It calls for investing in these stocks “on margin” — that is, borrowing money to buy more shares than could otherwise be purchased. To match Buffett’s long-term return, the researchers found, a portfolio would need to be 60% on margin — borrowing enough so that it owned $160 of “cheap, safe, quality stocks” for every $100 of portfolio value.
Andrea Frazzini, one of the study’s authors, a finance professor at New York Universityand a vice president at AQR, said the Berkshire portfolio has, on average, been leveraged to a similar extent through Buffett’s career.
It can be easy to overlook the extent of this leverage, since Buffett is able to borrow from other parts of his business. But that doesn’t mean the company isn’t still leveraged, Frazzini argues. According to its most recent annual report, for example, the total value of Berkshire’s holdings are double the company’s net worth, implying that its current leverage is about 2-to-1 — somewhat higher than its long-term average.
Employing margin can magnify profits, of course. It also increases potential losses when things go wrong. But note that the formula combines a heavy use of margin with stocks that tend to be much less risky than the market, so the net result can still be a portfolio that is no riskier than the market as a whole.
To be sure, a heavily margined portfolio will always run the risk that, if its holdings fall enough, of getting a “margin call” — the need to come up with additional cash. Berkshire Hathaway has been able to sidestep that risk over the last 50 years. Despite a heavily reliance on leverage, its worst return in any calendar year was a loss of 9.6%. And its book value has been less volatile than the S&P 500. Volatility is a common measure of a portfolio’s risk.
One factor that is conspicuous in its absence from the formula is anything to account for Buffett’s significant investments in privately owned companies. But that isn’t necessary, according to the researchers, because the public companies in which he has invested have outperformed the private ones.
Lasse Pedersen, another of the study’s authors, a finance professor at New York University and a principal at AQR, stressed that Buffett still deserves plenty of credit. After all, he says, it has taken years for researchers to come up with a formula that, after the fact, does as well as Buffett has been doing for nearly 50 years. In addition, he had the discipline to stick to his approach through both thick and thin.
Unfortunately, the investment formula that the researchers devised isn’t necessarily easy for individual investors to follow. It requires investing in a large and diversified basket of stocks, for example. Furthermore, adhering to the formula can be challenging for a portfolio that relies on margin.
Nevertheless, it may be possible for you to at least partially follow the researchers’ formula without actually resorting to borrowed money. If you have cash in your portfolio, for example, you could add it to the portion you already have allocated to equities-achieving the equivalent of going on margin by, in effect, “borrowing” from yourself. This, of course, is what Buffett does by borrowing from other parts of his business.
Even if you decide not to follow the researchers’ investment formula precisely, this new study has important investment implications. For example, since the study’s authors find that Buffett’s record is due to “neither luck nor magic,” Berkshire Hathaway’s performance need not suffer after Buffett retires — so long as his successor is able to do just as good a job picking stocks.
That’s a pretty big “if,” of course, but the researchers’ findings imply that a strict adherence to the same investment principles could, over time, do as well as Buffett has done historically.
The study also holds out the tantalizing possibility that an investor following the formula can perform even better than Berkshire. That’s because, as Buffett has pointed out, his portfolio has grown so large that it will be difficult for it to perform as well in the future. In contrast, a smaller portfolio can profit from investing in stocks that are too small to make any meaningful difference to Berkshire’s bottom line.
The following stocks from within the S&P 1500 index score favorably along each of the five dimensions that the researchers employ in defining “cheap, safe, quality stocks,” according to FactSet. The ratios of their prices to per-share book values are below average, as are their “betas” — a measure of the extent to which their prices move in lock step with the overall market.
In addition, these stocks are of companies whose “profitability” — or total profits as a percentage of assets — is above average, as is the five-year growth rate of that profitability. And, finally, these stocks are of firms whose dividends represent an above-average proportion of their earnings.
Examples include drug retailer CVS Caremark; Devry Education Group, a for-profit education company; chipmaker Intel, Owens & Minor, a medical-supplies distributor; grocery distributor Spartan Stores ; and Vectren , an energy holding company.
Though there are no mutual funds that pick stocks according to the precise formula the researchers devise, several come close. One is offered by AQR: the U.S. Defensive Equity Fund, with an annual 0.51% expense ratio, or $51 for every $10,000 invested. Though the fund has a high minimum for those investing in it directly, it is available to investors through their financial advisers.
Another fund that focuses on some of the same stock-picking methods is the DFA US Large Cap Equity Portfolio DUSQX +1.42% . It is available to individuals only through their financial advisers or certain retirement and 529 plans, and fees vary.
The exchange-traded fund that perhaps come closest to following the researchers’ stock-picking methodology is iShares MSCI USA Quality Factor, with an expense ratio of 0.15%. It invests in stocks with a high return on equity and stable earnings growth.