Buffett’s Alpha & Suspicious Minds

In a few weeks, I’ll be officially crossing Berkshire’s Annual Meeting off my bucket list.  Many thanks to our friends in the furniture business for allowing me to crash your Blumkin Family Party! And to any of our friends in the investment business that find themselves in Omaha for Buffett-a-palooza, please drop me a line.

Berkshire’s Annual Letter is closely scrutinized by the media these days, but in case you missed it, Buffett’s “certain fundamentals of investing” are worth highlighting:

  • You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
  • Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
  • If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
  • With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.
  • Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
  • My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following – 1987 and 1994 – was of no importance to me in making those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

Over the years, many self-proclaimed value investors have rehashed Buffettisms.  But while the masses talk the talk, few walk the walk.  Buffett’s track record is in a league of its own. According to a recent NBER Working Paper, Berkshire has the highest Sharpe ratio of all US stocks from 1926 to 2011 and a higher Sharpe ratio than all US mutual funds around for more than three decades.

Buffett Alpha

These results were produced without luck or magic.  Rather, Buffett’s genius is largely a function of his conviction, wherewithal and skill to manage leverage and risk over multiple decades.  He recognized early on that applying leverage to safe, cheap, high-quality stocks would magnify returns without the risk of fire-sale, allowing him to stick to the principles outlined above over the course of multiple economic and market cycles.  The author’s estimate that Buffett’s leverage has averaged about 1.6 to 1 over time boosting both his risk and return, proportionately.  They conclude that, “If one had applied leverage to a portfolio of safe, high-quality, value stocks consistently over this time period, then one would have achieved a remarkable return, as did Buffett.”

Of course, no one has actually managed to do so. See you in Omaha.