The Secret to Warren Buffett's Returns
Warren Buffett has long been heralded by fellow investors and the press as one of, if not the best stock picker of all time. He is the Oracle of Omaha, after all. If you went back in time to 1964 and bought Berkshire Hathaway (ticker: BRK.A, BRK.B) stock today you would have generated a return in excess of 750,000 percent.
Those are the returns that investors' dreams are made of.
What special sauce enabled Warren Buffett to beat every other stock over the last 50-plus years? Lasse Pedersen from New York University, along with Andrea Frazzini and David Kabillier, deconstructed the returns in a recent paper entitled "Buffett's Alpha." The paper identifies the primary driving force in Buffett's returns as a combination of the power of diversification and leverage.
[See: 9 Investing Steps from Warren Buffett's Playbook.]
It was not so much Buffett's ability to pick stocks, but rather his ability to capture returns from two totally different sources without increasing his risk that enabled these stellar returns.
Let's break down these two sources: diversification and leverage.
Diversification is no new concept in finance. Its basic premise is to spread investment risk and avoid over-exposure to any one asset. Buffett perfected this notion by investing in a range of industries. Ironically, Buffett is famous for his quote, "Diversification is protection against ignorance. It makes little sense if you know what you are doing."
But Buffett diversified the risks of Berkshire across a blend of business and reinsurance risk, which tend to have no correlation to one another. The risk of a hurricane or earthquake has little to do with the risks of an economic recession.
This diversification is complimented by Buffett's leveraging power, which was the second factor aiding his record returns. Using the premiums his insurance clients paid, Buffett invested in low-risk companies like Coca Cola Co. ( KO) and See's Candies. Berkshire's insurance business provided the leverage to these investments by upward of 60 percent, significantly boosting the firm's return. Buffett got paid insurance premiums that he used to invest, rather than borrowing money to invest, which would require interest payments.
The benefit of the returns from Berkshire's low-risk company portfolio combined with the returns from its insurance business enabled Buffett to earn nearly twice the return per unit of risk as other stocks. In funding additional investments without taking on additional risk, Buffet positioned himself, and Berkshire, for exponential returns. And this shows in the stock's performance.
It is possible for individual investors to replicate Buffett's success without running their own insurance company.
[See: 10 Long-Term Investing Strategies That Work.]
A portfolio that was equally allocated over the past 30 years to the U.S. stock market and long-term Treasury securities would have earned a return to risk ratio or Sharpe ratio of 0.63. The Sharpe ratio is a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment. Comparatively, over the past 32 years the Berkshire Hathaway stock has earned a risk to return ratio or Sharpe ratio of 0.64.
With such a seemingly simple solution, why haven't investors all become Warren Buffett-scale wealthy?
The answer comes down to leverage. A balanced portfolio would have generated a 10.5 percent compounded annual growth rate and a 9.5 percent volatility. Berkshire, on the other hand, has had a volatility of 21.3 percent over the past 32 years. Leverage matches proportionately with volatility. If you want to double your leverage, you would double your volatility.
If an individual investor had leveraged up their balanced portfolio up to the same volatility level as Berkshire, they would have nearly matched Buffett's long-term returns.
The magic created by Buffett's combination of equities and insurance can be reconstructed with a portfolio that is balanced between equities and long term treasuries.
This diversification positions investments similarly to Berkshire: reaping money from equities, Treasurys and insurance, without any overlapping risks and earning a return stream from all of them.
[See: 8 Investing Do's and Don'ts During Market Volatility.]
Using this model, any investor can position him or herself for Buffett-like returns.
David S. Miller is the co-founder of Catalyst Mutual Funds, where he serves as senior portfolio manager and CIO overseeing several of Catalyst's investment funds. Prior to joining Catalyst, he was founder and editor of the Investment Catalyst Newsletter. He also worked at UBS as an equities derivatives trader. Miller is a graduate from the University of Pennsylvania's Wharton School of Business, where he received a bachelor's degree in economics. He holds an MBA in finance from the University of Michigan.
