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Buffett’s alpha: secrets of a successful investor

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A new paper, 'Buffett's Alpha', claims to have identified the main factors that have driven Warren Buffett's extraordinary record in investment.

For more than 30 years, Buffett’s Berkshire Hathaway has delivered a better risk-adjusted performance than any other stock or US mutual fund.

The paper, written by researchers at New York University and AQR Capital Management, says Buffett’s success is partly down to how he has boosted his returns with leverage and has stuck to his strategy for the long term.

Buffett has survived very rough periods where others might have been forced into a fire sale or a career shift, according to the research.

“We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.

“His many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and its risk over multiple decades.”

Berkshire’s returns were also attributed to his focus on cheap, safe, quality stocks.

“This leaves the key question: how does Buffett pick stocks to achieve a relatively attractive return stream that can be leveraged? We identify several features of his portfolio.

“He buys stocks that are ‘safe’ (with low beta and low volatility), ‘cheap’ (value stocks with low price-to-book ratios), and high quality (meaning stocks that are profitable, stable, growing, and with high payout ratios).”

Such findings are in line with Buffett’s own remarks on stock picking, published in Berkshire Hathaway’s annual report in 2008: “Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down,” he said.

Buffett’s portfolio of public stocks performed better than private companies, suggesting the investor’s skill is mostly in stock selection.

However, the research found Buffett relies heavily on private companies such as insurance and reinsurance businesses, as this structure provides a steady source of financing, allowing him to leverage his stock selection ability.

“It cannot be emphasised enough that explaining Buffett’s performance with the benefit of hindsight does not diminish his outstanding accomplishment,” the paper said.

“He decided to invest based on these principles half a century ago. He found a way to apply leverage. Finally, he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies.”

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