Almost no one has emulated Berkshire Hathaway chairman Warren Buffett’s success, despite the masses of books out there that purportedly explain how to do so. This is one of the great paradoxes of investing. In fact, the paradox is deeper than it seems.
Economists at AQR Capital Management have found that Mr Buffett is not actually a great stock picker. They show that the sorts of shares he prefers – safer dividend paying stocks with a proven track record – tend to do as well as the actual ones he buys.
So how does he do it?
Buffett’s success lies in having the right strategy, rather than picking shares brilliantly within that strategy. Anybody who uses stock screens should therefore be able to copy him. So why don’t they? One reason is that Buffett has something most of us don’t – an insurance company. This has allowed him to borrow very cheaply: in effect, he collects insurance premiums today but pays out claims later. This is a kind of loan.
There is also something else he has which most of us don’t – discipline. He has stuck to his principles of investing in safe quality stock even in bad times, such as during the tech bubble of the late 1990s when those shares fell out of fashion. This meant that he made big returns when those stocks returned to favour.
The need for self-discipline
Many investors lack this self-control. They get disheartened by losses and therefore sell when stocks are unusually cheap. Or they start by investing in proven value shares but get tempted by speculative plays. Or they get carried away by herd thinking and so buy near the top of bubbles. Buffett has said discipline and the “right temperament” are more important than IQ when it comes to investing.
Sticking to your principles is only a good thing if your principles are correct. And here lies another of Buffett’s advantages over the average investor. As his colleague Charlie Munger has said, “we know the edge of our competency better than most.” This pair stick to what they know, and avoid what they don’t.
Access to the right knowledge
Which poses a question: what do we know about equity investing? Here are three things. First, there are very few types of stock that do beat the market on average over the longer run. These are: momentum; defensives; value; and quality. They are defined by objective factors such as past growth and pay-out ratios.
Of course, financial researchers claim to uncover other categories of share. But many of these findings are only temporary or actually spurious. As Campbell Harvey, a professor of international business at the US’s Duke University, has said, most such findings are “likely false”.
Secondly, speculative stocks – such as those on low or no dividends – under-perform on average. This could be because investors pay too much for lottery stocks – those with a (slim) chance of fast and substantial returns. Or it could be because they overestimate their ability to spot future growth, and think corporate growth is more predictable than it really is.
Sound and fury signify nothing
And thirdly, most of what you see in the stock market is noise, not signal. Day-to-day price moves tell us nothing. Pundit opinions have virtually no predictive power.
There’s a simple implication. If you must pick stocks – and there is nothing much wrong with just holding tracker funds instead – then stick to a few well established themes, such as defensive value stocks. Success in investing is mostly about having the discipline to do nothing for long periods of time.