Want to invest like Warren Buffett? It’s not just about employing value investing principles, according to new academic research.
In a new paper entitled “Buffett’s Alpha: Further Explanations from Behavioral Value Investing Perspective,” published this month by scholars at the University of New Brunswick and the Mount Saint Vincent University, the authors attempt to use academic measures to explain how qualitative factors — particularly behavioral ones — led to Buffett’s legendary successes.
The paper’s authors, Eben Otuteye of the University of New Brunswick and Mohammad Siddiquee of Mount Saint Francis, analyzed the conclusions of a 2013 academic paper that found that Buffett’s legendary track record came down to an adherence to value investing principles coupled with leverage to amp up returns. Otuteye and Siddiquee argue that the 2013 paper, entitled “Buffett’s Alpha” and written by three AQR Capital Management executives, missed important qualitative behavioral factors — such as patience, contrarian views and rationality — that Otuteye and Siddiquee claim are the “primary forces” driving Buffett’s investment decisions.
“It is clear that Warren Buffett’s investment and management success is extraordinary,” the authors write.
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However, explaining that success cannot be done by using a traditional capital asset pricing model, as the 2013 paper did, the report’s authors argue. Otuteye and Siddiquee say the capital asset pricing model “missed important behavioral elements.” Instead, nine qualitative factors are what sets Buffett’s method apart from traditional value investing, they argue.
Among them is the structure of Buffett’s investment company, Berkshire Hathaway. Buffett is the CEO and chairman of the board, a rarity among large corporations, according to the paper. This centralizes allocation decisions for Berkshire Hathaway.
Similarly, the “collection of good businesses” under the Berkshire Hathaway umbrella is another advantage according to the paper, which helps Buffett achieve high returns on a regular basis.
Buffett’s allocation of capital at Berkshire Hathaway, rather than simply his stock picking skills, is another major positive, the authors argue. The company allocates capital to operating executives at its portfolio companies, which in turn leads to higher returns, as these executives can manage those smaller businesses more effectively.
The company also has “an acute understanding of what is materially relevant in GAAP [Generally Accepted Accounting Principles] accounting,” the authors contend. They add that while they agree with some of the factors the “Buffett’s Alpha” authors used to explain his success, they have “serious reservations” about the thesis that lots of leverage — in Buffett’s case, borrowed money, insurance float (the difference between premiums collected and claims paid out), and the writing of put options — was a major contributor. Otuteye and Siddique argue that, for a variety of reasons, Berkshire “does not solely depend on float or leverage as the academics will say.”
Other things that set Buffett apart from other value investors, according to the researchers, are behavioral factors including knowing his own limits, or his “circle of competence.” He takes his time to find an investment he understands, the paper notes. He is also patient, contrarian and rational, the authors say.
Finally, Buffett is able to acknowledge his errors — and does so frequently. “Unlike many managers, Warren Buffett will publicly acknowledge his mistakes,” the authors note.
The authors acknowledge their paper’s own limits, in part a result of the few academic studies on Buffett’s investing style.
“There are so many books and articles written about Warren Buffett in the popular press,” they write. “However, despite his stellar performance record, Warren Buffett and his approach to investment is largely absent in standard finance or economics textbooks.”
There are likely far more qualities that set Buffett apart from other investors, but as the report notes, “a good starting point is to acknowledge the relevance of these behavioral factors.”
