Warren Buffett is one of the few investors who have consistently outperformed over a 20+ year period. There are plenty of investors and traders who massively outperform over a 10-20 year period. Believe it or not, you can get lucky in the markets over 10-20 years. Various strategies work well over 10-20 years for no reason other than luck, and then work poorly after that. Many successful hedge fund managers just so happened to stumble across a strategy that works well over 10-20 years. That’s why they have 10-20 years of great performance, make a name (and billions of $’s for themselves running other peoples’ money), and then perform poorly for the next 10-20 years.
Warren Buffett’s long term, sustained outperformance means that there must be a solid reason as to why his trading strategy is so good.
Moreover, I never understood why Warren Buffett bought Berkshire Hathaway until now. Warren Buffett ran one of the world’s first hedge funds until the 1970s. As a hedge fund, he took a big percentage of his investors’ profits. But in the 1970s, Buffett closed his hedge fund and bought Berkshire Hathaway. Now, investors could buy Berkshire Hathaway and perform as well as Warren Buffett himself, without paying Buffett any performance or management fees.
This doesn’t make sense from Warren Buffett’s perspective. Why let other people ride your coattails for free, when you can charge them via a hedge fund structure?
Reading Buffett’s Alpha, this has all become crystal clear. I suggest you read this study.
Buffett’s real strategy
Buffett portrays himself as a folksy American hero.
Buy and hold value stocks over the long run.
Nothing fancy. Nothing special. No trading around positions.
In reality, Buffett’s outperformance comes from much more than just “buy and hold value stocks”
*We measure “outperformance” as Buffett’s excess returns against buy and hold for the S&P 500.
A slight performance boost – value & quality (safe)
Buffett outperforms the S&P 500 a little bit by buying cheap, high quality value stocks. He doesn’t necessarily buy “small stocks”.
3 factors are well-known to outperform:
- Value (cheap value stocks perform better than expensive growth stocks)
- Quality (safe stocks tend to perform better than risky stocks)
- Size (small cap stocks tend to outperform large cap stocks)
Buffett applies “value” (cheap stocks) and “quality” (safe – low leverage, low volatility). He doesn’t apply “size” the way he used to in the 1950s and 1960s because Buffett himself has grown too large.
The study Buffett’s Alpha demonstrates that stocks with “value characteristics” outperform in general – it’s not just the stocks that Buffett buys. This means that much of Buffett’s success in value investing comes not from his stock picking abilities, but from the fact that value “works” in general.
High quality, value companies have:
- Low earnings volatility
- High profit margins
- High asset turnover
- Low leverage
- Low specific stock risk (e.g. management turnover risk).
These stocks outperform the broad market, especially during bear markets (these stocks fall less than the broad stock market).
*I’m not sure how well this will work in the future. Value outperformed from the Great Depression – the 1970s. Growth has outperformed from the 1980s – present.
*Value opportunities will become harder and harder to find because the level of competition in the finance industry is much higher than in the past. In the decades after the Great Depression, public interest in the stock market was low, which means that there were many hidden value gems. But with information flowing at a much faster rate (thanks to technology) and much more competition in the financial industry, value opportunities are much harder to find. It’s like arbitrage – the more competition and people there are looking for these opportunities, the more these market inefficiencies get knocked out. Investing in stocks did not really become mainstream until the early-1980s.
We don’t focus on value investing and stock picking here at Bull Markets. To achieve Buffett’s slight outperformance over the S&P 500, we can avoid bear markets and trade the NASDAQ. The NASDAQ outperforms the S&P in the long run. More on this later.
Decrease volatility and drawdowns
Warren Buffett picks value stocks not only because these stocks slightly outperform the S&P in the long run, but also because these stocks are less volatile than the S&P 500 during big corrections and bear markets.
The importance of this will soon become apparent.
We can decrease volatility by sidestepping bear markets and economic recessions using fundamental data.
Buffett’s secret – leverage
Believe it or not, Buffett uses leverage in his investments. Specifically, he uses an average of 1.6x leverage. This gooses up his returns.
The S&P (including dividends) has yielded an average of 10% per year over the past 40 years. Buffett has earned an average of 20%+ per year.
Leverage accounts for a significant portion of his outperformance. In this case, 10% gets turned into 16%.
Warren Buffett’s leverage is extremely cheap and unique. A lot of it comes from his insurance companies. Buffett’s Berkshire Hathaway buys entire insurance companies for the insurance float. That insurance float = very cheap loans for Berkshire to use as leverage. Once again, I suggest you read Buffett’s Alpha for more details. According to the article, 36% of Buffett’s liabilities consists of insurance float with an average cost below the Treasury Bill rate.
Buffett alludes to this insurance float in his annual letter to shareholders.
In terms of using debt, this point is critical. You MUST separate each division of a conglomerate. That way if one division goes down, it doesn’t drag down the rest.
If anything, Warren Buffett’s life is a tale that explains the importance of patience & consistency. There are a lot of fly by night successes. There are a lot of famous investors and traders whose strategies and funds did well for 10-20 years, and then performed poorly thereafter. But very few of them consistently did well over 40+ years.
This table demonstrates Warren Buffett’s net worth by age. As you can see, 99% of Buffett’s net worth came after age 50. That’s the magic of compounding. Compounding takes TIME.
When investing/trading, TIME is the most important factor. Successful investing/trading is about:
- Finding a GOOD strategy (you don’t need the BEST strategy)
- Stick to that strategy over a long period of time.
The first part is relatively easy.
The second part is hard.
In order to stick to a sound strategy over the long term
- You need the emotional fortitude to stick to your strategy (i.e. not panic and abandon your strategy when it is performing poorly.)
- You need the CAPABILITY (financial and structural) to stick to your strategy
Good investors and traders accept the fact that their strategy will go through ups and downs. Only when you stick with a strategy through the downs, will you experience the ups. You cannot have the ups and avoid all the downs. Life doesn’t work that way. Every strategy will inevitably lose money at some point. What matters is how well a strategy does in the long run.
Many investors and traders rethink and retreat from their original strategies when they experience the downs. That hurts them in the long run. Even Warren Buffett had many big losses.
Warren Buffett’s first big loss was in 1974, when he lost -49% in the bear market of 1973-1974. After that, he had several major losses as well.
When Warren Buffett says “if you can’t stomach a -50% drawdown, you shouldn’t be in the stock market”, Buffett means it. He has gone through several -50% drawdowns himself, mostly around the broad stock market’s bear markets.
Everyone is trying to avoid pain (smooth returns) and outperform. Life doesn’t work that way. Great entrepreneurs “eat shit”, the same great investors and traders do. You can dampen the losses, but you cannot avoid losses altogether.
Let’s examine the second point. In order to stick to a sound strategy over a long period of time, you need to avoid fire sales.
Fire sales can come from a personal finance problems.
Let’s assume that you have a sound strategy, and your strategy is down -30% right now. If your personal finances are strong, you can ride through the storm and watch your portfolio recover. If your personal finances are weak and you need cash NOW, you will need to sell your portfolio at the bottom of the market.
Fire sales can come from your business structure. This is a problem that hedge funds face but Warren Buffett’s Berkshire Hathaway doesn’t. If a hedge fund experiences 1-2 years of poor returns, it’ll face massive redemptions because its investors panic. Hedge fund investors will redeem their money at the worst time possible, just when the hedge fund is about to outperform. In other words, the hedge fund’s investors FORCE a fire sale.
Buffett doesn’t have this problem. As a corporation, Berkshire Hathaway never needs to sell losing positions just to acquire cash for investor redemptions, because investors can never redeem their capital from Berkshire Hathaway. The only way for investors to take their money out of Berkshire Hathaway is to sell Berkshire stock, which has no impact on Berkshire’s capital.
Here’s an example. Berkshire Hathaway fell 44% from 1998 – 2000 while the broad stock market increased more than 30%+. This is because Buffett’s strategy – value investing – performed very poorly those 2 years. His strategy is sound over the long run. But like every strategy, it inevitably went through a period of underperformance.
Similar to Warren Buffett was Julian Robertson, founder of the famous Tiger Fund. Julian Robertson employed a similar value-driven strategy to Buffett.
Like Buffett, Robertson underperformed from 1998-2000. He was hit by massive investor redemptions, and had to close his fund. Buffett’s corporate structure allowed him to ride out the storm.
A strategy that works well over the long run is good. But the long run is made up of a collection of short runs that need to be dealt with. Buffett’s corporate structure enables him to handle short term periods of underperformance that may kill hedge funds and other investment structures.
In order to know that a strategy works well over the long run, you need to backtest it through an extremely long period of time.
Stocks and strategies that “seem” the best (have the highest sharpe ratios) tend to be around for only 10-20 years and have had a good run. While these strategies seem good, they are not. They have merely been lucky, and occurred in market environments that suit them. If you run those same strategies over 40+ years, you will realize that that the sharpe ratios and returns are widely different than advertised.
It seems that all great investors and traders use leverage to help them outperform in the long run. Even Ray Dalio’s great Risk Parity strategy uses leverage. (For more on risk parity, click here)
The trick to using leverage is that your returns need to be relatively stable. If you lose -50% without leverage, using 1.6x leverage will be a catastrophic -80% event.
You cannot use leverage if your returns are extremely erratic and volatile.
Warren Buffett accomplishes this by buying low beta stocks.
We can accomplish this by sidestepping economic recessions, which is when the worst stock market losses typically occur. This is where our fundamental understanding of the U.S. economy and stock market comes into play, as demonstrated through our trading models and Macro Index.
Simplicity is the ultimate sophistication
I have been reading the works of many famous quants. I’ve realized that it’s not hard to build an exceptional strategy that works great for 10-20 years.
A lot of these exceptional strategies are complicated. And they always inevitably blow up, or their outperformance greatly diminishes over time. This could be for a variety of reasons:
- Strategies that are complicated tend to be curve fitted. Or at the very least, they work well under 1 type of price action, and when the market’s price action changes, the returns for that strategy change as well. The stock market’s price action seems to change every 20-30 years, based on the technological and macro environment at the time.
- When other investors copy an esoteric strategy too much (especially short-medium term strategies), the strategy’s performance deteriorates. Too much competition in any market (not just stocks) drives down performance. That’s rule #1 of free markets.
In trading and in life, simplicity is the ultimate sophistication. Many people ignore good, simple strategies because they think “how can something so simple be so good?” They think that success must be complicated. It must come from a secret, complicated strategy that no one else knows. And because everyone ignores these simple yet logical strategies, that’s precisely why it works well.
Simplicity ≠ dumb.
Or as Morgan Housel puts it
Some good advice is simple but made complicated because professionals can’t charge fees for simple stuff.
The fact that you can’t charge fees for it is part of what makes it good advice.
In a way, it’s not their fault. The whole finance industry creates complicated strategies that sound great on paper, but most of which can’t even beat buy and hold in the long run. Why do they do this?
Because it’s great for marketing.
Hedge funds hire legions of PhD’s when you can easily replicate their returns with a simple strategy. These PhD’s are great marketing tools – it gives investors the impression that these hedge funds have the secret sauce that others don’t. Trading gurus create crazy complicated strategies whose returns you can easily replicate with simple strategies. Why? Because it’s great for marketing their business.
Think about this. Who’s subscription service would you subscribe to?
- Guru XYZ: “using our proprietary Elliot Wave Model that has 40 different proprietary indicators, you too can outperform”. (Strategy actually yields 8% a year).
- Guru ABC: “using this very simple strategy with 2 indicators that anyone can use, you too can outperform. (Strategy actually yields 10% a year).
Of course you could subscribe to Guru XYZ. Shit, “proprietary strategy”, “40 different indicators” – the guru must know something I don’t! He must have some secret sauce!
Why am I examining this
By examining other peoples’ trading and investment strategies, I want to see what works well over the long run. I want to know what investment and trading strategies are truly timeless.
More and more, I’ve come to realize that simple FUNDAMENTAL based strategies work well over the long run and are relatively consistent.
In order for a strategy to work over the long run, it must be based on a simple fundamental truth. It cannot be based on technical analysis or technical factors (e.g. “momentum”), which tends to deteriorate over time as the market’s price action changes.
For us, our fundamental truth is simple
The stock market moves in the same direction as the economy in the long term.
If you just avoid 1-2 major bear markets in your lifetime, your returns will outperform that of buy and hold and be more steady.
If you add some leverage, your returns would increase even more.
Simple truth. And follows a clear logic.
I will probably be starting a small hedge fund in approximately 2 years. I am not starting it now because I want to optimize the probability that the hedge fund starts off with terrific returns. No investment strategy makes money every single year. Fundamental based strategies have mixed (but not terrible returns) in the last year of a bull market.
That’s why I will start the hedge fund AFTER the next recession when the probability of the stock market surging is extremely high, instead of starting the hedge fund right now. That is the most optimal time to employ these fundamental driven strategies.
*For hedge funds, how they start is extremely important. A hedge fund that’s been around for a long time can easily weather 1-2 years of poor returns. But a new hedge fund will die if it experiences 1-2 years of poor returns because it doesn’t have an established brand name or track record. Investors will panic and redemptions will surge.