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The secret to Buffett’s success?

A recently published academic paper titled Buffett’s Alpha by Frazzini, Kabiller and Pedersen claims to discovered new insights into famed investor and billionaire Warren Buffett’s investment style. Unlike much of the published analysis and commentary about Buffett, which is primarily qualitative in its appraisal, Frazzini, Kabiller and Pedersen “seek the answer via a thorough empirical analysis in light of some of the latest research on drivers of returns.”

The findings

The authors focussed on Buffett’s record at Berkshire Hathaway (NYSE: BRK.A) from 1976 and found that: “Buffett’s returns can largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks.”

Turning first to the finding regarding the use of leverage, the study estimates that on average Berkshire Hathaway has had leverage of roughly 1.6:1. This would suggest that the GEICO Insurance purchase was really one of the most important purchases Buffett ever made. This purchase alone gave Buffett access to literally “free” money in the form of insurance float – a primary source of the leverage described.

Secondly, the study found that buying cheap, safe, quality stocks is a key to his success. It’s worth repeating the authors’ definition of safe – stocks with low beta and low volatility — and cheap – value stocks with low price-to-book ratios and high quality, meaning stocks that are profitable, stable, growing, and with high payout ratios.

It is also worth noting that the study determined that Buffett’s ability to buy a bargain through publicly traded stocks versus private companies was an important contributor to his outperformance and where Buffett’s major advantage lies.

Will there be another Buffett?

That is of course a hard question to answer, however given human nature to keep evolving, expanding and learning it’s certainly quite possible. An obvious place to look for the next Buffett of Berkshire Hathaway is companies that are structured in a similar way.

Comparing any investor or company to Buffett is fraught with danger, however there are a few companies that offer ‘glimmers’ of a Berkshire Hathaway. Wesfarmers (ASX: WES) has a conglomerate structure and an enterprising nature that allows it to invest wherever it sees an opportunity. It also has an insurance division that is expanding and could potentially give it a GEICO-like attribute.

There are also investors who share a similar philosophy and approach to investing as Buffett. Hamish Douglas at Magellan Financial Group (ASX: MFG) is one investor who stands out. Douglas’ track record is of course much shorter that Buffett’s; however since the inception in 2007 of Magellan’s flagship fund, Magellan Global, the fund has achieved returns of 9.64% per annum, an outperformance against its benchmark of 9.62% per annum.

Foolish takeaway

Having attributes similar to Buffett or Berkshire certainly doesn’t mean the same outstanding returns can be achieved. As the study points out there are a number of unique aspects to the Buffett-Berkshire set-up which have all played their part in achieving the exceptional returns.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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