How To Invest Like Warren Buffett

All you need to is to pick cheap stocks and have access to a very profitable insurance company or two.

Warren Buffett's $60 billion fortune that makes him the fourth richest man in the world has always confounded academics. About 98% of his wealth comes from Berkshire Hathaway, the holding company with a market capitalization of $286 billion. And a whole lot of that comes from stock picking — acquiring large stakes in publicly traded companies like Coke or American Express and taking companies private — and then beating the market, a feat that consensus academic economists says is, at best, very difficult or usually attributable to good luck.

But Buffett's performance has been too good to ignore. According to new research by a trio of economists, two of whom work for the hedge fund giant AQR, for any stock that has traded for more than 30 years between 1926 and 2011, Buffett's Berkshire Hathaway has the highest risk-adjustment performance of any of them. And the same with mutual funds. Berkshire best them all. "A dollar invested in Berkshire Hathaway in November 1976...would be worth more than $1,500 at the end of 2011," they write.

Similarly, his risk-adjusted performance in that period has been twice the stock market as a whole. Since 1990, according to data compiled by Bloomberg, Berkshire's "A-shares" have gone up 2518% while the S&P 500 has only advanced 776%, including dividends, which Berkshire never pays out. So how does he do it? Well, he's been telling people for years. And he's right.

Buy cheap.

In a 1984 speech, later published, Buffett explained that a group of investors who followed the basic principles of Benjamin Graham, who was Buffett's professor at Columbia Business School and probably the most famous stock analyst of all time, had consistently beat the S&P 500 throughout their investing careers. That they all followed a similar strategy suggested that something larger than luck was at play. The basic insight is to buy stocks that are "cheap," meaning that the assets of the company are more valuable than the stock of that company and whose stock prices didn't jump around too much.

What's interesting is that the three researchers found that the stocks Buffett picked didn't matter so much as just applying the strategy of buying any large collection of safe and cheap stocks over a long period of time. "Buffett's genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work," they write.

But this strategy means sitting out on any high growth, headline-grabbing companies. Buffett famously does not invest in technology companies — which tend to be highly volatile and have market values that are almost entirely based on future growth (like Twitter, which isn't even profitable but worth $22 billion) — even passing up an opportunity to invest in Intel when the company was founded in 1968. But sticking to the strategy has unambiguously worked for Buffett and his fellow value-investors, "a significant part of the secret behind Buffett's success is the fact that he buys safe, high-quality, value stocks."

Fund even cheaper (or: have a really good insurance company or two).

But while picking cheap stocks and holding on to them for a long period of time can give you solid results, it won't make you $60 billion. For that, you need to get your money cheaply. Buffett does this by issuing very highly rated debt and by owning a gaggle of insurance companies, including the car insurer GEICO and the reinsurer General Re (it basically insures insurance companies). When insurance companies issue policies, they are able to collect a stream of payments and then only have to pay out some of them over the life of the policy. In 2012, Berkshire had over $73 billion worth of insurance money to play around with. Many insurance companies actually lose money on writing insurance and have to make it back form investing their float, Berkshire on the other hand, has run an underwriting profit for a decade, giving the company what Buffett calls "better than free money."

So, instead of having to go out into the market and borrow all the money it needs to make investment, a huge portion comes from the insurance business — "Buffett's low-cost insurance and reinsurance business have given him a significant advantage in terms of unique access to cheap, term leverage. We estimate that 36% of Berkshire's liabilities consist of insurance float on average."

So can you do it?

Almost certainly not. You should probably avoid stock picking entirely. But if you find yourself in the possession of a money tree in the form of an insurance company, by all means follow in the path of the Oracle of Omaha.

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