What's special about Buffett (and what isn't) - part 1

When economist Michael Jensen stepped onto the stage at a Columbia Business School conference in 1984, it wasn't his intention to discredit a former student. Jensen had been invited to speak on the occasion of the 50th anniversary of Security Analysis.

Authored by Columbia alumni Benjamin Graham and Graham Dodd, the book had become a bible of sorts. It argued that the market was focussed on the short term, sometimes mispricing the value of particular securities as a consequence, and that investors could take advantage by examining the underlying operating businesses. Where a substantial difference existed between estimated value and market price – a margin of safety – investors could purchase stocks cheaply, buying dollar coins for 50 cents.

The approach had its followers but it was hardly mainstream. Value investing was even less popular in academia than it was on Wall Street. Jensen for one wasn't a fan. In 1978 he had confidently stated that 'there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis (EMH)'. The theory, developed by Eugene Fama in the sixties, claimed that the price of an asset incorporates all of the information, obtained legally or otherwise, relevant to its value. Ergo, large-scale mispricings couldn't occur.

How then to explain Warren Buffett, who by this time had already carved out a reputation for beating the market over a few decades? Jensen had prepared well. The world was full of investors, so many in fact that every now and again one would deliver exceptional results, not through skill but sheer luck. Buffett was an ignorant but happy winner of a coin-flipping contest, a statistical anomaly, an outlier.

In truth, although it had its supporters, pockets of academia were reticent. The EMH was, after all, only a hypothesis, the point of which was to have other academics challenge it. But Wall Street was all over it like a cheap suit, not least because it meant the smartest guys in the room could forget about stock picking and get on with the new business of financial engineering. Why worry about stocks when it was more profitable to invent and flog new products notionally based on assets like them?

Even Ben Graham was somewhat persuaded: 'In the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.'

Graham and Doddsville

Graham's former pupil was having none of it. Mounting the stage after Jensen, Buffett delivered a paper called The superinvestors of Graham and Doddsville [highly recommended and well worth your time – Ed]. The paper detailed the market-beating performances of a number of money managers from the same 'intellectual village' as himself.

The rebuttal was clear – I might be a freak, the monkey that has bashed out the works of Shakespeare on a typewriter by accident, but what if there are more freaks like me, getting superior results, year after year – and what if we all used the same underlying approach?

The first person Buffett used to refute Jensen's position was Walter Schloss. 'He knows how to identify securities that sell at considerably less than their value to a private owner,' said Buffett, 'And that's all he does. He doesn't worry about whether it's January, he doesn't worry about whether it's Monday, he doesn't worry about whether it's an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me.'

Tom Knapp and Ed Anderson of Tweedy Brown Inc, Bill Ruane of Sequoia Fund, Charles Munger, Buffett's current business partner, and Rick Guerin were other examples. 'From 1965 to 1983' said Buffett, 'against a compounded gain of 316% for the S&P, [Guerin] came off with 22,200% which, probably because he lacks a business school education, he regards as statistically significant.'

Buffett's implied slight of academia was prescient. Despite his prolific and detailed examples professors failed to take the bait and moved on. The EMH held sway, especially over Wall St, which went off to lay the groundwork for the GFC with an industry built around what Buffett would later call 'weapons of financial destruction'. And the disciples of Ben Graham were left to carry on making money from situations that the models said couldn't exist. Until May 2012 that is, when the first draft of another academic paper, this time called Buffett's alpha, by Frazzini, Kabiller and Pedersen, was published.

Not an outlier

I'll admit to an inherent wariness towards the cult of Buffett, an expression of a quasi-religious tendency to place those we admire on a pedestal, often at the expense of our own capacity for rational decision making. This seems to be completely at odds with what Buffett himself argues – the primacy of independent thinking. For my liking, too many Buffett disciples express the same righteous self-confidence in their own positions as Jensen did in the EMH back in 1984.

One of the many good things about the 2012 paper is that it proves that Buffett is not merely an outlier – although it does that, but perhaps not for the reasons you expect. It also indicates that he is not quite as special as his fervent adherents might claim. In fact, in revealing the analytical techniques and mental processes, identifiable and replicable by anyone, to produce market-beating returns that the EMH cannot account for, Buffett isn't a Messiah, although to paraphrase Monty Python, he is 'a very naughty boy'.

In part two we'll identify the key factors in the research that investors can replicate and those advantages that Buffett has that we don't. Lastly, we'll discuss the one key factor that top investors possess that the research doesn't address. Watch out for it.