If you’re an investor in Berkshire Hathaway Inc., your performance need not suffer when Warren Buffett stops running the company.
That’s according to researchers who claim to have created a stock-picking algorithm that, in back tests, performed just as well as Berkshire Hathaway.
The existence of this algorithm is important for at least two reasons. Perhaps the most obvious is that Buffett, who will be 92 years old in August, won’t be picking stocks forever. Followers of his approach urgently need to know what to do when he no longer is doing so.
At last year’s annual Berkshire meeting, Buffett indicated that he has chosen Greg Abel, currently a vice chairman at the company, to be his successor. In a 2013 video message, Buffett said Abel is “a first-class human being. … There’s a lot of smart people in this world, but some of them do some very dumb things. He’s a smart guy who will never do a dumb thing.”
To the extent you have confidence that the company’s stock picking under Abel’s leadership will be just as good as it has been under Buffett, then your response to Buffett’s stepping down might be to simply stay the course.
But there’s another reason it’s important to know that Buffett’s stock picking approach can be replicated: Berkshire Hathaway is so huge that neither he nor Abel can be bothered even considering the smaller companies that otherwise would attract their attention.
Though these smaller-cap stocks’ potential is typically greater than for the largest-cap stocks, their size prevents them from contributing much more than a rounding error to Berkshire Hathaway’s bottom line.
This second reason suggests it may be possible in coming years to not only do as well as Berkshire Hathaway, but perhaps do even better — regardless of how long Buffett remains the company’s CEO.
The researchers who “broke Buffett’s code,” all with strong academic credentials, are principals at AQR Capital Management: Andrea Frazzini, David Kabiller and Lasse Pedersen. Their study reporting this algorithm appeared in the Financial Analysts Journal in 2018, titled “Buffett’s Alpha.” (A request for comment about this study from Berkshire Hathaway was not immediately answered.)
The specifics of the algorithm that the researchers derived are complex, and interested readers should consult the study for a full description. In general, the algorithm focuses on what might be called “cheap, safe stocks” — those with low price-to-book-value ratios, have exhibited below-average volatility, and are from companies whose profits have been growing at an above-average pace and which pay out a significant portion of their earnings as dividends.
The proof of the pudding, of course, is in the eating. The researchers’ study first began circulating in academic circles in late 2013, and I wrote a column about it in December 2013. I specifically mentioned an AQR mutual fund as perhaps the one that most closely follows the researchers’ algorithm — the AQR Large Cap Defensive Style Fund
Since then, it has very closely matched Buffett’s performance, gaining 13.1% annualized versus 13.5% for Berkshire Hathaway
To illustrate the kind of stocks that satisfy the algorithm, the following are those from within the S&P 1500 index that satisfy a number of the algorithm’s specific criteria: Each has a below-average price-to-book ratio, a below-average beta, above-average profitability, an above-average five-year growth rate of its profitability, and an above-average dividend payout ratio. (All data courtesy of FactSet.)
The 16 stocks that survived this winnowing process are listed below, in alphabetical order:
American Vanguard Corp.
Cato Corp. Class A
Comcast Corp. Class A
DENTSPLY SIRONA, Inc.
Edgewell Personal Care Co.
FirstCash Holdings Inc.
Juniper Networks Inc.
Matthews International Corp. Class A
Newell Brands Inc.
Resources Connection Inc.
Walgreens Boots Alliance Inc.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org.