An article in The Economist's September 29th - October 5th issue, has revealed the secrets behind Warren Buffet's stock picking prowess. Research by New York University and AQR Capital Management, a hedge fund adviser; say they have identified the main factors that have driven his success over decades.
Turns out there are two main factors. Buying stocks with a low beta and a cheap source of funds by drawing on the floats maintained by the insurance companies he owns.
It is a popular misconception that low beta equals low return. A good example is this excerpt from the investopedia.com
Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk. Read more: www.investopedia.com/terms/b/beta.asp#ix...
The economist article goes on to say that pension and mutual funds are barred from borrowing, so opt for higher beta stocks hoping for higher returns, making their portfolios more volatile. With funds chasing higher beta and ignoring lower beta stocks, the latter become under-valued and vice versa. So the astute Warren is using cheap money to buy undervalued stocks.
We thought we would do a test on the 986 stocks that we cover at OnlineSPX.com, beta range 0.17 to 2.93, and we have found it to be true. Lower beta stocks do out-perform their more volatile counterparts and we have found the optimum level, to draw the line. More on that later.
What was also interesting is what we found when we grouped stocks by our recommendation and their average beta.
Value Buys averaged a 1.06 beta, non-value Buys 0.96 and Holds 0.94, had an overall average of 0.99, so lower by .01 than the S&P500. These are stocks we like and like Warren we are leaning towards lower betas.
Sells 1.25 and *no opinion offered 1.39, had an average of 1.32. These two, for varying reasons, are not wanted, at least not by our modeling and the much higher beta would suggest Warren doesn't want them either.
* These stocks have a OnlineSPX.com safety rating (NYSE:SR) greater than 4, our cut-off point.
Now to our test. We took the 986 stocks, their respective betas and their *2yr ARR then sorted by beta low down to high. To smooth data, we ran a moving 200 over the ARRs. As the chart below shows, the average ARR constantly rises and began to accelerate once 1.00, the index average, was past and continued to rise more steeply after that. So there you have it, stocks with a beta lower than 1.00, all other aspects being satisfactory, are likely to be good additions to your portfolio.
* This Annualized Rates of Return (NYSE:ARR) period closely corresponds to the period we do our beta calculation over.